25 February 2008

GAO report on Hedge Funds

The US Government Accountability Office released a report on Hedge Funds. The use of multiple prime brokers as service provider by most large hedge funds may limit the effectiveness of market discipline or illustrate failures to properly exercise it, the report finds, because  no one broker may have all the data necessary to assess the total leverage of a hedge fund client.

The report describes how federal financial regulators oversee hedge fund-related activities under their existing authorities. It examines what measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds, and explores the potential for systemic risk from hedge fund-related activities and describes actions regulators have taken to address this risk.

SEC, CFTC, and federal bank regulators, can provide direct oversight of registered hedge fund advisers under the existing regulatory structure. However, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing. Market participants suggested that not all investors have the capacity to analyze the information they receive from hedge funds.

Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk. These factors can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets.

Financial regulators and industry participants remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk.

GAO report

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