[Federal Register: April 17, 2000 (Volume 65, Number 74)]
[Proposed Rules]
[Page 20395-20403]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr17ap00-21]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 1
RIN 3038-AB53
Public Reporting by Operators of Certain Large Commodity Pools
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed regulations.
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SUMMARY: In April of 1999, the President's Working Group on Financial
Markets (comprised of the Secretary of the Treasury, the Chairman of
the Board of Governors of the Federal Reserve System, the Chairman of
the Securities and Exchange Commission, and the Chairman of the
Commodity Futures Trading Commission) (the ``PWG'') issued a report
entitled ``Hedge Funds, Leverage, and the Lessons of Long Term Capital
Management: Report of The President's Working Group on Financial
Markets'' (the ``PWG Report''). This report reviewed the events
surrounding the near-collapse of Long Term Capital Portfolio, L.P.
The PWG Report contained eight recommendations. The first was that
``more frequent and meaningful information on hedge funds should be
made public'' and the fourth was that ``regulators should encourage
improvements in the risk management systems of regulated entities.'' In
furtherance of the first objective, the report specifically recommended
that commodity pool operators (``CPOs'') of large commodity pools
should file quarterly reports, that these reports should ``include more
meaningful and comprehensive measures of market risk'' such as ``value
at risk'' and that these reports be published.
Consistent with this unanimous recommendation of the PWG, the
Commission is proposing new Rule 4.27, which would require the CPOs of
the largest commodity pools to provide to the Commission the specified
aggregate financial and risk information on a quarterly basis. In order
to provide context for the evaluation of this information, these CPOs
would also be required to provide certain summary information about
their risk management systems and practices.
DATES: Comments must be received on or before June 16, 2000.
ADDRESSES: Comments should be mailed to Jean A. Webb, Secretary,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155--
21st Street, NW, Washington, DC 20581; transmitted by facsimile to
(202) 418-5521; or transmitted electronically to ([email protected]).
Reference should be made to ``Public Reporting by Operators of Certain
Large Commodity Pools''.
FOR FURTHER INFORMATION CONTACT: Robert B. Wasserman, Associate
Director at [email protected], Tobey Kaczensky, Special Counsel at
[email protected], or James L. Carley, Attorney at [email protected],
Division of Trading and Markets, Commodity Futures Trading Commission,
Three Lafayette Centre, 1155--21st Street, NW., Washington, DC. 20581,
Telephone (202) 418-5430.
SUPPLEMENTARY INFORMATION:
I. Background
The events in 1998 involving highly leveraged hedge funds,
particularly the near collapse of Long Term Capital Portfolio, L.P.
(``LTCM''), raised concerns that problems at one such financial
institution, under certain circumstances, could be transmitted to other
financial institutions and pose material systemic risks to the
financial system of the United States and to international financial
systems. In the months following these events, the President's Working
Group on Financial Markets (the ``PWG'') conducted a study of the
events and their policy implications and, in April of 1999, issued
``Hedge Funds, Leverage, and the Lessons of Long Term Capital
Management: Report of The President's Working Group on Financial
Markets'' (the ``PWG Report'').\1\
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\1\ As noted above, the President's Working Group on Financial
Markets is comprised of the Secretary of the Treasury, the Chairman
of the Board of Governors of the Federal Reserve System, the
Chairman of the Securities and Exchange Commission, and the Chairman
of the Commodity Futures Trading Commission. A number of other
federal agencies participated in the study, including the Council of
Economic Advisers, the Federal Deposit Insurance Corporation, the
National Economic Council, the Federal Reserve Bank of New York, the
Office of the Comptroller of the Currency, and the Office of Thrift
Supervision.
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The PWG Report stated that the ``primary mechanism that regulates
risk taking by firms in a market economy is the market discipline
provided by creditors, counterparties (including financial contract
counterparties), and investors.'' \2\ The report observed, however,
that ``market discipline tends to be effective only when creditors have
the incentives and the means to evaluate the riskiness of the firm.''
\3\ The report concluded that investors and counterparties had
``exercised minimal scrutiny of its risk management practices and [its]
risk profile'' and were ``almost certainly not adequately aware'' of
the ``nature of the exposures and risks [LTCM] had accumulated.'' \4\
The report attributed this ``insufficient monitoring'' to ``LTCM's
practice of disclosing only minimal information'' about itself that
``did not reveal meaningful details about [its] risk profile.'' \5\
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\2\ PWG Report at 25.
\3\ Id.
\4\ Id at 15.
\5\ Id.
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Thus, the members of the PWG unanimously recommended that ``more
frequent and meaningful information on hedge funds should be made
public'' \6\ and that the public disclosures should include risk
information. Specifically, the report recommended that: (i) registered
CPOs operating large funds begin filing with the Commission quarterly,
rather than annual, reports of financial information; (ii) in addition
to traditional financial statements, these reports include more
``meaningful and comprehensive measures of market risk (e.g., value at
risk or stress test results), without requiring the disclosure of
proprietary information on strategies or positions;'' \7\ and (iii)
these reports be published. Separately, the report recommended that
``regulators should encourage improvements in the risk management
systems of regulated entities.'' \8\
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\6\ Id at 31.
\7\ PWG Report at 32-33.
\8\ Id at 34.
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With respect to hedge funds that are not currently registered as
CPOs, the PWG Report recommended that ``a means for disclosure should
be developed to ensure that similar financial information is provided
to the public'' but recognized that ``Congress
[[Page 20396]]
would need to enact legislation that authorizes mechanisms for [such]
disclosure.'' \9\ On September 23, 1999, Representative Richard Baker
of Louisiana introduced a bill which would require unregulated hedge
funds to report certain financial and risk information to the Federal
Reserve Board. As amended on March 16, 2000, and referred by the
Subcommittee on Capital Markets to the full Committee on Banking and
Financial Services, this legislation would require each such hedge fund
or family of such hedge funds with total assets of $3 billion or net
assets of $1 billion to report to the Board on a quarterly basis both
``[m]eaningful and comprehensive financial information (such as a
complete set of financial statements * * *)'' and ``[m]eaningful and
comprehensive measures of risk (such as value-at-risk or stress test
results).'' \10\
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\9\ Id. at 33.
\10\ H.R. 2924, 106th Cong., 1st Sess. (2000).
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In advocating the reporting of risk, as well as financial,
information, the PWG report pointed out that financial leverage,
particularly when measured by balance sheet leverage, does not by
itself provide an adequate measure of risk because ``for any given
balance sheet leverage ratio, the fragility of a portfolio depends on
the market, credit, and liquidity risks in the portfolio.'' \11\
Financial information should be supplemented with a ``statistical
measure'' such as ``value-at-risk relative to net worth,'' which would
``produce a more meaningful description of leverage in terms of risk.''
