Hedge Funds andInternational Financial Markets
1. Introduction (excerpt)
Since the outbreak of the Asian financialcrisis in the summer of 1997, the rapid flow of private-sector capital intointernational financial markets and the role played by institutional investorshave been drawing renewed attention. And unfamiliar words, such as "hedgefunds," have started to appear frequently in newspapers along theargument that speculative activities by hedge funds and other institutionalinvestors have played havoc with the economies of emerging countries, inparticular with those of emerging countries in Asia. But the authorities ofadvanced countries and the IMF did not seem to have been fully aware of theimplications of hedge fund activities. For example, an IMF report on hedgefunds, which was worked out in May 1998, does not make thorough discussion onthe dire impact of hedge fund activities with high leverages. It contains suchsentences as "hedge fund capital is small relative to the resources at thecommand of other institutional investors" and "hedge funds have theflexibility (to cope with changes in the market.)… Thus, they can function as'stabilization speculation.' "
The international financial communityas a whole began to deal with problems caused by hedge funds only after theRussian crisis in the summer of 1998 and the near collapse of Long Term CapitalManagement (LTCM) of the U.S. that followed. The problems have been taken up anddiscussed at the Summit of the Asia Pacific Economic Cooperation (APEC), whichis composed of newly industrializing Asian countries, and the Asia EuropeMeeting (ASEM) since the fall of 1998. They have been and will also be one ofthe major topics of discussion at such global economic and financial forums asthe IMF, G-7 meetings of finance ministers and central bankers, and meetings offinance ministers on the occasion of G-7 summits. Japan has made proposals onthe need to enhance transparency with regard to hedge fund activities in view oftheir impact on emerging market countries.
Following the release of a report by theBasle Committee on Banking Supervision in January 1999, G-7 countries incooperation with the Basle Committee and IOSCO established the FinancialStability Forum in April to promote discussions on banking supervision. Inthe private sector, the Counter Party Risk Management Policy Group, a groupformed by financial institutions with global operations, published a report inJune. Furthermore, in the United States, the President’s Working Group onFinancial Markets (chaired by Treasury Secretary Robert Rubin) released areport on April 28.
2. What are hedge funds? (omission)
3. Legal status of hedge funds in the U.S. (omission)
4. Role and impact on international financial markets (excerpt)
Generally speaking, the existence ofinvestors, including hedge funds, who are willing to take risks provide theliquidity to the market and allows easier reallocation of market risks. Someargue that hedge funds, as willing risk takers, have played a role of alubricant in the market just as "oil money" once did.
Speculation performs a market stabilizingfunction when, for example, some one buys an asset when its price is low andsells it when the price is high in a situation where there is only actualdemand. In this case, the speculator can make profits, but prices tend to beequalized since there would be additional demand when prices are low and therewould be additional supply when prices are high. In this connection, the IMFreport released last May gives a positive evaluation on the function of hedgefunds; while a mutual fund that enjoys high returns may attract new investorsand be bound by its prospectus to buy more of the recently appreciated asset andother institutional investors may be forced to cut their losses by theirinternal controls and to sell into a falling market, hedge funds are better ableto ride out these fluctuations because their investors are locked in forsubstantial periods and thus hedge fund should stabilize the market.
Contrary to the view just mentioned, otherswould argue that hedge funds sometimes have an extremely strong influence or monopolisticallydistorting power on a specific market due in some part to herd behavior(which will be described later), bringing about an equilibrium far removed fromthe economic fundamentals of a country, which would not have occurred but fortheir speculative activities. They argue that hedge funds fall into either oneof the following models-"self-realizing monetary crisis model"(which maintains that a monetary crisis is not necessarily caused by theaggravation of economic fundamentals but rather it becomes actual crisis becauseinvestors make a speculative attack on a currency in anticipation of adevaluation of the currency) and "multiple equilibria model"(which maintains that although in an economic model there is only oneequilibrium guided by initial conditions or exogenous variables, there could bemore than one equilibrium in a market like a foreign exchange market, where aprice forecast for the future often determines the price for the moment.)According to these arguments, in small economies adopting a fixed exchange rateregime, for example, a massive short-selling of the country's currency inexpectation of a shift from the fixed exchange rate regime could cause a plungein the value of the currency first on the futures market and then on the spotmarket and it could make it impossible to restore the original equilibrium, eventhough its policy management is sound.
