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Committee on Financial Services

United States House of Representatives

Archive Press Releases







Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises





MARCH 3, 1999

Mr. Chairman, Mr. Ranking Member, Mr. Committee Chairman, Mr. Committee Ranking Member, and Distinguished Members of the Committee: I was thrilled that you invited me to today’s hearing and immediately accepted the invitation. I applaud your efforts to learn more about the operations of hedge funds and their role in the financial system. I represent Paloma Partners Company L.L.C., which is the manager of several private investment funds that primarily employ relative-value strategies. I believe that I can offer a hedge fund’s perspective on the recent period of market turmoil, which led to the much-publicized near-collapse of Long Term Capital Management. Today, I plan to offer three recommendations in response to proposals that some have suggested in the aftermath of the Long Term Capital debacle: first, that government not undertake any additional regulation of hedge funds; second, that no arbitrary limits be placed on leverage; and third, that, although market self-discipline is the best regulator, government should continue its practice of providing guidance to business.

Many misperceptions of hedge funds have developed recently. In fact, hedge funds play a positive role in maintaining the smooth operation of the financial markets. Hedge funds enhance market liquidity, helping to absorb economic shocks in times of high volatility, which might otherwise cause market crises. The added liquidity makes markets more stable, and, therefore, high volumes of buying and selling, cause less market-price fluctuation. A more-liquid market also has smaller bid-ask spreads, which result in lower transaction costs. Hedge funds create liquidity by taking the side of a trade that others do not want. They are the buyers when there are only sellers and the sellers when there are only buyers. Hedge funds search out assets whose prices are temporarily out of line with fundamental values, helping to re-establish the true market value of securities, by selling short an overpriced instrument and buying an underpriced one. In short: they help make financial markets more efficient. More-efficient markets reduce the cost of capital to issuers of securities, as prices more accurately reflect underlying values.

To say that hedge funds are not subject to any regulation is quite misleading. Hedge funds and their affiliates are not only subject to direct government regulation, but they are members of self-regulatory organizations. For example, if a fund uses any futures contracts as a hedging mechanism, it acts as a commodity pool, and its operator is subject to regulation by the Commodity Futures Trading Commission. Many funds are structured to trade through their own broker-dealers, which are subject to oversight by the Securities and Exchange Commission. The regulations of the Federal Reserve prescribe margin rules for stocks. Commodity pool operators are members of the National Futures Association, while broker-dealers subject themselves to the scrutiny of the National Association of Securities Dealers. Moreover, hedge funds are indirectly subject to regulation through their creditors that are subject to direct regulation on how they can do business with those funds.

Nonetheless, it is important to remember, when one discusses the role of hedge funds in the financial markets, that there is no established definition of a "hedge fund." Today, the term generally is used to describe any private investment fund, whether it employs "hedging" strategies, or not. Therefore, it is difficult, if not impossible, to make general statements that would apply to all, or even most, hedge funds.

The recent stereotype of hedge funds has been based on Long Term Capital Management. In fact, Long Term Capital is unique in the world of hedge funds. Few hedge funds either use as much leverage, or have as much capital, as Long Term Capital did. This massive combination of both unusually large amounts of capital and leverage was unprecedented the hedge-fund world. Furthermore, there are many categories of hedge funds, and each has different strategies, risks, and potential rewards. Even within one category, funds use a variety of strategies. For example, relative-value funds’ strategies include convertible-bond, statistical-equity, and fixed-income arbitrage (for details, see Appendix I). Moreover, bank exposure to Long Term Capital was unusual, as the Office of the Comptroller of the Currency stated in its recent bulletin on Risk Management of Financial Derivatives and Bank Trading Activities. It wrote that creditors’ "normal risk management standards were compromised" as a result of "placing too much reliance on assumed financial strength and reputation and too much emphasis on meeting competitive pressures."1 Long Term Capital also may have had cross-default agreements in place with its counterparties, whereby if it had defaulted on one loan or derivative contract, it could have triggered defaults on other loans and contracts with other counterparties. Long Term Capital’s creditors may have been forced to re-capitalize it to prevent this from happening.

