IMF Survey: Is the speculative activity of hedge funds in the oil market causing the price hike?
Groome: We do not believe that is the case. Hedge funds appear to be no more participating in this market movement than pension funds, investment banks, and mutual funds. All investors are diversifying their portfolios into alternative investments such as commodities, including oil. We do not believe that speculation in the energy market is the primary reason why prices are up. Most investors in the world believe that we face real supply constraints in the face of growing demand and that we will likely experience a period of sustained higher prices that will induce more infrastructure investment and eventually alleviate current bottlenecks.
Hedge funds are taking off
Note: 2004 numbers are estimates.
Data: 2004 Van Hedge Fund Advisors
IMF Survey: The Global Financial Stability Report suggests that you intend to closely monitor energy trading and energy market developments as part of your financial market surveillance work. Why?
Groome: There is a lot of activity in the financial markets, including among energy assets—both cash and derivative. Enron’s crisis did not halt the growth or interest in these markets; in fact, it arguably helped by making it evolve, mature, and become a bit more stable. There have also been interesting structural developments in the energy markets. Some of the big investment banking firms have bought companies that generate power—which signals how serious they are about remaining in the energy trading business. The more they get into these markets, the more they need the physical assets to hedge positions, because you can’t always rely on using financial instruments exclusively to hedge in the energy markets.
IMF Survey: What is behind this growing activity in the energy market?
Groome: We believe that the energy market—especially oil and natural gas—is undergoing a structural change. Why? Supply, supply, and supply. China is certainly a big part of the recent surge on the demand side and, no doubt, much of China’s increased demand is structural. But the other component most frequently cited by investors for a sustained price adjustment has been the lack of infrastructure investment. If the level of investment in refineries and delivery systems in the 1980s and 1990s hadn’t greatly diminished from the level in the 1970s, meeting China’s and others’ increased demand would not be such a problem today. So we have a bottleneck in supply—particularly for refined products. But keep in mind that we can expect prices to decline once capacity has been adequately expanded, which takes time.
IMF Survey: In general, why are hedge funds so poorly understood?
Groome: There isn’t enough transparency in the hedge fund industry for third parties, particularly the official sector, to fully understand whether and how hedge fund market activities may pose systemic risks. With the large inflow of capital into the sector, we see two reasons why we should seek more transparency. First, there are so many new investors coming into the hedge fund world, seeking to diversify their portfolios, that demand is much greater than the supply of hedge fund capacity. This shifts the balance of market power to the hedge funds, even in relation to large institutional investors such as pension funds. Second, brokers, dealers, and banks that act as counterparties to hedge funds are aggressively competing for this profitable business, and some counterparties may relax credit terms and allow much greater levels of leverage.
IMF Survey: Why not rely on market discipline to encourage greater transparency?
Groome: A lot of the reports that came out after the LTCM crisis said that market discipline had failed to limit risk taking by hedge funds. We believe in markets, and we think that market discipline is a good and often very effective influence. However, we don’t believe that market discipline alone should be relied upon.
Lee: We think markets work. But can market discipline itself do the job? The answer is not necessarily. Market discipline has failed in the past, and we’re trying to understand better why.
Groome: Moreover, without sufficient transparency, market discipline doesn’t have the ability to be exercised effectively. In addition, market forces themselves—supply and demand—will ebb and flow, and at the moment don’t favor greater transparency or market discipline.
IMF Survey: You propose monitoring to detect systemic risks. Who should monitor, and how should it be done?
Groome: The banks and brokers that are themselves the counterparties to hedge funds have the best access to relevant information. As systemically important and highly regulated and supervised institutions, the system exists for effective monitoring by the regulators of these banks and brokers, including their activities related to hedge funds or any other activity. The regulatory authorities may ask the banks as part of their normal supervisory review process to break out their hedge fund exposure by strategy, which the largest and most active banks and brokers say they do already for internal risk management purposes. The strategies they should be most concerned about are often easily identified: you look for the smaller margins, the lower or inconsistent levels of liquidity, and the use of higher levels of leverage. Once the supervisors begin monitoring, they will develop a better ability to detect potential or rising risks.
Lee: The best way to monitor and understand the hedge fund industry is through indirect observation. Look through the eyes of the hedge funds’ main counterparties—the prime brokers and the banks. But this needs to be coordinated. The supervisors of the main counterparties also need to understand what questions to ask about hedge funds and related market activities. But getting agreement among supervisors isn’t a simple task, especially when you have an industry that is global and operates across borders. Nevertheless, it shouldn’t be beyond their capabilities.
IMF Survey: Where specifically should regulators look for systemic risks?
Lee: Almost one-half of the industry’s assets are in equity-related hedge funds. In very general terms, we aren’t particularly worried about them. We are more concerned about the other half of the industry that is engaged in fixed-income, convertible arbitrage, and similar strategies. That is where we think there is less transparency, higher leverage, and many of the ingredients that contributed to LTCM’s collapse. That is where we suggest focusing the monitoring effort.
IMF Survey: What happens if a trend is detected that could evolve into a potential risk?
Groome: The supervisors may begin by asking questions of the banks and prime brokers. History has shown that the right question will change, or certainly influence, the behavior of regulated entities. A recent example is the lending to telecoms in the late 1990s. Institutions were deemed to have too much telecom exposure, so the supervisors began to ask questions and request information in this area. Subsequently, the banks changed their behavior and began to monitor their risk to telecoms more precisely and to reduce exposure to that sector.
IMF Survey: Could there be another LTCM?
Groome: Keep in mind that—with all due respect to hedge fund investors—we aren’t worried about a hedge fund failing. We’re worried about systemically important institutions like banks and brokers getting hurt. If there was going to be an accident related to hedge fund activities, we suspect it would most likely occur in the fixed-income markets. It would arguably be in sectors where margins are tight, leverage is relatively higher, and 90 percent, or a substantial majority, of the market participants are hedge funds. Any asset class where 80–90 percent of participants are hedge funds is a market that is subject to relatively higher risk, because these participants are active, highly leveraged, and likely to react to a market shock in the same way at the same time.
Having said that, we want to emphasize that hedge funds are an established investor group and a constructive influence on efficient market behavior. Hedge funds, like other institutional investors, can contribute to or adversely affect financial stability. As such, we still don’t know what we don’t know about hedge funds, and we support efforts to improve our understanding of their market activities.