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The world’s top hedge funds have hit back against plans by global regulators to restrict their use of borrowing to finance trades, which the investors say has been wrongly blamed for recent financial market wobbles.
Bodies representing big hedge funds — including Izzy Englander’s Millennium Management, Ken Griffin’s Citadel, Paul Singer’s Elliott Management and Cliff Asness’s AQR — have attacked proposals by financial policymakers to limit how much leverage they take on and force them to be more open about it.
The lobbying offensive sets up a showdown between some of the most powerful investors in markets and the world’s top financial regulators over the rapid growth of hedge funds and other forms of alternative finance outside the traditional banking sector.
Central bankers and regulators have identified hedge funds and other non-bank actors that make heavy use of leverage but enjoy lighter regulation than banks as one of the biggest risks to the financial system.
Hedge funds use leverage to boost returns. One of the most controversial hedge fund trades, the Treasury basis trade, involves taking a short position on Treasury futures while borrowing money from a bank to take a cash Treasury position, in effect betting that the prices of the two products will converge. By levering both sides of the trade, hedge funds can magnify what would ordinarily be minuscule gains.
Global regulators have warned that if a highly leveraged trade like the basis trade collapses, it could affect Treasury prices and rattle global markets.
The Financial Stability Board, which brings together top finance ministers, central bankers and regulators to co-ordinate policy, has proposed a range of measures to clamp down on leverage at hedge funds and other non-bank groups.
However, hedge fund bodies attacked these proposals in letters to the FSB this week, seen by the Financial Times, which warned the regulatory clampdown was misplaced and would backfire with the risk of making markets more vulnerable to stress.
“Applying a regulator-conceived artificial limit on leverage would do more harm than good,” said Jillien Flores, head of government affairs at the Managed Funds Association, which represents the biggest hedge funds. She said such moves were likely to “introduce unnecessary friction and reduce efficiency and liquidity in the markets”.
Flores said 1,000 alternative asset managers closed every year “all without raising systemic concerns”, adding they were “less leveraged than banks and hold more liquid assets, reducing their liquidity risk” so they should not be subject to the same rules as banks.
Jiří Król, deputy head of the Alternative Investment Management Association, criticised the FSB for “trying to fit anecdotal evidence to theoretical hypotheses” and said the market stress events blamed on hedge funds “do not support this assertion”.
Both groups rebuffed the FSB’s plan to force hedge funds to disclose more detail on their leverage to banks and other counterparties. The MFA warned that disclosing “otherwise confidential investment positions” would allow “copycatting” by rivals to mimic a fund’s strategy.
The most common way for hedge funds to make their trades is through a prime brokerage relationship with a large bank. Banks lend to hedge funds by making stock purchases for instance while demanding an amount of margin from the hedge fund corresponding to the perceived risk, in effect lending to the hedge fund.
Critics argue that because of hedge funds’ close lending relationships with banks, blow-ups can spill over into the banking sector and risk triggering another crisis. The default of family office Archegos in 2021 caused billions of dollars in losses at banks, including Credit Suisse.
Authorities show little sign of backing down from their plans. “The presence of leverage can create vulnerabilities, especially when it’s poorly managed, there’s a lack of transparency, or it is concentrated,” said Sarah Pritchard, executive director of the UK’s Financial Conduct Authority, in a speech this week.
“In those cases, when a shock occurs, what normally brings benefits to the economy can suddenly become an amplifier of instability and a cause for loss of confidence,” said Pritchard, who is also co-head of the FSB’s working group that co-ordinated its proposals. “For regulators, that’s a real concern.”