Because of the problems that Long Term Capital faced, there has been a call to regulate hedge funds further. After all, we ought to blame someone; who is better than the rich perpetrators who were "gambling" with other people’s money? Unfortunately, this view fails to make the distinction between gambling and the type of "risk absorbing" financial speculation necessary to keep our markets efficient. Economist Dr. Aaron Levine has pointed out:

[The basis for] objection to gambling is that this activity does not contribute to the welfare of society…Unlike gambling, many forms of speculative activity have socially useful purposes…One of the most common forms of speculative activity today is trading in stocks and bonds…These exchanges promote vital economic function…Business units raise capital for the purpose of financing plant, equipment, tools, and inventory by issuing securities in the primary, or over-the-counter, market. Stock exchanges provide a secondary market for these securities. Sales in the primary market are facilitated by a dependable secondary market in which any holder of a security can resell his stock or bond at a fair price. Moreover, the auction nature of the securities markets provides an efficient method for allocating funds among competing sectors in a free economy. Since widespread and informed participation in the stock exchanges enhances the markets' capital-formation and capital-rationing functions, speculative activity in these markets contributes to their efficient working.2

As I described earlier, hedge funds play a uniquely beneficial role in the financial markets. If the government further regulates hedge funds, it, in turn, will be regulating the flow of liquidity and, hence, may interfere with the efficiency of the markets, causing the public and investors, in particular, to be worse off. This is a compelling argument for government not to get involved any further.

The most-likely outcome of any significant additional regulation of hedge funds in the United States is that they would be driven offshore to countries where that regulation does not exist. To be effective, any regulation would have to be coordinated worldwide. Even then, as experience has shown, some small country inevitably will open up its laws to welcome all the business associated with providing an unregulated home.

Some have said that hedge funds are doing terrible things to the economies of "good" countries, for example, destroying the value of currencies. There is substantial evidence to the contrary, however. As reported in the The Economist, a study published by the National Bureau of Economic Research found no correlation between hedge funds’ positions in Asian currencies and past, current, or future moves in exchange rates. 3,4 The study examined the Malaysian ringgit crisis in particular, and found no evidence that any hedge-fund manager contributed to that crisis. Furthermore, the International Monetary Fund recently published a study that found that, in general, hedge funds make financial markets more stable, not less, and that macro hedge funds are not to be blamed for currency crises.5 Hedge funds have been the messengers delivering the news that certain countries’ currencies were overvalued, but the cause of that overvaluation was the policies of the countries themselves.

By propping up overvalued currencies, governments wasted an enormous amount of public money trying to undo the judgement of the market. In contrast, no public money was used to prevent Long Term Capital from collapsing. As William J. McDonough, President of the Federal Reserve Bank of New York, explained in his testimony before the House Committee on Banking and Financial Services last October, it was "a private-sector solution to a private-sector problem." We applaud the efforts of the Fed in providing guidance to the private sector. This was not a "bailout" of investors: their interests were reduced to ten cents on the dollar. If anything, the fund’s creditors bailed themselves out of trouble.

So what went wrong last September? The popular scapegoat is leverage. The majority of hedge funds, however, use leverage to a prudent degree. Moreover, since the troubles of Long Term Capital, many hedge funds, some voluntarily and others under pressure from their investors or lenders, have decreased their leverage, and refocused their trading on strategies that rely less on leverage. Put another way, the market has already addressed the problem, and, therefore, it is unlikely to happen again.

It would be highly unwise to regulate "leverage," as such, any further. The amount of leverage that is prudent in any case depends entirely on the type of trade. Basic economics teaches that higher potential return is accompanied by higher risk. Therefore, very low-risk trades usually have lower profit margins. In those lower-risk trades, leverage is used to magnify the profit (see example in Appendix II), which then increases the risk.

To make a profit, however, a fund must have the power to stay in a position until the spread converges. On an interim or mark-to-market basis, a trade might record losses if the spread irrationally widens, before narrowing. Thus, a problem may occur if the fund does not have this "staying power." Last Fall, for instance, funds may have been forced to liquidate positions at a loss to harvest cash. That cash might have been needed, for example, to prepare for investors’ year-end redemptions. In contrast, other financial institutions probably could have held on to their positions, because they do not face year-end redemptions. If they had been able to hold on to those positions long enough, those funds most likely would have made the expected profit.

