U.S. Government Accountability Office issues report on market discipline and regulation of hedge funds

  • Market discipline imposed by investors, creditors and counterparties is the most effective mechanism for limiting systemic risk, though regulation – in particular, internationally coordinated regulation – retains an important role in risk management.
  • Counterparty credit risk is main source of systemic risk.
  • Prime brokers and institutional investors impose market discipline through more extensive due diligence and ongoing monitoring.
  • OCC and prime brokers said losses from hedge fund clients were rare.
  • However, three factors limit effectiveness of market discipline: use of multiple prime brokers by large firms; prime brokers’ risk controls may not keep pace with financial innovation at hedge fund clients; in competition for hedge fund business, creditors and counterparties may relax credit standards.
  • Regulators retain an important role in containing systemic risk. In that regard, President’s Working Group on Financial Market has recently: issue guidance (2/07), organized manager and investor private sector committees (9/07) and formalized protocols (fall 2006).
  • SEC conducted examinations of 321 hedge fund advisers in fiscal 2006, and discovered deficiencies in information disclosure, personal trading, performance advertising, brokerage arrangements, etc.
  • SEC has identified various hedge fund risk-related areas for further regulatory attention.

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