Furthermore, if there is a lack oftransparency and no restrictions or supervision are in place on certaininstitutional investors like in the case of hedge funds, there is a greaterpossibility that trading partners (counter parties) of such investors will notbe fully aware of the risks involved and the final risk-taking burden willshift to the trading partner or the whole system. The case of LTCM suggestssuch a possibility. The collapse of LTCM revealed that in an extremelycompetitive market environment 1) it was difficult for each trading partner tohave a full picture of the business risks involved in LTCM, 2) there weretrading incentives based on the need to know LTCM's investment strategy andthere was excessive confidence in the risk management ability of the LTCMmanagement and 3) the effective leverage was underestimated so that somefinancial institutions offered generous trading terms.
When we consider the impact of hedge funds'behavior on financial markets, we have to pay attention not only to hedge funds'investment behavior per se, but also to the existence of financial institutionsand investors who copy hedge funds' behavior. The influence of hedge funds onthe market will become greater if they behave in anticipation that otherinvestors would follow them. According to thoughts that investors tend to makeinvestment decisions based on how they think other investors as a whole wouldbehave rather than on their own judgment of economic fundamentals, we have tokeep in mind that hedge funds could induce such “herd behavior," in theexamination of the influence of hedge funds. It is generally said that sincehedge funds' investment strategy is presumed to be based on a more sophisticatedinvestment theory, other investors often conduct copycat trading.
In order to explain that herd behavior isrational, the following three models are often cited. 1) According to the"profit externality model," the higher the number of investorsthat adopt similar behavior, the more profit they will earn. For example, asMaynard Keynes said in his "beauty contest theory," you can getgreater return by investing on the basis of "many other investors think ita good investment" rather than on "this is a good investment." 2)According to the "principal-agent model," when information toevaluate the investment results of a fund manager is not sufficient, theevaluation is made by comparing with others. So the fund manager, out of hisdesire to uphold his reputation, would behave based on how the herd wouldbehave. However, some argue that this model does not apply to hedge fundsthemselves because the rewards for a fund manager of a hedge fund are determinednot in comparison with those of other institutional investors but on the sheerinvestment returns. 3) According to the "information cascademodel," investors make the same investment decision as the investorswho acted earlier, believing that those who acted earlier must have had betterinvestment information and must have made the investment decision based on theinformation. When information spreads in a cascade fashion, the herd as a wholetakes investment action in the same direction. In addition to these threemodels, some argue that the fact that many institutional investors adopt asimilar investment decision model is the source of herd behavior.
In view of the fact that hedge funds weremost active in relatively small markets in Asia in the process of Asianfinancial crisis, their influence has to be evaluated in relation to themarket size of emerging market countries. If a market is small, hedge fundscan exert a greater influence through fluctuations in market prices. On theother hand, what is most important for hedge funds' investment strategy isliquidity of the market. If there is not enough liquidity, it is difficult tohedge risks for investments or liquidate positions just before a crisis occurs.Therefore, some people maintain that rather than a market that is too small, anopen and highly liquid market is essential for hedge funds to be active players.It also has to be noted that if a hedge fund liquidates its position drasticallyin a low liquidity market, it would have far-reaching effects on the wholemarket.
5. Policy issues in advanced countries
Some people argue that hedge funds should becarefully supervised and kept under control in advanced countries where hedgefund investors and fund managers reside and where there are a lot of financialinstitutions as trading partners. In general, financial markets and financialinstitutions should be kept under control for three reasons, that is 1) toprotect investors, 2) to ensure the soundness and integrity of the market, and3) to maintain the stability of the financial system. Every advanced country hasregulations on such traditional financial institutions as banks, brokeragehouses and insurance companies in this regard. However, advanced countries havefew regulations, including disclosure requirements, on hedge funds, not even inthe United States where most hedge funds have their bases in effect. If advancedcountries supervise and control hedge funds in one way or another in respect ofthree purposes (as described above 1)-3) ), we can reduce the possibility ofhedge funds' speculative activity causing a crisis in emerging market countriesand thereby stabilize the international financial system.
First, regarding investors protection,it is generally thought that tighter controls, including more informationdisclosure, on hedge funds to protect investors are not necessary becauseinvestors in hedge funds are a small number of high-income earners, haveprofessional knowledge on investment, and because hedge funds are on a privatesubscription basis. Some argue that hedge funds are already providing investorswith fairly detailed information in line with their business strategy ofcomplying with investors' demands. If the degree of information disclosure toinvestors becomes one of the factors in choosing a hedge fund, informationdisclosure will make progress under the market mechanism. But others argue thatthe quality of information provided to investors varies depending on theimportance of the investors. On this issue, there are two opinions. One of themis that it is not necessary to seek proper disclosure of information throughtighter regulations since it is a matter just between a limited number ofprofessional investors and hedge funds. The other is that further examinationshould be made to see if it is necessary to work out some measures to provideinvestors protection.