In fixed-income arbitrage, funds should employ leverage based upon their tolerance for how much money could be lost on a mark-to-market basis. Although fixed-income opportunities such as the one described in Appendix I are not that frequently available, it effectively illustrates the types of trades in which larger amounts of leverage would be reasonable.

Market-neutral hedge-fund strategies, like those Long Term Capital used, generally have a very low probability of an enormous loss, and a very high probability of a small gain. These probabilities are similar to those faced by a property- or casualty-insurance company, or a bank that makes loans. These businesses also have a very high probability of a small profit, from premiums or interest and fees, and a very low probability of a large loss, in case of a catastrophe or major default, respectively.

It is important to remember that risk-management systems do not attempt to eliminate risk, but instead help to determine which risks are appropriate to take, given the probability of loss. One of the lessons that has been learned from Long Term Capital’s difficulties is that it is possible that the risk-assessment models of some hedge funds and creditors alike failed to place enough weight on the possibility of a low-probability, catastrophic or high-stress event such as the world-wide liquidity crunch that occurred last Fall. Sometimes, it seems that an event that people believe will happen as infrequently as a "100-year flood" actually happens every ten years. This happens because a 100-year flood does not mean a flood that happens every one hundred years, but, instead, a flood that has a one-in-100 probability of happening in any given year. Therefore, just because a flood happened one year, does not make it any less likely to happen in the next year.

Creditors and hedge funds are constantly working to improve their risk-assessment models. It is impossible for any equation to model every possible risk, in the case of extreme market conditions. As creditors and hedge funds modernize their risk-assessment policies, including improved stress testing and other means, they will have a better understanding of the impact of the use of leverage in each strategy.

Now that one understands the potential for a 100-year flood, should leverage be regulated, "just in case?" In fact, this already occurs. Last October, before the House Committee on Banking and Financial Services, the Honorable Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, testified that hedge funds already are regulated, indirectly, through the financial intermediaries that lend to them. Creditors seem to have made some errors in their lending practices to hedge funds, and may need additional guidance, but not regulation, to prevent this from happening again. The Federal Reserve, the Office of the Comptroller of the Currency, and the Basle Committee are most qualified to assess what that additional guidance should be. After reading their reports, I agree with their conclusions.

It seems that some creditors limited their risk assessment to credit exposures, without fully considering the contingent liabilities in derivative financial instruments (see Appendix III for discussion of measuring the risk in derivative financial instruments), which are not recorded on the balance sheet and are inherently leveraged. Because the market is such a harsh disciplinarian, however, it is a mistake that the creditors are unlikely to repeat.

Lenders also may have placed too much reliance on collateral arrangements. The OCC cautions that collateral itself poses market risks, saying, "banks can face potentially significant unsecured exposure in their trading and derivatives activities…because of the existence of loss thresholds or when disorderly market conditions create uncertainty regarding both collateral values and contractual exposures."6 Furthermore, when lenders exercised their contractual right to demand more collateral and additional "haircuts"7 as the market value of collateral fell, they may have exacerbated the problem by forcing hedge funds to liquidate positions in illiquid markets to meet those demands.

Many creditors probably were unable to understand the full exposure of large hedge funds, because those funds spread their business among many lenders. Even if the creditors could see the full exposure of the funds, in many cases, lending officials may have been more accepting in their analysis of potential future exposure and credit-line management, because many other lending institutions were competing with them to do business with hedge funds. This "herd mentality" can be compared to the current trend of buying Internet stocks at inflated prices, without fully assessing or understanding the future of those companies in the market. And just as creditors are correcting past deficiencies in their relationships with hedge funds, last Wednesday’s Wall Street Journal reported that, with regard to Internet stocks, Wall Street firms have upgraded their systems to deal with plunging markets and stiffened trading limits to curb speculation.8 Often, self-regulation is the best therapy.

