Time For Everyone To Pull Together

AIMA’s Groome moulds debate over hedge funds

Originally published in the May/June 2009 issue

It may verge on understatement but the world economy and financial markets face gargantuan challenges during a period when growth is anaemic and stability may be elusive. Throw in a rising regulatory backlash, particularly in Europe, and the stage is set for some dramatic changes in how hedge funds are permitted to operate in the future.

Todd Groome, who became non-executive chairman of the Alternative Investment Management Association (AIMA) in February, is grappling with these challenges. It is a battle that will draw on his recent five-year advisory role with the International Monetary Fund and earlier capital markets roles with Deutsche Bank and Credit Suisse.

Groome has some key messages about how the alternative investment sector is changing. What’s more, he matches that analysis with what hedge fund mangers need to do to be relevant in the changing order of financial markets regulation.

On this point, Groome says that the industry’s main representative bodies must pull together and endorse a common platform of standards. Initially, this means pulling together a road map and committing to a date – the November G20 finance ministers is a possible deadline – to achieve consensus.

“The Americans and the British need to come together and work with the G20,” Groome says. “AIMA’s contribution to that is that the industry needs to come up with a global set of standards to convergence around the very good standards that are already out there.” He notes that the Hedge Fund Standards Board took AIMA’s standards and made them even more specific. Also, the President’s Working Group worked with the US Treasury and the Managed Funds Association to put together two guidelines, one for managers and one for investors, while the International Organization of Securities Commissions had done extensive work on valuations.

“We should take all of this and bang it together,” Groome says. “Quite frankly, it’s not simple, but it’s not that hard. You can see there is tremendous overlap among these different sets of standards. We need to bang that together and then give it to the Financial Stability Board and say this is something we are prepared to be held accountable to. That’s an important step which hopefully is starting to take shape.”

The current impasse over regulating finance follows a deep crisis of confidence in the system. It coincides with not only the growth of hedge funds, but the increasing role of non-banks in the broader financial system since early in the decade.

Whether it is the origination or the extension of credit, the reinsurance market, helping pension funds manage inflation or longevity risk there is a deeply embedded use of risk transfer instruments in the credit sector and beyond. Groome’s message is a simple but important one: hedge funds play a very important role here and are an extension of all these other investors’ capabilities.

Consider student loans. An insurance company, pension fund or sovereign wealth fund will originate the capital but it will be a hedge fund that links the balance sheets of those lenders with borrowers. “The hedge fund balance sheet is nothing more than the balance sheet of the pension funds, the sovereign wealth funds and the insurance company’s balance sheet that they lend us to use on their behalf and hopefully to make very attractive returns for them,” Groome says. “They are never going to be the entity that officially allocates that credit and capital around the globe. They need that intermediary called a hedge fund or a private equity fund or whatever it might be.”

Groome is by turns wary and optimistic about whether the authorities in the US, UK and Europe understand the connections that facilitate the workings of the contemporary financial system. Political utterances that blame hedge funds for the travails of the financial system concern Groome. At the same time, he is convinced that people like US Treasury Secretary Tim Geithner and Financial Services Authority Chief Executive Hector Sants do understand the importance of non-banks to the financial system and are working to ensure that others understand this, too.

Groome offers some evidence to suggest the message – that hedge funds are not a threat but a contributor to the return of market stability – is getting through. One is the Term Asset-Backed Securities Loan Facility, or TALF, in the US.

“The TALF is a very conscious effort,” Groome says, “by the Treasury, the Fed and others to reach out to the non-banking world and very particularly hedge funds and say: ‘What do you think about this?’ ‘Will you participate in this?’ They realised with TALF that if you don’t have these non-banks willing to participate it’s not going to happen.” He adds that he has seen the same thing happen in the UK with the public private initiative.

