Netting reduces the counterparty risk to financial institutions and thus reduces the «systemic» risks that the failure of one financial institution will cause a «domino» effect on other institutions and disrupt the financial markets. Bank supervisors have recognized the importance of close-out netting in reducing systemic risk to the financial system and have incorporated that recognition into advantageous capital treatment in U.S. and international bank capital regulations. All banks place significant emphasis on collateral in managing their derivative exposures with hedge funds. The ability of hedge funds to meet margin calls as necessary is therefore an important consideration for banks in the credit process. Most of these two-way arrangements also provide for rehypothecation of collateral, i.e., they allow the party holding the collateral to re-pledge it.
In many cases, banks and securities firms did not require collateral for potential future exposure. In addition, one-way collateral agreements in which the hedge fund was required to post collateral to the dealer, but not vice versa, gave way to reciprocal collateral agreements where either party could be required to post collateral, depending on the direction of the credit exposure. Such arrangements were typical only for the more established market participants. Disclosures by hedge funds to counterparties and investors are often made using accounting and balance-sheet concepts. While such information includes notional amount and market value of derivatives contracts, the typical accounting statement is still not informative about the risk profile of trading activity (e.g., the nature of the exposures to market risk and credit risk). Hedge funds are only one example of a collection of institutions that actively trade securities and derivative instruments.
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In measuring and managing derivative exposures with the LTCM Fund and other hedge funds, banks relied primarily on the timely collateralization of the current market value of their exposures. Although the LTCM incident did not expose major difficulties in the operation of collateral management systems, the specific measures used to assess potential credit exposure to the LTCM Fund, and more generally for other collateralized counterparties, require enhancements. Maintaining current documentation of all outstanding contracts is an important component of credit risk management. Generally, signed master agreements are required prior to initiation of trading transactions. Where master agreements have not been signed, «full» confirmations containing many of the provisions found in a master agreement are used.
By contrast, if the value of a member’s account has fallen below required original margin levels, the member will be required to pay additional margin. In addition, CFTC Rules 32.9 and 33.10 prohibit fraud by any person in connection with commodity option transactions. 39 Some hedge fund managers register under the Investment Advisers Act because an exemption from registration is unavailable. A hedge fund manager may also choose to register if registration is important to its clients. 23 Federal margin rules are administered by the Federal Reserve Board under Section 7 of the Securities Exchange Act. SROs, including the securities exchanges and the National Association of Securities Dealers, which are overseen by the SEC, also impose margin requirements on their members.
A more volatile risk profile, combined with the absence of external monitoring (e.g., by credit rating agencies), demands that banks update their internal assessments of hedge fund credit quality more frequently. Thus no rule of the Commodity Futures Trading Commission («CFTC») applies specifically to hedge funds as a separate category of regulated entity. However, to the extent that hedge funds trade commodity futures or option interests and have U.S. investors, their operators or advisors become subject to CFTC registration and/or reporting requirements. In addition, all persons, including hedge funds, who trade on U.S. commodity futures and commodity option exchanges are subject to reporting requirements with respect to large, open positions held on regulated markets as well as limits concerning speculative positions in certain contracts.
27 The CEA and CFTC rules prohibit the use of one customer’s funds to satisfy obligations of another customer, so if there is a customer default on a margin call, an FCM may be required to put its own funds in the segregated account. 2 The CFTC has delegated to the National Futures Association («NFA»), the futures industry self-regulatory organization, direct responsibility for the primary monitoring of compliance with those requirements. Thus, NFA, subject to CFTC oversight and review, receives and reviews applications for registration and grants, denies or conditionally registers CPOs and CTAs.
After learning of LTCM’s financial difficulties, the CFTC staff contacted FCMs carrying large positions on behalf of pools and confirmed that daily margin obligations continued to be met on a timely basis. CFTC staff also have reviewed recent futures positions of the ten largest pools that responded to the request for information. As of December 15, 1998, there were 33 instances where these pools had reportable futures positions. In 31 of these cases, the net positions represented less than 1 percent of the total open interest in the contract.
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Such counterparty discipline, however, failed to constrain leverage adequately in the case of LTCM. The ability to net may also contribute to market liquidity by permitting more activity between counterparties within prudent credit limits.16 This added liquidity can be important in minimizing market disruptions due to the failure of a market participant. Closeout, or termination, refers to the right under a master agreement to terminate one or more contracts immediately upon certain specified events and to compute a termination amount due to, or due from, the defaulting party. The termination amount is generally based upon the value of the contract at the time of closeout. The ability to terminate most financial market contracts upon an event of default is central to the effective management of market risk by financial market participants like the trading counterparties of the LTCM Fund.