Although I am not advocating suitability standards for financial intermediaries, I wonder if, in some cases, officials in charge of credit decisions may not have understood all the risks involved in their transactions with hedge funds. For example, I doubt that all credit officials fully understand the highly-specialized strategies and risks involved in the convergence trading described in Appendix II. Therefore, although it would increase the cost of doing business, I would suggest that lending institutions add to their credit departments analysts who are familiar with the particular businesses of their borrowers. The recommendation of the OCC that "front, middle and back office personnel, as well as oversight units should be sufficiently staffed and trained to accommodate the challenges associated with new lines of business" is logical.9

While lenders to hedge funds may have thought that it was a good business decision to tighten credit in volatile markets, that decision had severe consequences for their own proprietary-trading desks’ positions. Creditors may not have been able to consider the additional risk involved in lending to hedge funds that had the same or similar positions as those creditors’ own proprietary-trading desks, because of the "firewall" that is supposed to be in place between the credit department and proprietary trading desk. As a result, they may have been forced to bailout Long Term Capital out of self-interest, for if Long Term Capital had been forced to liquidate in a fire-sale, the institutions’ own positions would have dropped significantly in value. I am not suggesting, however, that credit officials should share their information about a potential borrower’s trades with their proprietary-trading desks, so that they can assess the additional risks of holding the same or similar positions. Preventing a lender’s proprietary-trading desk from seeing a borrower’s positions is critical to maintaining the proprietary nature of the strategies of hedge funds, and preventing those trading desks from misappropriating those strategies, which ensures that the integrity of the market is secure. Moreover, it should be a breach of the lender’s obligations to its borrower to disclose proprietary information of the borrower to its competitor. Instead, I would suggest that the proprietary-trading desk share information about its exposures with the lending institution’s credit officials, who would keep the information confidential, so that they can take those exposures into account when making credit decisions.

If Congress’ goal is to protect investors, there are other more-significant potentially-damaging issues on which to focus. Consider, for example, the inexperienced "day traders" of Internet stock, who are leveraging themselves by buying on margin without any understanding of the potential consequences. The Wall Street Journal reported "that the volatile mixture of high-priced Internet stocks, novice investors, and buying on margin is so combustible that a shock could spread quickly through the rest of the market, ruining some investors and jeopardizing the health of some smaller firms."10 Furthermore, it is important also to remember that hedge funds were not the only ones to lose money last Fall. Mutual funds and banks also had significant losses. The Economist reported that banks’ losses from unregulated hedge funds were in the tens of millions of dollars, while their losses in emerging-market lending, which is regulated, ran in the tens of billions of dollars.11 Is Congress considering further regulation of emerging-market lending?

In conclusion, again I would like to call attention to the self-regulation that is already occurring in the private sector. Lenders are demanding more transparency from their borrowers, and hedge funds are opening their books to their lenders and investors. Because of the self-discipline imposed by the market, creditors have tightened their lending practices with more thorough due diligence and stricter margin requirements, and hedge funds and other financial institutions are improving their risk-assessment procedures to include stress-testing for extreme market conditions. Lenders should ensure, not only that they are employing stress-testing, but that their senior managers are reviewing the stress-testing reports regularly.

Market discipline and self-regulation are the best ways to reduce risks to the financial system in adverse market conditions. The hedge-fund industry is a dynamic one, producing, some say, the most financial innovation in the last twenty years. Further regulation of this industry only would result in less-efficient markets. Furthermore, regulation, which already exists over credit providers, can be supplemented by additional guidance to address areas of concern. The best possible solution, therefore, is for intra-industry discussion and vigilance combined with government guidance – not further regulation of hedge funds, not arbitrary limits on leverage.

Thank you for inviting me to share my views with you.12



Examples of Relative-Value Strategies

Convertible-Bond Arbitrage

Convertible-bond arbitrage opportunities exist when the relationship between a convertible bond and the security into which that bond may be converted becomes distorted. For example, one would buy the undervalued convertible bond and simultaneously sell "short"13 the related equity security. Interest income on the convertible bond and positive cash flow from the rebate on the short stock provide a "static" return. The rebate is the difference between the interest earned on the proceeds of the short sale and the cost of borrowing the security to sell it short. There are further opportunities for gains as the relationship corrects, independent of market direction.