\12\
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\11\ PWG Report at 24.
\12\ Id.
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The PWG believes that improving the transparency of the risk
profiles of hedge funds would help other market participants make more
informed judgments about market integrity and the creditworthiness of
borrowers and counterparties. Secretary of the Treasury Lawrence
Summers recently noted that the public sector ``can help to enhance the
effectiveness of market discipline by creating an environment of
greater transparency and disclosure. * * * [A]gencies should continue
to apply the recommendations of the [PWG Report] that are designed to
enhance the monitoring of leverage and risk, and to improve
transparency, especially the steps to increase reporting by the largest
hedge funds. * * *'' \13\
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\13\ Remarks presented to the Futures Industry Association on
March 17, 2000.
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Moreover, the PWG has not been the only group to recognize these
advantages of greater public disclosure. The PWG's recommendations have
met with the approval of international financial regulators. The
International Organization of Securities Commissioners (IOSCO) released
a report last November which stated that:
``The [hedge fund] information gap can, in principle, be
addressed through greater public disclosure to permit market
participants to assess [hedge fund] risks independently * * * .
Market participants might use additional information * * * for a
number of purposes, including making more informed decisions with
respect to the pricing of transactions and the proper assessment of
risks and returns inherent in investment and trading decisions.''
\14\
\14\ ``Hedge Funds and Other Highly Leveraged Institutions--
Report of the Technical Committee of the International Organization
of Securities Commissioners,'' November 1999 (hereinafter the
``IOSCO Hedge Fund Report'') at 24-25.
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Similarly, the Financial Stability Forum, a group consisting of the
U.S. Treasury and the Federal Reserve Bank of New York as well as the
Basel Committee on Banking Supervision, IOSCO and financial regulators
from the UK, France, Germany, Australia, Italy, and Hong Kong, released
in March a report which stated that:
``The [FSF] Working Group firmly supports the objective of
enhancing public disclosure by HLIs [highly leveraged institutions,
or, hedge funds] and endorses U.S. efforts to achieve this through
both regulation and legislation.'' \15\
\15\ ``Report of the Working Group on Highly Leveraged
Institutions'' (hereinafter the ``FSF Report'') at 3.
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The FSF Report went on to state that ``[t]he Working Group agrees [with
the PWG and IOSCO] that enhanced public disclosure by HLI's would be
desirable.\16\
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\16\ Id. at 31.
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The regulations proposed today are intended to implement the PWG
Report recommendations discussed above, and are consistent with the
recommendations of the IOSCO Hedge Fund Report and the FSF Report. As
described more fully below, they would require operators of the largest
commodity pools to file, with respect to each pooled investment vehicle
under their direct or indirect control, including vehicles which are
not commodity pools, (1) an initial report that would provide summary
descriptions of key aspects of their risk management practices, and (2)
quarterly reports that would disclose both financial information and
information about the exposure of the pool to market risk over the
course of the quarter (but that would not reveal positions or trading
strategies).
II. The Hedge Fund Reporting Regulation--Proposed Regulation 4.27
A. Persons Required To Report
1. Size and Leverage Thresholds
Proposed Section 4.27(b) would define a reporting person as a
commodity pool operator that controls one or more pools where, at the
end of a quarter, either (a) the controlled assets of such pool or
pools total three billion dollars ($3,000,000,000) or greater or (b)
the controlled net assets of such pool or pools total one billion
dollars ($1,000,000,000) or greater. These thresholds are intended to
limit the reporting requirement to the CPOs of funds whose activities
potentially could have systemic risk effects. Any person which has met
these thresholds at the end of any of the past three quarters is
included as a reporting person in order to ensure a reasonable
continuation of coverage of hedge funds which may be experiencing
problems. Based on financial filings received pursuant to existing
rules, the Commission believes that approximately twenty-five pool
operators would be required to report under the proposed rule.
The Commission requests comment on whether these criteria for
``reporting persons'' are appropriate and whether other criteria should
be applied.
2. The Effect of Current Exemptions
a. Pools Limited to Sophisticated Investors--Rules 4.7, 4.8 and 4.12(b)
Participation in many of the funds that would be subject to
proposed Rule 4.27 is limited to large, sophisticated investors that
are generally considered to need less protection than other customers.
Pursuant to Rules 4.7, 4.8, and 4.12(b), these funds may be exempted
from specified provisions of other Part 4 rules. \17\ In contrast to
other rules under Part 4, however, Rule 4.27 is not intended primarily
as a means of customer protection. Rather, the regulation is intended
to facilitate the exercise of market discipline by other market
participants in their dealings with hedge funds that, because of their
size, could potentially have systemic risk effects. The importance of
facilitating market discipline, to the benefit of counterparties and
the market at large, is independent of the sophistication of the
investors in any particular pool. Accordingly, the proposed rule does
not exempt funds from the provisions of Rule 4.27 on the grounds that
participation in such funds
[[Page 20397]]
is limited to large, sophisticated investors.
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\17\ Commission regulations referred to herein are found at 17
CFR Ch. 1 et. seq. (1999).
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b. Pools That Have Received Exemptions on a Case by Case Basis
Rule 4.12(a) permits the Commission to ``exempt any person or any
class or classes of persons from any provision of this Part 4 if it
finds that the exemption is not contrary to the public interest.'' A
number of persons have received such exemptions on the grounds that
participants in their pools are not in need of customer protections
provided by the Part 4 rules. Most of these persons manage funds that
would fall below the size threshold of Rule 4.27. However, for the
reasons stated above, no person that controls any pool or pools that
satisfy the thresholds of Section 4.27(b) and that has obtained relief
pursuant to Rule 4.12(a) prior to the effective date of these rules
will be exempt from Rule 4.27 by virtue of such relief. No person that
obtains relief pursuant to Rule 4.12(a) in accordance with a Commission
order or an exemptive letter issued subsequent to the effective date of
these rules will be exempt from Rule 4.27 unless such order or letter
expressly exempts such person from Rule 4.27.
c. Entities Excluded From the Definition of Commodity Pool
Rule 4.5 excludes certain entities from the definition of commodity
pool operator on the grounds that they are otherwise regulated.\18\
These entities include investment companies, insurance companies,
banks, trust companies, and fiduciaries and employers subject to
ERISA.\19\ Proposed Rule 4.27, by its terms, would only apply to
commodity pool operators. Therefore, entities excluded from the
definition of commodity pool operator pursuant to Rule 4.5 would not be
required to file reports under proposed Rule 4.27.
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\18\ See 50 FR 15868 (April 23, 1985).
