FSOC to scrutinize leverage in hedge funds

The Financial Stability Oversight Council will take a closer look at hedge funds’ use of leverage as it reviews potential risks to U.S. financial stability, according to an updated statement released Monday.

In that update of its risk review process, FSOC members said the relationship between a hedge fund’s level of leverage and risk, and the implications for financial stability stemming from that relationship are “highly complex,” with most of the leverage concentrated in large hedge funds, according to the FSOC statement. While reporting by private funds through Form PF has increased transparency, “it does not provide complete information” and no single regulator has enough data to evaluate complete risks, the statement said. To get that, the FSOC is forming an interagency working group to gather and assess data, and report to the council by the fourth quarter of 2016.

Hedge funds represent $3.4 trillion, or 13% of the assets being reviewed by the FSOC, the second-largest share after pooled investment vehicles.

In a separate statement, the Managed Funds Association, an industry group that represents hedge funds, said its members “hope to have a constructive dialogue with this newly formed group as FSOC works to fulfill its important mission.” The MFA told the FSOC last year that given the relatively small size of the hedge fund industry compared to other market participants, “existing regulations, and built-in safeguards all prevent the industry from posing systemic risk to the U.S. financial system. … Furthermore, almost all of the borrowing done by hedge funds is fully collateralized, which minimizes counterparty risk. To further protect against potential destabilization, hedge funds’ positions and associated collateral are subject to daily mark-to-market requirements.”

FSOC officials said they will also consider potential risks and seek to gather more data on service providers, securities lending, and liquidity and redemption risks.

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