An example follows:

Purchase Convertible Bond $1,000
Sell Stock Short $800
Dividend 0
Convertible Bond Yield (at 10%) $100
Short Rebate $60
Total Gain $160
Convertible Hedge Return (static) 16%

A bond that costs $1,000 will yield, assuming a 10% interest rate, $100 per year in interest. To create a convertible hedge, an investor may simultaneously buy the bond for $1,000 and sell short the amount of underlying stock that equals 80% of the value of the bond ($800 worth of stock). This short sale does not require additional capital investment since the bond is used as collateral. The $800 derived from the short sale earns interest. If interest rates are 10%, the investor would earn $80 (10% of $800) less, say, $20 in expense for borrowing the stock that was sold short. So the investor gets interest from two sources: $60 from what the proceeds of the short sale earned, and $100 of interest from the bond issuer. Accordingly, the investor’s static return on investment is 16% ($160 divided by $1,000).

The profits from a convertible bond hedge may also be substantial when the hedge is unwound. Since the market value of convertible bonds is based, in part, on the value of the stocks into which they are convertible, both classes of securities of the same company usually move up or down in market value together, although not at the same rate. As the shares’ value declines, the bond should fall less quickly as it reaches a high yield without regard to its conversion feature. Next, let me show you four simple illustrations of how the transactions might unwind.

  Scenario 1 Scenario 2 Scenario 3 Scenario 4



declines 50%




inverted market: bonds decline while stocks rise


Sell Bond + 2,000 +1,000 + 800 -200 +300 -700 +700 -300
Cover Short - 1,600 -800 -400 +400 0 +800 -850 -50
Net from Trading   +200   +200   +100   -350
Bond Yield (@10%)   +100   +100   +0   +100
Short Rebate   +60   +60   +0   +60
Total Gain   +360   +360   +100   -190
Return   36%   36%   10%   -4%

If the stock doubles in price (Scenario 1), the bond price will tend to double as well; this results in a $1,000 gain on the bond. Conversely, the investor will repurchase for $1,600 the stock that was sold short for $800; this produces an $800 loss. Adding the bond profit to the short sale loss ($1,000-$800) would yield a $200 profit, besides the 16% yield.

On the other hand, should the stock price decline by 50% (Scenario 2), the bond price will tend to fall as well, but at a lesser rate, say 20%. It declines less than the stock because it is a higher yielding instrument senior to the stock. This should result in a $200 loss ($1,000 - $800) on the bond. Conversely, the investor might repurchase for $400 the stock that was sold short; this produces a $400 gain. The net of the bond loss and short sale gain ($400 - $200) would yield a $200 profit besides the 16% yield.

At one extreme, if the bond issuer defaults (Scenario 3), the bond that was bought for $1,000 would be worth substantially less. If the bond sells for $.30 on the dollar, the sale of the bond produces a $700 loss ($300 - $1,000). However, the investor probably can repurchase at virtually no cost the $800 of stock that was sold short; this yields an $800 profit ($800 - $0). This profit would offset the loss on the bond for a net profit of $100 ($800 - $700) besides the yield, if any, before default.

In the rare event that the bonds decline while the stocks rise (Scenario 4), which is uncommon because the stock and convertible-bond prices usually move in the same direction, if the bond that was bought for $1,000 were worth $.70 on the dollar, the sale would produce a $300 loss ($700 - $1,000). The investor also would need to repurchase for a higher price (assume $850) the $800 of stock that was sold short, producing a $50 loss. The 16% yield would not be enough to offset the bond and short-sale loss, $350 (-$300 - $50).

Statistical-Equity Arbitrage

In statistical arbitrage, opportunities for profit exist because of the trading relationship between individual equity securities or "baskets" of securities. One such statistical arbitrage method is based on the theory that security prices have a mean level to which they return. Hedge funds use mathematical techniques, advanced computer capabilities, and proprietary trading models to identify these predictable fluctuations in the values of related securities.

The following is a simple example of a statistical-arbitrage trading opportunity:

  Closing $ - Stock X Closing $ - Stock Y
Monday $10 $10
Tuesday $11 $9
Wednesday $10 $10
Thursday $9 $11
  Expected Closing $ Expected Closing $
Friday $10 $10

Both Stock X and Y are in the same industry with similar market shares. There have been no announcements that would lead one to believe that they should be trading at different prices.