\19\ The Employment Retirement Income Security Act of 1974
(ERISA), 29 U.S.C. 1001-1381 (1982), as amended by the Multiemployer
Pension Plan Amendments Act of 1980, Pub. L. No 96-364, 94 Stat.
1208 (1980).
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B. Reporting Requirements
Each reporting person would file two types of reports: (i) An
initial set of qualitative descriptions of its risk management
practices and (ii) quarterly reports disclosing quantitative financial
and risk exposure information. The initial descriptions would be filed
concurrently with the first quarterly report; thereafter, revised
responses that reflect material changes, if any, to the initial
descriptions would be filed concurrently with subsequent quarterly
reports. Each quarterly report would be filed not later than thirty
days after the end of each quarter.
As noted above, the discipline exercised by other market
participants can provide a critical means of controlling excessive
leverage and, thus, constraining the added market, credit, and funding
liquidity risks generated thereby. Public disclosure of the information
collected under this rule should help other market participants to make
more informed judgments and to more effectively exercise market
discipline. This discipline is expected to both constrain excessive
leverage of reporting persons and encourage reporting persons to adopt
best practices in risk management as such evolve within the industry.
Accordingly, the Commission is proposing to disclose publicly both the
initial descriptions and the quarterly reports.\20\ Section 4.27(f).
The Commission intends to make this information available over the
Internet within one business day after receipt. Thus, the Commission
effectively would serve as a conduit for transmitting this information
to the public.
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\20\ Section 8(a)(1) of the Commodity Exchange Act, 7 U.S.C.
12(a)(1), provides that ``the Commission may not publish data and
information that would separately disclose the business transactions
or market positions of any person and trade secrets or names of
customers.'' The disclosure called for by proposed Rule 4.27 is of
aggregate information which would not require the disclosure of
information covered by Section 8(a)(1).
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Discussions of the quantitative financial and risk information
proposed to be reported on a quarterly basis are presented in sections
1 and 2 below, respectively. The qualitative risk management
information to be reported initially is discussed in section 3.
Specific filing and attestation requirements are set forth in section
4, while definitional matters are discussed in section 5.
1. Quarterly Reporting of Financial Information Under Rule 4.27
Market discipline can only serve as an effective check upon
excessive leverage if other market participants can obtain meaningful
information about a reporting person's financial condition on a
reasonably timely basis. The PWG Report observed that ``[c]urrently,
the scope and timeliness of information made available about the
financial activities of hedge funds are limited.'' \21\ As noted above,
the first of its recommendations was that ``[h]edge funds should be
required to disclose additional, and more up-to-date, information to
the public'' and that CPOs should file ``quarterly reports rather than
annual reports.'' \22\ Accordingly, consistent with the PWG Report's
recommendations, Section 4.27(d)(1) of the proposed rule would require
each reporting person to report on a quarterly basis certain key
financial information for each pool under its control, including
statements of income, financial condition, changes in financial
position, and changes in net asset value.
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\21\ PWG Report at 32.
\22\ Id.
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2. Quarterly Reporting of Risk Exposure Information Under Rule 4.27
Leverage has been described within the hedge fund industry not as
an independent source of risk but, rather, as ``a factor that
influences the rapidity with which changes in market risk, credit risk
or liquidity risk factors'' create losses.\23\ It has been noted that
``the market risk inherent in a [hedge fund], coupled with the
constraints imposed by funding liquidity, make the amplifying effect of
leverage of particular concern to [hedge fund managers].'' \24\ The PWG
emphasized that leverage is not an adequate measure of risk because
``for any given balance sheet leverage ratio, the fragility of a
portfolio depends on the market, credit, and liquidity risks in the
portfolio.'' \25\
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\23\ Caxton Corporation, Kingdon Capital Management, LLC, Moore
Capital Management, Inc., Soros Fund Management, LLC, and Tudor
Investment Corporation, ``Sound Practices for Hedge Fund Managers,''
February 2000 at l-1 and l-2 (hereinafter the ``Industry Sound
Practices report'').
\24\ Id.
\25\ PWG Report at 24.
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Accordingly, the Commission believes that, in order to fairly
portray the risk profile of reporting persons, the quarterly financial
information discussed above should be supplemented with certain
quantitative risk information. Currently, the most widely accepted
methodology of calculating exposure to market risk is value-at-risk
(also called ``capital-at-risk''). Value-at-risk is calculated using
statistical techniques, and represents the largest dollar loss \26\
which is expected to be suffered over a given investment horizon or
``holding period'' (for example, one day or ten days) with a given
degree of certainty or ``confidence level'' (for example, 95% or
99.6%).\27\ Because it is expressed in dollars, value-at-risk for a
particular entity can be compared over time and, in some circumstances,
across multiple entities
[[Page 20398]]
(for example, when all such entities compute value-at-risk using the
same confidence level and holding period). Most importantly, value-at-
risk incorporates correlations among positions in the portfolio without
revealing the positions themselves; it does not compromise the
confidentiality of a firm's trading strategies.
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\26\ As used herein, the term ``loss'' means any adverse change
in the value of a pool's portfolio, whether realized or unreailzed.
See infra at 20.
\27\ Value-at-risk can, of course, be measured in any currency.
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The methodology commonly understood as ``value-at-risk'' may, in
the future, be replaced by some other method of measuring of market
risk. Indeed, one or more reporting persons may already have developed
such an alternative method. Accordingly, for purposes of proposed Rule
4.27 and in the discussion below, the term ``VAR'' shall mean any
measure of exposure to market risk, including value-at-risk, that can
be expressed in dollars and that represents the amount that a pool's
losses during a stated period are expected not to exceed, with a stated
degree of certainty.
VAR would complement traditional balance sheet measures of leverage
by giving other market participants insight into the magnitude of the
firm's exposure to losses. Under Section 4.27(d)(2)(i), each reporting
person would be required to report for each pool under its control the
highest, lowest, and ending VAR calculated during the reporting period
at each confidence level and holding period for which VAR is normally
calculated by the reporting person. However, as further discussed
below, the proposed rule would not require disclosure of stress test
results so as not to discourage reporting persons from conducting the
most rigorous stress tests.\28\ Some reporting persons may conduct
stress testing by calculating VAR at extremely high confidence levels.
Accordingly, no reporting person would be required to report VAR
calculated at a confidence level in excess of 99.6%. (This is the
confidence level corresponding to a VAR not expected to be exceeded
more often than once in a year of 250 trading days).
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\28\ See discussion infra at 14-15.
