Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13, 1994

Federal Reserve Bulletin, June 1994 | Go to article overview

Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13, 1994


I appreciate the opportunity to appear before you and present the views of the Federal Reserve Board on several topics related to hedge funds. These topics fall into three main categories, which correspond to the major points raised by the questions contained in your letter of invitation. First, what do we know about hedge funds and their activities? Second, what are the risks to banks that have exposures to these funds? Third, do the particular activities of hedge funds pose special risks for the markets in which they operate and the financial system more broadly?

DEFINITION AND CHARACITERISTICS OF HEDGE FUNDS

The Federal Reserve does not regulate hedge funds and does not have comprehensive information on their size or activities. Moreover,there is no formal definition of "hedge fund" that is universally accepted. Banks and other financial insitutions that deal with or monitor these entities have developed their own specific working definitions of the term. The definitions used by banks generally mention several elements in characterizing so-called hedge funds:

* an investment partnership or mutual fund that is unregulated;

* one that seeks high rates of return by investing or trading in virtually any form of financial instrument;

* an entity that may take long and short positions and invest in many markets:

* an entity that uses leverage;

* an entity whose manager's compensation is based on its financial performance.

A hedge fund might not exhibit all these characteristics all the tiem, and other financial institutions also exhibit many of these characteristics. Indeed, it is important to recognize that the activities of hedge funds are not fundamentally different from those of many other institutions.

Banks often distinguish between two categories of hedge funds. The first category consists of those organized by one or more individuals with particular trading philosophies such as Soros Fund Management, Tiger Management Corporation, and Steinhardt Management Company. The second category consists of funds that are advised by the proprietary trading desks of investment banks or internationally active commercial banks and bear a name linked to the advising entity.

So that managers of hedge funds can be free to use various trading strategies, and free to change those strategies quickly, the funds are structured to avoid the regulatory limitations on permissible assets, leverage, and concentration of assets that apply to other managed funds that are offered to the public. Hedge funds achieve their essential flexibility either by organizing offshore or by using the benefits of limited partnerships. For example, hedge funds may avoid registration as an investment company under the Investment Company Act of 1940 by restricting participation to fewer than 100 persons. In enacting the Investment Company Act, the Congress believed that these companies did not involve significant public policy issues and were not properly subject to federal regulation. The number of investors in hedge funds is also limited by their high minimum investments, typically from $25,000 to $1 million or more. Paticipation in some funds is further restricted to professional traders or persons with specialized knowledge of particular markets, regardless of their wealth.

There are currently hundreds of hedge funds. One market consultant specializing in hedge funds identified at least 800 hedge funds, up from about 100 in 1987, and others cite far higher number.(1) Other privately published directories of hedge funds indicate the Soros group of funds alone has about $9 billion of capital and the Tiger group has $6.5 billion of capital (net asset value). A few fund families, therefore, have capital comparable to or exceeding that of some large U.S. commercial and investment banks. It should be noted, however, that although funds under the same management may share similar trading strategies, they are separate entities operating on their own capital. …

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Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13, 1994
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