On Monday, one observes that the closing price of Stock X and Stock Y is $10. On Tuesday, one observes that Stock X has risen to $11 while Stock Y has declined to $9, but by the close of trading on Wednesday, both stocks have returned to $10. Then, on Thursday, Stock X has dropped to $9 and Stock Y has increased to $11. Based on one’s observations throughout the week, it would be reasonable for one to expect that Stocks X and Y will both revert to their historical price of $10. Therefore, one would purchase Stock X and sell "short" Stock Y. The expected profit from this trade is $2 ($1 on each position), as prices revert to their expected mean.

Fixed-Income Arbitrage

One example of fixed-income arbitrage relies on the assumption that sovereign fixed-income securities should have a lower yield14 than all other debt of similar duration within a country. Opportunities are available when market factors cause distortions in these relationships. For example, assume that a trader buys a ten-year G-7-country sovereign-debt bond and sells short a ten-year bank paper of the same country. The spread between the two is, say, 20 basis points. That is to say, if the spread narrowed to zero, we would suffer our maximum loss, 20 basis points. The spread should never reverse itself (i.e. the sovereign-debt bond should never have a higher yield than the bank paper), because a country’s sovereign debt should always be less risky than its bank paper, since the sovereign debt is an obligation of the government. If the spread widened, we would make a profit. On a $1 billion portfolio (meaning a portfolio with $1 billion in both the long and short positions), the most we could lose on the trade is $2 million. If that trade were leveraged 100 to 1 (we put up $10 million in collateral to leverage the trade 100 times to $1 billion), there is enough collateral to cover the maximum potential loss. Thus, I say, leverage may not be as risky as you might think. Nevertheless, if the spread of the trade were 40 basis points, because our potential for loss would be twice as much, we might use significantly less leverage.


Example of the Use of Leverage to Magnify Small Profits

Take a fund that expects the spread between two similar securities to narrow to historical levels. The excess spread, however, may be as small as, say, 67 basis points (or 2/3 of 1%), which does not present much of a profit opportunity, and, therefore, will not attract capital, without leverage. Furthermore, the probability that the spread will widen significantly is quite small. If the probability that the spread would converge were very high, then using higher leverage would be reasonable. Leveraging fifteen-to-one would present a profit opportunity of ten percent on this trade. It would be reasonable to expect, however, that hedge funds would use smaller levels of leverage in riskier trades.

For example, one possible low-risk trade might exploit the spread between the prices of newly issued ("on-the-run") U.S. Treasuries and previously issued ("off-the-run") U.S. Treasuries of the same maturity. Economically, there is no rationale for this spread, because the credit risk and the maturity are the same. This example of a very low-risk trade is one in which a fund might use a higher level of leverage.


Why it is Wrong to Quantify the Risk of a Derivative Financial Instrument by the Notional Principal Amount

I would like to clarify that it is wrong to quantify the risk in derivative financial instruments by the notional principal amount. Without attempting to be disrespectful, please let me give you an exaggerated example that illustrates my point: Mr. Chairman, pretend that you and I enter into a swap with a notional principal amount of $100, and I pay to you a percentage of that notional amount based upon the number of home runs Mark McGwire hits next August, and you pay to me a percentage based upon the number of home runs Sammy Sosa hits in that same month. Therefore, if McGwire hits fourteen home runs, I would owe you fourteen percent of the notional amount, or $14, and if Sosa hits twelve, you would owe me $12, meaning I would owe you a net amount of $2. Does this mean that there is $100 at risk? No. If McGwire hits 115 and Sosa hits zero, I would owe you $115.

If we entered into a different swap, still with a $100 notional amount, but I paid to you a percentage based on twice McGwire’s home runs and you paid to me a percentage based on twice Sosa’s home runs, then in a month that McGwire hit 14 and Sosa hit 12, I would owe you $4. That is twice as much risk, with the same notional amount. Therefore, to quantify the risk in derivatives, one must quantify potential future exposure accurately and convert the derivative risk into a loan equivalent.