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A matrix of VAR results (e.g., for 95%, 98%, and 99.6% confidence
levels) would be more informative than a single result. Accordingly,
the proposed rule requires disclosure of the highest, lowest, and
ending VAR at each confidence level and holding period for which VAR is
calculated by the reporting person. The Commission is aware, however,
that this approach might be more burdensome than requiring, for
example, results at the single highest confidence level for which VAR
is calculated. The Commission invites comment on the best approach to
take in this regard.
Under Section 4.27(d)(2)(ii), each reporting person would be
required to report for each holding period for which it calculates VAR
the frequency during the quarter with which losses for each pool under
its control exceeded the corresponding VAR for such pool (at the
highest confidence level calculated not exceeding 99.6%). Each
reporting person would also be required to report the dollar magnitude
of the greatest loss experienced by each pool during the quarter. The
importance of examining the magnitude, as well as the frequency, of
losses in excess of VAR is exemplified by the recommendation of one
group of hedge fund managers that ``[e]ven if the frequency of changes
in value in excess of that generated by the market risk model is within
the expected range, if the observed change in the value of the
portfolio differs significantly from the change that would be expected,
given the composition of the portfolio and the observed changes in the
market factors, [the hedge fund manager] should reconcile the
difference.'' \29\
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\29\ Industry Sound Practices repoert at 17.
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Many hedge funds actively seek risk, and indeed serve the market by
acting as ``risk absorbers;'' that is, ``by standing ready to lose
capital, [they] act as a buffer for other market participants in
absorbing `shocks.' '' \30\ The ratio of VAR to net asset value
(``NAV'') provides an indication of the ability of a firm to absorb the
losses that it is likely to experience during normal market conditions.
This type of ratio very usefully relates the separate concepts of
leverage and risk to one another. The Industry Sound Practices report
recommends that hedge fund managers track the leverage of their funds
by ``using `risk-based leverage' measures reflecting the relationship
between the riskiness of a * * * portfolio and the capacity * * * to
absorb the impact of that risk.'' ``VAR/Equity'' is one of several such
measures mentioned in the report.\31\
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\30\ Id. at 3.
\31\ Id. at 19-20.
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To be sure, the calculation of VAR is highly sensitive to the
selection of the confidence level at which it is measured, and the
holding period over which it is calculated. There is no widely accepted
standard for either of these parameters. For example, a 95% one-day VAR
for a particular firm may be a relatively low dollar value that is
expected to be exceeded every month (95% covering 19 out of 20 trading
days in a month). By contrast, a 99.6% one-day VAR for the same firm
might be a significantly larger dollar value that is not expected to be
exceeded more often than once a year (99.6% covering 249/250 trading
days). Many firms use each of these confidence levels and still other
firms use levels of 98%, 99%, and so forth.
The Commission has considered whether it would be advisable to
ensure that reported VAR information would remain directly comparable
across multiple firms. To do so, the Commission would have to mandate
the confidence level and holding period for which firms would be
required to calculate and report VAR. This would mean, however, that
some firms might be compelled to begin calculating VAR information that
they do not already prepare and that would be inconsistent with the
information used internally to manage trading activities. The Basel
Committee on Banking Supervision (``Basel'') and IOSCO have recognized
that the objectives of comparability across firms and consistency with
internal risk management systems are not always compatible. They have
emphasized the latter objective because ``linking public disclosure to
internal risk management processes helps ensure that disclosure keeps
pace with innovations in risk measurement and management techniques.''
\32\
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\32\ Basel and IOSCO, ``Recommendations for Public Disclosure of
Trading and Derivatives Activities of Banks and Securities Firms,''
October 1999, at 6 (hereinafter the ``Basel/IOSCO Disclosure
Recommendations'').
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The Commission believes that it is more important to ensure
consistency with internal practices and proposes to require reporting
persons to report VAR only for confidence levels and holding periods
for which VAR is routinely calculated for internal purposes. This
approach would provide other market participants with information which
is consistent with information the pool's management utilizes in
managing risk internally, in addition to imposing a lighter regulatory
burden upon reporting persons.
Nor is the Commission proposing to specify a particular method or
model that a firm should use to calculate VAR. To do so could create
significant burdens for reporting persons and, given the rapid pace of
innovation in both financial engineering and risk management, would be
of questionable utility. Rather, the Commission is following the
``internal model'' approach chosen by Basel and IOSCO.
The Commission does seek to encourage firms to use accurate,
reliable VAR models, and would do so by mandating the disclosure of the
firms'
[[Page 20399]]
backtesting results. Backtesting is a process by which the losses
implied by the VAR calculation are compared to the losses
experienced.\33\ The results of this comparison provide valuable
information about the validity of a firm's VAR model.\34\ The
Commission believes that market discipline will be facilitated by
disclosing this information, so that other market participants may
reach their own conclusions as to the accuracy of the firm's VAR, and
the reliability of the firm's risk management systems. For example, if
a firm calculates VAR at a 95% confidence interval over a one-day
holding period, the expected value for the number of trading days that
the VAR figure will be exceeded over a quarter-year of approximately 60
trading days is three (60 trading days x 95% = 57; 60-57=3). If a
firm's actual one-day losses exceeded its calculated 95% one-day VAR on
ten separate occasions during a quarter, and no sufficient explanation
is provided, other market participants might conclude that the VAR
calculated by the firm is of questionable reliability, and might draw
adverse inferences concerning the firm's risk management.
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\33\ ``By comparing actual changes in the value of the portfolio
to the changes generated by the VAR calculation, the [hedge fund
manager] can gain insight into whether the VAR model is accurately
measuring a [hedge fund's] risk.'' Industry Sound Practices report
at I-13.
\34\ ``[I]f the frequency of changes in value of the portfolio
exceeds the frequency generated by the market risk model (a
statistical expection based on the confidence level of the market
risk model), such deviation should be scrutinized to determine its
source.'' Id. at 16.
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Even when validated by solid backtest results, however, VAR
provides only part of the information necessary to fully evaluate a
firm's exposure to market risk. VAR represents merely the loss that is
not expected to be exceeded under ``normal'' market conditions; it
provides no information whatsoever about the possible extent of losses
under ``abnormal'' market conditions. Even if VAR accurately predicts
the worst loss that would occur in 99.6% of the trading days over a
year (250 x 99.6% = 249), it would not provide any information as to
the magnitude of potential losses on the remaining 0.4% of the trading
days (250 x 0.4% = 1). A reporting person can only explore the
potential extent of such extraordinary losses by conducting stress
tests.