A second sign the message is getting through is that the main aim of the G20 focus on hedge funds is to improve transparency. “I want to be careful not to be too optimistic,” Groome says, citing the G20 communiqué and an attachment to it called the Washington Action Plan, which focuses on improving hedge fund transparency. “That’s what this is really all about,” Groome says. “The people who really understand the issues want to say hedge funds need to provide more information to their national authorities so the national authorities can understand markets better and understand financial stability risk better.”

What this doesn’t mean is that hedge funds have all of a sudden become systemically important. No one, Groome says, is expecting the authorities to prevent the failure of a hedge fund because it is intricately involved in providing a public good like the payments system or deposit taking.

“Hedge funds are I think now being recognised for all these market reasons as being systemically relevant,” Groome says. “Not systemically important but systemically relevant. And that’s a big difference. If we are systemically relevant, a regulator, macro policy maker or the Financial Stability Forum overseers have every right to ask us to contribute to the knowledge base of the country and the world on key financial stability issues so the world understands these risks better.”

“We are able to be valuable contributors to that,” Groome says. “I have never met a hedge fund in any part of the world which is not willing to contribute to the improved understanding through the sharing of information with national authorities. Where people in the industry bristle, and they rightly do, is when it is said that means more rules and regulations. We have a history in the non-banking world where rules and regulations haven’t worked very well.”

Exhibit one: the Savings and Loans industry in the US in the 1970s and 1980s. It is well documented that S&L operators had very prescriptive rules about the operation of their balance sheets. The corollary was that no risk management skills were developed in the industry. There was a similar phenomenon with insurers in Switzerland, the UK and elsewhere which had very prescriptive rules about how to run their balance sheets and even where to invest their assets. The end result was that their risk management systems weren’t sophisticated enough to deal with the market volatility earlier in the decade.

This makes Groome worried about prescriptive measures being enacted to limit leverage and mandate capital adequacy. He believes it is a fallacy to think that policy makers can set such limits better than investors or hedge fund managers. One thing that makes such measures difficult is the heterogeneous nature of the hedge fund industry, even within just one sector like credit hedge funds that compose part of the shadow banking system.

But Groome is a realist about how regulation is evolving. And that means, for better or worse, recognising that the world system has evolved quickly to be far more multi-polar in how the financial system will both function and be regulated.

On the US and UK continuing to dominate financial system regulation, Groome says: “I don’t think so. We are not in that world any more. We are in a G20 world.” He adds: “The G20 for a number of years has been saying to the US and UK or the G7 that whether it is a Basel II process or a solvency process, we’re thinking about demographic pressures in the world and how we regulate our pension funds. Whatever the big issue is, you guys in the G7 have dominated it, but if you get it wrong it is going to affect my economy: banks, insurance companies, even the households sector in my country. Well guess what. All those concerned conversations have come home to roost. Those countries are suffering.”

“I’m not saying they are correct when they say the blow up occurred in the US, UK and Western Europe and polluted the rest of the world,” Groome says. “That is probably oversimplifying things. The problems are more complex than that. But that is what people are saying.”

He observes that the move by President Bush late in his presidency to bring together the G20 to mediate the crisis was the right thing to do. Not only is it the G20 that is providing growth, it is also where the savings are coming from, too.

“When you are in a G20 world it is tougher now for the US or UK to say we have got this figured out, guys, now relax, we’ll sort it out ourselves,” says Groome. “These guys are now partners at the table and have to be treated as such and that makes the conversations more complicated and difficult. So I’m not so sure that we can sit here and say the US and UK want to go this way and so we’re definitely going to go that way. Today you have to reach out to these other people as genuine partners and make sure they are on for that.”

But Groome realises that as the forum of action spreads from the G7 to the G20, the likelihood of any particular action becomes more and more diffuse. What’s more, tradeoffs multiply. In the G20, for example, it means that action on off-shore regimes is increasingly unlikely since China wants to retain the status quo. In turn, that may mean further trade-offs around the G20 table.