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Supervisors should encourage institutions to use more robust monitoring tools and require more complete, and current, information from their counterparties. When hedge funds will not provide such information, banks should compensate with more conservative credit structures and/or refuse to provide credit. In general, most banks use standard ISDA documentation and have closeout rights that allow the banks to closeout contracts if the financial condition of a counterparty becomes significantly impaired. For hedge funds, a standard closeout provision is one based on declines in net asset value («NAV»). While the standard NAV closeout trigger for most hedge funds is a 20 percent drop in NAV, several large hedge funds, including the LTCM Fund, brought competitive pressures to bear in order to gain percent NAV declines as their closeout provision. Although the liquidation of direct exposures to the LTCM Fund could have significantly impacted quarterly earnings at several banking institutions, it would not have threatened the solvency of any U.S. commercial bank.
An assessment of the public policy issues posed by hedge funds might therefore benefit from a consideration of hedge funds in the broader context of trading activity. In today’s economy, the markets for traded securities are performing an increasingly important role in the intermediation of credit. Among the wide range of institutions participating in this trading activity are hedge funds, trading desks of banks, securities firms and insurance companies, mutual funds, and other managed funds. Some of these institutions engage in trading activity more intensively than others.
Trading leveraged products such as Forex and CFDs may not be suitable for all investors as they carry a high degree of risk to your capital. It is really important that you do not trade any money that you can’t afford to lose because regardless of how much research you have done, or how confident you are in your trade, there will always be a time that you lose. The margin requirement level must be maintained over and above any profit or losses on your account.
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By increasing the chance that problems at one financial institution could be transmitted to other institutions, leverage can increase the likelihood of a general breakdown in the functioning of financial markets. The firms participating in the consortium invested about $3.6 billion in new equity in the fund, and in return received a 90 percent equity stake in LTCM’s portfolio along with operational control. The responsibility and burden of resolving LTCM’s difficulties remained with the counterparties that had allowed the hedge fund to build up its positions in the first place. The principals and investors in LTCM suffered very substantial losses on their equity stakes in the fund when their claim was reduced to ten percent. During the first two weeks of September 1998, concern about LTCM was a major topic of conversation in the financial markets. The LTCM Fund suffered substantial further losses and found it difficult to reduce its positions because of the large size of those positions.
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The LTCM Fund was, to a large extent, an exception with regard to both the amount of leverage employed and the lack of information it provided to creditor banks. At the same time, LTCM seems the extreme case that illustrates the inherent weaknesses of some prevailing credit practices. Importantly, the lessons learned regarding the measurement, monitoring, and management of counterparty credit risks arising from this incident are generally applicable to the management of all derivatives transactions. Overall, the factors underlying the LTCM incident in particular, and the current state of banks’ relationships with hedge funds in general, bear some resemblance to past commercial bank excesses such as the real estate phenomenon of the late 1980s and early 1990s. Some large institutions need to enhance their counterparty credit risk exposure measurement and management regimes. Banks generally calculate derivatives and foreign exchange exposure as the sum of current market exposure and potential future exposure («pFE»).
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More importantly, hedge funds tend to seek prices that either diverge from fundamentals or offer arbitrage opportunities. Since these circumstances are supposed to be temporary, the funds hope to make money and unwind their positions in a short period of time. The propensity of hedge funds to alter market positions quickly distinguishes them from pension funds and bank personal trusts.
Bankruptcy Code («Section 304») specifies general criteria for determining whether a U.S. bankruptcy court should defer to a foreign bankruptcy proceeding such as the one that probably would have occurred with the LTCM Fund and its affiliates. However, the Bankruptcy Code does not clearly address when a debtor’s «main» insolvency proceeding must take place in the U.S. courts. Amendments to U.S. and foreign bankruptcy laws based on the UNCITRAL language would make it much more likely that with entities like the LTCM Fund, whose mainplace of business is the U.S., the U.S. bankruptcy proceeding would be the «main», and not an ancillary, bankruptcy proceeding. The Bankruptcy Code normally governs the bankruptcy of nonbank debtors in the United States. However, like many hedge funds, the LTCM Fund was a partnership organized in the Cayman Islands.
Examiners assess the level and direction of risk, and the quality of risk management for different types of risks (e.g., credit, market, liquidity, operational, legal, reputation) on an aggregate basis. They also review risk profiles for various product offerings, business lines or activities (e.g., lending, trading, investing, and derivatives). Accordingly, bank exposures from hedge funds are primarily supervised within the context of the functional area or product line in which they arise, such as lending or derivatives activities. Unless targeted for special review, exposures arising from any one type of customer or counterparty, such as hedge funds, are generally not singled out from other types of customers. Most large firms have made changes and enhancements to their risk management processes in response to the market turmoil.
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