Stress tests involve subjecting models of the firm's positions to
various sets of extreme market conditions and measuring the losses that
would result.\35\ These conditions might include historical
circumstances, such as the 1987 stock market drop or the 1998 Russian
loan default, or hypothetical scenarios specifically designed to stress
the firm's current positions. Consequently, the results of properly
performed stress tests can show extraordinarily high hypothetical
losses. For example, a firm with total assets of $3 billion, a net
asset value of $500 million, and a 99.6% one-day VAR of $100 million
(e.g. a VAR-to-NAV ratio of only 20% which many might consider quite
adequate) could very likely, through rigorous stress tests, generate
modeled losses well in excess of $500 million.
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\35\ Hedge fund managers are advised to ``perform `stress tests'
to determine how potential changes in market conditions could impact
the market risk of [their] portfolio[s]. * * * [and] also consider
conducting `scenario analyses' to benchmark the risk of the [the
fund's] current portfolio against various scenarios of market
behavior (historical or prospective) that are relevant to the
[manager's] trading activities (e.g. the October 1987 stock market
event, the Asian financial crisis * * *).'' Industry Sound Practices
report at 15-16.
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If reporting persons were compelled to publicly disclose their
stress test results, they might be discouraged from performing the most
rigorous stress tests that they could develop and might not learn of
and address potential weaknesses in their portfolio strategies.
Therefore, the proposed rule would not require reporting persons to
report stress test results. Rather, reporting persons would be required
simply to report whether stress tests have been performed during the
quarter and, if so, whether the results of such tests are communicated
to an appropriate level of management.
The reporting person would be permitted (but not required) to
provide any other information with which it might wish to supplement
the reported VAR information. This information would be posted publicly
along with the required information.
3. Initial Reporting Concerning Risk Management Practices Under Rule
4.27
As discussed above, the Commission is not proposing to mandate use
of specific parameters or methodologies for monitoring the risk
exposures. This means, however, that for the quantitative information
in the quarterly reports to be useful to other market participants,
some additional information must be made available to enable the
quarterly reports to be placed in context.
The Commission therefore proposes that each reporting person submit
narrative descriptions of their practices in five areas set forth in
Section 4.27(c)(2). These cover the reporting person's policies,
procedures, and systems for supervising, monitoring, and reviewing
market, credit, and funding liquidity risks generated by its financing,
trading, and investment activities. Initially, each reporting person
would be required to submit an entire set of responses. Thereafter, a
revised set of responses would be required following any material
change in those policies, procedures, or systems. Such updated
responses would be due concurrently with the submission of the next
quarterly report required under Section 4.27(d)(2).
The Commission has developed the topics described below based on a
review of discussions of ``best practices'' from both governmental
organizations \36\ and private industry.\37\ It is important to note
that the Commission is not proposing to require reporting persons to
use any of the tools that are the subjects of the inquiries. This is
consistent with the caveats in the private industry reports, which
emphasize that the best practices they discuss may not be appropriate
for hedge funds of all sizes.\38\ Rather, the Commission is simply
proposing that reporting persons be required to disclose to the market
information about its use of such tools, along with any additional
information the reporting person might believe is necessary to put that
disclosure in context. It would then be up to a reporting person's
counterparties to determine whether or not the reporting person's risk
management efforts are adequate, and the appropriate steps to take in
light of that determination. Thus, these reports are expected to lead
to improvements in risk management systems as market discipline
encourages firms to adopt best practices as they evolve in the
industry.
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\36\ See generally PWG Report; Basel and IOSCO, ``Trading and
disclosures of Banks and Securities Firms--Results of the Survey of
Public Disclosures in 1998 annual Reports,'' December 1999; the
IOSCO Hedge Fund Report; the Basel/IOSCO Disclosure Recommendations;
Basel, ``Sound Practices for Banks' Interactions with Highly
Leveraged Institutions,'' January 1999; Basel/IOSCO, ``Framework for
Supervisory Information about Derivatives and Trading Activities,''
September 1998; IOSCO, ``Principles for the Supervision of Operators
of Collective Investment Schemes,'' September 1997; and Basel,
``Supervisory Framework for the Use of `Backtesting' in Conjunction
with the Internal Models Approach to Market Risk Capital
Requirements,'' January 1996.
\37\ See generally the Industry Sound Practices Report and the
Counterparty Risk Management Policy Group (or ``CRMPG,'' a group of
major commercial and investment banks), ``Improving Counterparty
Risk Management Practices,'' June 1999 (hereinafter the ``CRMPG
Report'').
\38\ See, e.g., CRMPG Report at 2 and Industry Sound Practices
report at 2.
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[[Page 20400]]
Topic 1--Approach to Risk Management
The first topic is the reporting person's overall approach to risk
management. A responsive disclosure would include a discussion of the
extent to which the reporting person has established an independent
risk monitoring function within its organization, the extent of that
function's resources and the nature of its authority, the types of risk
monitoring techniques the reporting person employs, and the ways in
which senior management is involved in risk management.\39\
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\39\ The risk monitoring function ``should report directly to
[s]enior [m]anagement and be staffed with persons having sufficient
experience and knowledge to understand [the fund's] trading
strategies and the nature and risk of its investments.'' In
addition, ``[c]omprehensive and centralized systems for position and
global exposure reporting and risk analysis should function
independently of risk selection/portfolio management personnel so
that trading activities and operations may be effectively supervised
and compliance with trading policies and risk limits can be
controlled.'' Industry Sound Practices report at 10.
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The Commission believes this information would be of particular
value in helping other market participants to develop an understanding
of the strength of the reporting person's commitment to sound risk
management practices. For example, information about the degree to
which senior management is involved in risk monitoring, the authority
which the risk monitoring function may exercise over other functions
such as the trading desk, and the financial and human resources
dedicated to risk management efforts could assist other market
participants in gauging how rigorously the firm balances its risk
taking against potential returns.
Topics 2 (Market Risk in Normal Markets) & 3 (Market Risk in Abnormal
Markets)
The second and third topics both relate to the reporting person's
approach to measuring and managing its exposure to market risk. The
second topic is the method used by the reporting person to measure
market risk during normal market conditions, how it validates its
models (for example, backtesting), and whether its practices are tested
by external auditors. These inquiries are intended to give other market
participants insight into the reliability of the quantitative market
risk information conveyed quarterly by reporting persons. The knowledge
that a reporting person is utilizing contemporary techniques to measure
market risk, has addressed major problem areas with input data, and
subjects its methodologies to backtesting and external audits might
give other market participants greater confidence in these quarterly
numbers.
The third topic is the reporting person's use of stress tests, its
policies and practices for ensuring that meaningful and realistic
scenarios are used in stress tests, and the extent of management
involvement in the process of developing scenarios and evaluating
results. This information is important in helping other market
participants evaluate the extent to which the reporting person prepares
for abnormal market conditions. Stress tests are an essential tool for
exploring the potential extent of extraordinary losses under such
market conditions. The value of stress testing depends on the
development and use of scenarios that are meaningful to the unique
market positions of the reporting person. Ensuring that scenarios are
meaningful requires the involvement of experienced and seasoned traders
and managers.