To quantify your potential future exposure, Mr. Chairman, you would want to estimate your worst-case potential loss in the month. One way to do this would be to consider the maximum number of home runs that Sammy Sosa (or anyone, for that matter) has ever hit in one month: twenty in June of 1998. Then you might increase that number by 25%, or five, to 25, to account for the remote possibility that he would break that record. You could then assume that, with a much-greater-than-99% probability, the maximum number of home runs that Sosa would hit in one month would be 25. The minimum possible amount for McGwire to hit in a month would be zero, if, for example, he cannot play because he is injured. Therefore, your potential future exposure would be $25, in the worst-case scenario. You would use this number to compute a loan equivalent of the derivative risk.

I hope that this example demonstrates why it is essential that lenders develop accurate methods of determining the potential future exposure of a derivative contract.


Making Investment Decisions

Mr. Chairman, you specifically have said that you would like to acquaint yourself with the manner in which our funds make investment decisions. I will try to give you the outline that, in general, we follow in selecting trading strategies. Some consider us to be at the forefront of researching and identifying non-directional arbitrage opportunities. Our first step is to become aware of, and educated about, new trading opportunities in the marketplace. We receive numerous business plans from traders who are aware that we seek innovative arbitrage opportunities. Furthermore, we sometimes seek to identify traders who fill a desired niche for our portfolios. From that universe, we accept a potential trading strategy for review, if it has a low-risk and superior risk-adjusted-return profile, and we have the appropriate expertise to manage the strategy. Considering the overall portfolio’s existing strategies, the potential strategy must represent a significant diversification or portfolio enhancement. It must use a level of leverage consistent with our approach (in general, lower for statistical arbitrage, higher for non-U.S. convertible arbitrage). If the strategy is already being implemented, we verify its record of accomplishment; if not, we review simulations of its performance. The strategy must allow for the timely withdrawal of capital without a significant impact on the value of the strategy. The compensation of the trader must be aligned with our interests. We look for a stable management structure, and look favorably when the principal invests side-by-side with us. We expect that the manager will demonstrate to us that he or she has risk controls in place and the ability to report to us valuations of positions promptly. He or she must agree to use our risk-control system. We meet with potential managers, both at our headquarters and at the places from where the traders intend to operate. After we select a trading group, we fund it with seed capital. If the trading strategy’s performance matches its expected performance, we may increase funding.

1Office of the Comptroller of the Currency, "Risk Management of Financial Derivatives and Bank Trading Activities – Supplemental Guidance," OCC 99-2, January 25, 1999.

2Aaron Levine, Economics and Jewish Law (Hoboken: Ktav Publishing House, Inc., 1987), 207-8.

3"A Hitchhiker’s Guide to Hedge Funds," The Economist, June 13, 1998.

4Stephen J. Brown, William N. Goetzmann, and James Park, "Hedge Funds and the Asian Currency Crisis of 1997," NBER Working Paper No 6427, February 1998.

5"Hedge Funds and Financial Market Dynamics," IMF Occasional Paper 166, May 1998.

6Office of the Comptroller of the Currency, "Risk Management of Financial Derivatives and Bank Trading Activities – Supplemental Guidance," OCC 99-2, January 25, 1999.

7Haircuts are the way that brokers and clients protect themselves from market risk in doing repos. An entity wanting to finance the purchase of $100 million in Treasury bonds may borrow just $98 million of the money. The 2-percent difference between the amount of securities purchased and the amount of money borrowed is the haircut.

8Rebecca Buckman and Aaron Lucchetti, "Wall Street Firms Try to Keep Internet Mania From Ending Badly," The Wall Street Journal, February 24, 1999, A1.

9Office of the Comptroller of the Currency, "Risk Management of Financial Derivatives and Bank Trading Activities – Supplemental Guidance," OCC 99-2, January 25, 1999.

10Rebecca Buckman and Aaron Lucchetti, "Wall Street Firms Try to Keep Internet Mania From Ending Badly," The Wall Street Journal, February 24, 1999, A1.

11"Turmoil in Financial Markets," The Economist, October 17, 1998.

12I thank my Research Analyst, Michelle Kultgen, for helping me prepare my testimony.

13Selling short means borrowing a security one believes is overvalued, and selling it.

14The yield of a bond varies inversely with its price.


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