Groome says the G20’s heightened importance will see sub-groups created for different aspects of financial regulation such as solvency, insurance and others. This was the legacy of the Basel II process, he notes, and will be used by the newly established Financial Stability Board.
One such group created by Treasury Secretary Geithner while at New York Federal Reserve was the senior supervisors group. Put in place in 2007, it had a mandate to go out and evaluate direct counterparty risk management practices between the major banks and brokers and the hedge funds. Its members included the US, UK Germany, France and Switzerland; it then expanded to include Japan. Groome’s point is that the key forums within the G20 need to be small enough to be effective.

On the matter of hedge funds, insurers, pension funds and banks providing more information to national authorities who then log it with the G20’s FSB, Groome argues that there are three clear uses for that information. One is for larger hedge funds to provide quarterly data to their national regulator around a specific template that breaks out portfolio concentrations, liquidity levels, the volatility of different assets and, most obviously, leverage. It means that each fund will be totally transparent to its national authority.

“The regulators will then look for outliers – and may even meet with the manager – as the data gives them a precise scope to have a more targeted conversation,” Groome says. “They’ll say to that manager: ‘Why should I not be worried about the way you are managing that portfolio because you look so different?’” He adds: “That’s a valid and educated conversation.” If the regulator leaves not satisfied, it has the option ask the prime broker why there shouldn’t be concern about its counterparty exposure to that hedge fund. “Almost certainly, as history demonstrates, the bank will react in a way to improve its counterparty or reduce its risk to that entity,” Groome says.

One of the other two uses of the information will be in the high level conversations of the senior supervisors group. This is a forum of central bank governors and top regulatory chiefs. The third and final use of the data will occur at the FSB, likely aggregated by strategy that will consider trends over time in areas such as concentration and liquidity risk or leverage.

“That’s all healthy,” Groome says. “I have never met a hedge fund anywhere in the world which is not comfortable with the use of the information and the provision of it to that constituency of audiences. But I do think people are worried about what the real issue is here.”

Famously, during the German presidency of the G8, they sought to make alternative investment funds part of the agenda and to do an analysis of the implications hedge funds have for financial stability. Surprisingly, perhaps, Groome says the German approach was “constructive and very intelligent” as they argued that market discipline can’t work without adequate transparency. “That’s undoubtedly true,” Groome says. “We’re still on that path.”

The lending practices of banks, of course, rather than hedge funds or insurers, were primarily responsible for the credit crisis. But Groome’s bigger point is that bolstering transparency and disclosure is a natural response to what has happened whether the hedge fund industry likes it or not.

“I think everyone agrees we need better transparency,” he says, “but there will be some who say: ‘is that enough’?” He adds: “What if there is another fraud? Everyone is going to say: ‘I told you so, the industry can’t hold themselves accountable to their own standards’.” The upshot could be even harder rule than the proposals made in April in the European Commission’s Alternative Investment Manager directive.

“There is that camp,” Groome says. “I think they are wrong. But they are making reasonable arguments in a world where we have just gone through what we’ve gone through. That’s why I’m saying it is time to improve transparency and time to show that a new system can work.”

He says that regulators like the Securities and Exchange Commission, the FSA and their counterparts in Hong Kong and Singapore have a generally good record of hedge fund oversight. “These guys understand the systems, they understand hedge funds,” Groome says. “They interact with them all the time and do a good job of supervision. There are different degrees of involvement but they ask good questions. What I think is if we provide better information they will ask even better questions. More importantly, they’ll then share that information at the G20 level so the G20 crowd sees that they know and that they’re asking good questions.”


Groome is a managing director of Diversified Global Asset Management in Toronto. Most recently, he was an adviser to the monetary and capital markets department of the IMF, responsible for multilateral surveillance activities and review of capital markets developments, focusing on structural issues. Previously, Groome was managing director and head of the financial institutions groups of Deutsche Bank and Credit Suisse in London. He also worked with Merrill Lynch in London and New York in the financial institution’s corporate finance group.