Topic 4 (Credit Risk)
The fourth topic is credit risk; that is, the likelihood that
trading counterparties will be unwilling or unable to perform their
obligations to a reporting person (also sometimes called ``default
risk''). Credit risk is currently the focus of widespread efforts to
develop quantitative measurement techniques similar to those that have
been developed to measure market risk. However, these techniques are
not yet as well developed nor are they as generally accepted as are the
market risk measurement techniques such as value-at-risk. Accordingly,
the Commission does not propose to require any disclosure of
quantitative credit risk information in the quarterly reports.
The Commission does believe that other market participants will
benefit from insight into the extent to and means by which a reporting
person monitors its credit risk exposures. Therefore, under the
proposal, each reporting person would be required to provide
information about the basic processes by which it evaluates the
creditworthiness of potential counterparties, whether it employs any of
various methodologies to quantify its credit risk exposures, whether it
monitors the concentration of its exposures, and whether it uses credit
risk mitigation tools such as netting agreements.
Topic 5 (Funding Liquidity Risk)
The fifth topic is funding liquidity risk; that is, the risk that
due to its capital structure or to constraints upon its ability to
access additional external capital a reporting person will be unable to
fund its operations or to fulfill its trading obligations without
resorting to the unplanned liquidation of positions.\40\
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\40\ Hedge fund managers ``should evaluate the stability of
sources of liquidity and plan for funding needs accordingly,
including a contingency plan in periods of stress * * * [including]
taking into account potential investor redemptions and contractual
arrangements that affect [the hedge fund's] liquidity (e.g. notice
periods for reduction of credit lines by counterparties).'' Industry
Sound Practices report at 18.
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The Commission has concluded that requiring a reporting person to
disclose detailed information on its access to additional capital might
impinge upon sensitive relationships and has decided not to propose
requiring the disclosure of quantitative information about funding
liquidity risk in the quarterly reports. Each reporting person would,
however, be required to provide a description of the processes by which
it monitors its funding liquidity, determines an appropriate limit on
financial leverage, and ensures its ability to access additional
capital when necessary.
4. Filing and Attestation
Proposed Section 4.27(e) would provide for the filing of required
reports by mail and concurrently by e-mail. The Commission believes
that electronic filing would expedite processing and publication of the
data filed, and that the large, sophisticated entities that would be
required to report under this regulation are likely to have the
facilities to file reports in this matter without undue burden. The
Commission proposes to require attestation of all required filings in a
manner consistent with Section 4.22(h).
5. Definitional Matters
Proposed Sections 4.27(a)(1) and (7) refer to the definitions of
commodity pool operator and net asset value set forth in Sec. 4.10 of
Part 4.
Section 4.27(a)(2) would define control as the direct or indirect
power to direct or cause the direction of the management and policies
of the pool, whether through the ownership of any share, partnership
interest or other investment in the pool, by contract or otherwise.
This definition is modeled after that found in regulation 12b-2 under
the Securities Exchange Act of 1934, 17 CFR 240.12b-2.
Section 4.27(a)(3) would define controlled assets as the aggregate
of all assets in one or more pools under common control. (Investments
by one such pool in another are excluded to avoid double counting).
Section
[[Page 20401]]
4.27(a)(4) would define controlled net asset value in a similar manner.
Section 4.27(a)(5) would define governing authority of a pool to
mean the pool's Board of Directors, managing member, general partner,
trustee or similar person with the legal authority and responsibility
to manage the affairs of the pool, while section 4.27(a)(10) would
define senior management of a reporting person as the managing
committee, group of executives, or other body with the authority and
responsibility to direct and oversee the trading activities of a pool
controlled by the reporting person.
Section 4.27(a)(6) would define loss as any adverse change,
realized or unrealized, in the value of a pool's portfolio, as measured
for risk management purposes. This definition focuses on losses as
actually measured by the reporting person. This calculation excludes
additions, withdrawals, and redemptions of capital.
Section 4.27(a)(8) would define pool as any investment trust,
syndicate or similar form of enterprise that is controlled by a
commodity pool operator.
Section 4.27(a)(9) would define reporting period as each calendar
quarter; however, if all pools controlled by the same person have a
fiscal year other than the calendar year, and all such pools have the
same fiscal year, it shall mean each such fiscal quarter. The latter
restriction is intended to avoid confusion in cases where multiple
pools controlled by the same person have different fiscal years.
Section 4.27(a)(11) would define VAR as the amount, stated in U.S.
dollars, which a pool's losses during a stated period (the ``holding
period'') are expected, with a stated degree of certainty (the
``confidence level''), not to exceed. This includes the statistical
measure, ``value-at-risk,'' currently calculated by many market
participants, as well as any similar measure of market risk that may be
developed or used.
III. Related Matters
A. Paperwork Reduction Act
Rule 4.27 contains information collection requirements. As required
by the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)), the
Commission has submitted a copy of this section to the Office of
Management and Budget (OMB) for its review.
Collection of Information
Rules Relating to the Public Reporting by Operators of Certain
Large Commodity Pools, OMB Control Number 3038-XXXX.
The burden associated with the proposed new rule is estimated to be
1,125 hours which will result from new reporting requirements for
certain large commodity pool operators (CPOs).
The estimated burden of the proposed new rule with respect to
ongoing quarterly reports required under Section 4.27(d) of each entity
that qualifies under Section 4.27(b) was calculated for each year in
which Rule 4.27 is effective as follows:
Estimated number of respondents: 25
Annual responses by each respondent: 4
Total annual responses: 100
Estimated average hours per response: 5
Annual reporting burden: 500 hours
The estimated burden of the proposed new rule with respect to the
initial report required under Section 4.27(c) of each entity in the
year in which such entity first qualifies under Section 4.27(b) was
calculated for the first year in which Rule 4.27 is made effective as
follows:
Estimated number of respondents: 25
Annual responses by each respondent: 1
Total annual responses: 25
Estimated average hours per response: 25
Annual reporting burden: 625 hours
Organizations and individuals desiring to submit comments on the
information collection requirements should direct them to the Office of
Information and Regulatory Affairs, OMB, Room 10235 New Executive
Office Building, Washington, DC 20503, Attention: Desk Officer for the
Commodity Futures Trading Commission.
The Commission considers comments by the public on this proposed
collection of information in--
� Evaluating whether the proposed collection of information
is necessary for the proper performance of the functions of the
Commission, including whether the information will have a practical
use;
� Evaluating the accuracy of the Commission's estimate of
the burden of the proposed collection of information, including the
validity of the methodology and assumptions used;
� Enhancing the quality, usefulness, and clarity of the
information to be collected; and
� Minimizing the burden of collection of information on
those who are to respond, including through the use of appropriate
automated electronic, mechanical, or other technological collection
techniques or other forms of information technology, e.g., permitting
electronic submission of responses.
OMB is required to make a decision concerning the collection of
information contained in these proposed regulations between 30 and 60
days after publication of this document in the Federal Register. A
comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publication. This does not affect the
deadline for the public to comment to the Commission on the proposed
regulations.
Copies of the information collection submission to OMB are
available from the CFTC Clearance Officer, 1155--21st Street, NW,
Washington, DC 20581, (202) 418-5160.
B. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601-611,
requires that agencies, in proposing regulations, consider the impact
of those regulations on small businesses. The Commission has previously
established certain definitions of ``small entities'' to be used by the
Commission in evaluating the impact of its regulations on such entities
in accordance with the RFA.\41\ The Commission has previously
determined that FCMs and CPOs are not small entities for the purpose of
the RFA.\42\ Moreover, the regulations that are the subject of the
present rulemaking apply, by their terms, only to extraordinarily large
entities. The Chairman, on behalf of the Commission hereby certifies,
pursuant to 5 U.S.C. 605(b), that these proposed regulations will not
have a significant economic impact on a substantial number of small
entities. Nonetheless, the Commission specifically requests comment on
the impact these proposed regulations might have on small entities.
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\41\ 47 FR 18618-18621 (April 30, 1982).
\42\ 47 FR 18619-18620 (April 30, 1982).
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List of Subjects in 17 CFR Part 4
Advertising, Commodity futures, Commodity interest, Commodity pool
operators, Consumer protection.
In consideration of the foregoing and pursuant to the authority
contained in the Commodity Exchange Act and, in particular, section
1a(4), 4l, 4m, 4n, and 8a, 7 U.S.C. 1a(4), 6l, 6m, 6n, and 12a, the
Commission hereby proposes to amend Chapter I of the Code of Federal
Regulations as follows:
PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS
1. The authority citation for Part 4 continues to read as follows:
[[Page 20402]]
Authority: 7 U.S.C. 1a.2, 4, 6b, 6c, 6l, 6m, 6n, 6o, 12a and 23.
2. A new Sec. 4.27 is proposed to be added to subpart B to read as
follows:
Sec. 4.27 Public reporting by operators of certain large commodity
pools.
(a) General definitions. For the purposes of this section:
(1) Commodity pool operator or CPO has the same meaning as
``commodity pool operator'' defined in section 1a(4) of the Commodity
Exchange Act;
(2) Control means the possession, direct or indirect, of the power
to direct or cause the direction of the management and policies of a
person, whether through the ownership of voting securities, by
contract, or otherwise;
(3) Controlled assets means the sum of all assets in all pools
controlled by the same person, exclusive of any interest that any pool
controlled by such person may have in any other pool controlled by such
person;
(4) Controlled net asset value or CNAV means the sum of the net
asset values for all pools controlled by the same person, exclusive of
any interest that any pool controlled by such person may have in any
other pool controlled by such person;
(5) Governing authority means a pool's Board of Directors, managing
member, general partner, trustee or similar person with the legal
authority and responsibility to manage the affairs of the pool;
(6) Loss means any adverse change, realized or unrealized, in the
value of a pool's portfolio, as measured for risk management purposes.
This calculation excludes any additions, withdrawals, or redemptions of
capital;
(7) Net asset value or NAV has the same meaning as ``net asset
value'' as defined in Sec. 4.10(b);
(8) Pool means any investment trust, syndicate or similar form of
enterprise that is controlled by a commodity pool operator;
(9) Reporting period means either:
(i) Each quarter ending March 31, June 30, September 30, or
December 31, or
(ii) In the case of a reporting person controlling one or more
pools of which each has the same fiscal year that is not the calendar
year, each quarter of such fiscal year for such pool(s);
(10) Senior management means the managing committee, group of
executives, or other body of a reporting person with the authority and
responsibility to direct and oversee the trading activities of a pool
controlled by such reporting person; and
(11) VAR means the amount, stated in U.S. dollars, which a pool's
losses during a stated period (the ``holding period'') are expected,
with a stated degree of certainty (the ``confidence level''), not to
exceed.
(b) Persons required to report. (1) A reporting person is any
commodity pool operator that:
(i) Controls one or more pools where, as of the last business day
of a reporting period,
(A) The controlled assets of such pool or pools are equal to or
greater than three billion dollars ($3,000,000,000); or
(B) The controlled net asset value of such pool or pools is equal
to or greater than one billion dollars ($1,000,000,000); or
(ii) That qualified as a reporting person pursuant to this
paragraph (b)(1) as of the last business day of any of the prior three
reporting periods.
(2) For purposes of calculations pursuant to this paragraph (b),
all amounts shall be converted to U.S. dollars at the rate in effect on
the date for which such report is made.
(c) Initial reporting. Each reporting person shall file with the
Commission, not later than 30 days after the end of the first reporting
period during which such reporting person satisfies the requirements of
paragraph (b) of this section, a report with respect to each pool under
its control and each such report shall contain the name and address of
the reporting person, the name of the pool with respect to which the
report is being filed, and the following information:
(1) A narrative description of the strategic approach taken toward
the management of market, credit, and funding liquidity risk exposures,
including:
(i) The process by which the pool's governing authority sets
standards for appropriate risk taking,
(ii) The structure, autonomy, and authority of the risk monitoring
function,
(iii) The types of tests and tools used to control risk taking in
trading and investment activities, and
(iv) The extent and frequency of risk information routinely
provided to the governing authority and senior management;
(2) A narrative description of the technique (such as value-at-
risk) used to measure, monitor, and manage the exposure of the pool to
market risk, including discussions of, as applicable:
(i) Methodology (for example, historic, parametric, Monte Carlo, or
quasi Monte Carlo),
(ii) Confidence levels and holding periods,
(iii) The evaluation of correlations within and among markets,
(iv) How the position liquidity of portfolios is monitored,
(v) How non-normally distributed data is handled,
(vi) Whether historic data is weighted,
(vii) How models are backtested or otherwise validated, and
(viii) How often models are tested by an external auditor;
(3) A narrative description of the use of stress tests to determine
the magnitude of potential losses in excess of VAR, including
discussions of:
(i) The methodologies used (for example, historic events,
hypothetical scenarios, or matrix analysis),
(ii) Stress factors examined,
(iii) The extent of senior management's involvement with the design
and construction of stress tests,
(iv) The extent to which stress test results are communicated to
the governing authority and to senior management, and
(v) The policies established with respect to actions that
management should take in response to results deemed incompatible with
its risk appetite;
(4) A narrative description of the measurement, monitoring, and
management of the pool's exposure to credit risk, including:
(i) How the creditworthiness of individual counterparties is
evaluated,
(ii) Whether value-at-risk-style techniques for quantifying credit
risk are utilized,
(iii) How the concentration of exposures to particular
counterparties and sectors is monitored, and
(iv) Whether netting agreements and other credit risk mitigation
tools are employed; and
(5) A narrative description of the measurement, monitoring, and
management of the pool's exposure to funding liquidity risk, including:
(i) The approach taken toward managing financial leverage,
(ii) How the level of liquid reserves is determined, and
(iii) The extent of the authority, if any, to:
(A) Restrict withdrawals of capital or other redemptions of
interests in the pool or repayments of subordinated debt,
(B) Compel additional contributions of capital, and
(C) Access committed lines of credit.
(6) If any tests, analyses, or practices discussed in paragraphs
(c)(1) through (5) of this section are not performed, the reporting
person should so state separately with respect to each item.
(d) Quarterly reporting. Each reporting person shall file with the
Commission, not later than 30 days after
[[Page 20403]]
the end of each reporting period, a report with respect to each pool
under its control. Each such report shall contain the name and address
of the reporting person, the name of the pool with respect to which the
report is being filed, and the following information:
(1) Financial information:
(i) A statement of financial condition as of the end of the
reporting period;
(ii) A statement of income or loss for the reporting period;
(iii) A statement of changes in financial position for the
reporting period; and
(iv) A statement of changes in net asset value over the reporting
period which shall be prepared in accordance with Sec. 4.22(a)(2).
(2) Risk information:
(i) The highest, lowest, and last VAR for the pool during the
reporting period at each confidence level and holding period for which
it was calculated by the reporting person; provided that VAR calculated
for confidence intervals in excess of 99.6% need not be reported;
(ii) (A) For each holding period for which the reporting person
calculated VAR, the number of occasions, if any, on which losses
exceeded the corresponding VAR calculated for that holding period at
the greatest confidence interval, not in excess of 99.6%, for which VAR
was calculated by the reporting person and
(B) The dollar amount of the greatest loss during the reporting
period, whether or not it exceeded the corresponding VAR;
(iii) A brief discussion of whether, during the quarter, stress
tests were performed with respect to the pool's positions and, if so,
whether the results thereof were reported to senior management and the
governing authority; and
(iv) Any additional information which the reporting person wishes
to present to supplement the information in paragraph (d)(2) of this
section.
(3) Changes in risk management practices: If, for any pool
controlled by the reporting person, there is any material change to the
information provided pursuant to paragraph (c) of this section, as
modified by previous submissions pursuant to this paragraph (d)(3)
concerning that pool, the reporting person shall submit a revised set
of responses pursuant to paragraph (c) of this section.
(4) All financial information shall be reported in accordance with
generally accepted accounting principles consistently applied.
(e) Filing requirements. Each report required to be filed with the
Commission under this section shall:
(1) Be signed in accordance with the requirements of Sec. 4.22(h);
and
(2) Be sent via first-class mail, postage prepaid, to: Commodity
Futures Trading Commission, Three Lafayette Centre, 1155--21st Street,
NW., Washington, DC 20581, Attention: Managed Funds Branch, and by
attachment to an e-mail message addressed and sent to [email protected]
with electronic confirmation of delivery activated.
(3) Copies of reports shall be retained in accordance with
Sec. 1.31.
(f) Public records. Reports filed pursuant to this section shall be
considered Public Records as defined in Sec. 145.0 of this chapter.
* * * * *
Issued in Washington, DC, on April 11, 2000 by the Commission.
Jean A. Webb,
Secretary of the Commission,
Dissenting Remarks of Commissioner Barbara Pedersen Holum, Proposed
Rule 4.27;Reporting by Operators of Certain Large Commodity Pools
In April 1999, the President's Working Group on Financial
Markets issued a report entitled ``Hedge Funds, Leverage, and the
Lessons of Long-Term Capital Management'' (the ``PWG Report'').
Among other things, the PWG Report recommended (i) that registered
CPOs operating large funds begin filing with the Commission
quarterly, (ii) that the reports include more comprehensive
information on market risk, and (iii) that information in the
reports be published.
These recommendations respond to events occurring twenty months
ago. However, market developments since then call into question
whether a specific prescriptive rule, such as proposed Rule 4.27, is
the appropriate response at this time.
In my judgement, and in light of the recommendations of the CFTC
staff task force report entitled ``A New Regulatory Framework,'' the
Commission should seek comment on whether the specific
recommendations of the PWG Report remain current and, if so, how
best to achieve them. For these reasons, I respectfully dissent from
the Commission's issuance of proposed Rule 4.27.
Commissioner Barbara Pedersen Holum
Date: April 7, 2000.
Concurring Statement of Commissioner Erickson
I concur with the Commission's publication of the proposed rules
that would require commodity pool operators (CPOs) of the largest
commodity pools to file quarterly reports with the Commission. Given
that the proposed rules are intended to respond to the events
surrounding the near-collapse of Long-Term Capital Management
(LTCM), comments from the public and especially from the industry
will be instructive in the Commission's efforts to craft an approach
that is indeed effective. In addition to comments limited to the
proposed rule, I am interested in comments that will inform the
Commission about how the industry has addressed the potential risks
posed by certain highly leveraged institutions since the LTCM
episode. Moreover, I encourage the submission of comments that
provide input on the following issues:
1. The proposed rules envision a reporting system whereby the
Commission is essentially a conduit for the public dissemination of
quarterly reports without any further review by any federal
financial regulator. Is publication alone sufficient?
2. It is not clear that reporting on a quarterly basis would
have been sufficient to address the events precipitating the private
rescue of LTCM. Assuming that reporting alone is an adequate
response, would quarterly reporting be effective?
3. The April 1999 report of the President's Working Group on
Financial Markets concluded that the ``central public policy issue
raised by the LTCM episode is how to constrain excessive leverage
more effectively.'' One possible way to address leverage concerns
would be to require CPOs to provide the Commission with a
confidential early warning notification structured similar to the
Commission's existing notification requirement with respect to net
capital requirements for futures commission merchants. Such an
approach may address publicly expressed concerns about the quantity
and quality of the information available to federal financial
regulators in the weeks preceding LTCM. What are the public policy
implications of such an approach--either in addition to or in lieu
of quarterly reports?
[FR Doc. 00-9463 Filed 4-14-00; 8:45 am]
BILLING CODE 6351-01-P
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