Ensuring the soundness and integrity ofthe market is an important policy objective. If such things as marketmanipulation by a big player, circulation of rumors, water sales and insidertrading become rampant, the market would lose its integrity and would eventuallylose its function to effectively allocate resources. Market rules to cope withthese problems are already in place in advanced countries' securities markets.But we have to keep in mind that excessive restrictions will disrupt freetransactions and efficiency of the market. It should also be noted thatmanipulation of transactions on exchange markets and of derivative trading onOTC markets are difficult to recognize because they are negotiated transactionsand extremely varied demand and supply are offset in these markets. Since thesetransactions are not made on the exchanges, it is difficult for supervisors toconstantly keep a close watch and take timely measures. However, in the UnitedStates, it is legally required to report to authorities if an exchangetransaction is unusually large. Some point out that if such a rule is properlyapplied, it could hold artificial market disturbance in check to a certainextent.
Maintaining the stability of the financialsystem is also an important policy objective for every country from thestandpoint of maintaining the settlement system, which is the fundamentalinfrastructure for economic activity, and of protecting depositors. A hedge fundper se does not have settlement-system or deposit-accepting functions. But if ahedge fund incurs a huge loss, it would cause deterioration of assets atcreditor financial institutions and this would worsen market sentiment and causea flight to liquidity, leading to a sharp decline in liquidity. Depending on thedegree of the decline, it could cause anxiety about the financial system as awhole. The collapse of LTCM is a good case in point. From the standpoint ofmaintaining a stable financial system, strengthening regulations on financialinstitutions (e.g. large-lot loan regulations and raising lending risk weightsunder capital adequacy rules) would help protect the financial system from therisks of hedge funds. The Basle Committee report proposes tightening theserestrictions, while at the same time calling for financial institutions'thorough risk management on transactions with hedge funds. It is expected thatthese steps, if implemented, would help to indirectly curb hedge funds'risk-taking behavior.
Hedge funds are generally viewed as"speculators" who make highly risky investments. But as describedearlier, there are views that they make cool-headed investment judgmentsconsistent with economic rationality; their behavior provides liquidity to thefinancial market and prevents the market from moving in only one direction;their behavior greatly helps to establish an efficient, transparent andundistorted market. (In this last sense, some commentators described hedge fundsas "yield curve police.") In any case, in order to reducedestabilizing factors to be caused by international investors like hedge funds,every country should strive to establish and maintain an undistorted, highlyliquid and transparent market as much as possible.
On the other hand, if some measures arereally needed to cope with problems posed by hedge funds, there are twoapproaches. One is a "direct approach," which calls on hedgefunds to disclose their information and report to authorities and/or imposesregulations on their establishment and management. The other is an "indirectapproach," which calls on those financial institutions having abusiness or lending relationship with hedge funds to enhance the risk managementand/or imposes regulations on such operations. Yet other approaches wouldinclude strengthening the market rules by obligating every market participant todisclose and report large-lot transactions, tightening rules on leverage of OTCand negotiated transactions and supervise large-lot transactions from thestandpoint of maintaining a fair market. It is noteworthy that the President'sWorking Group in its report called for introducing and reinforcing reporting anddisclosure obligations of hedge funds, in addition to thoroughly implementingthe "indirect approach."
In either case, costs and benefits should befully compared in working out measures to cope with risks that would be broughtabout by hedge fund operations. In particular, it is important to be aware of thetechnical or legal difficulties with regard to how to define coverage ofregulations, how to prevent regulation-evading behaviors once the coverage ofregulations defined and how to have the regulations observed effectively. Ifsome kinds of restrictions on hedge funds are really necessary, it is pointedout that we should study and explore a system through international cooperationby establishing a realistic and practical standard.
If it is necessary to impose certainobligations or discipline the behavior of hedge funds, we need to study whichcountry should have legislative and legal power over them, in view of theinternational nature of hedge funds. As to legislative jurisdiction,there are four basic ideas in international law. They are 1) territorialprinciple (A country has legislative jurisdiction over any act done within itsterritory.), 2) nationality principle (A country has legislative jurisdictionover any act done by its citizen or by a company established under the country'slaws, regardless of where the act has been done.), 3) national interestprinciple (A country has legislative jurisdiction over any act that may have agrave impact on the country's national interest, such as national security andstability of the economic system, regardless of who did the act and where.), 4)universality principle (A country has legislative jurisdiction over any actwhich runs counter to the universal interest of the whole world, regardless ofwho did the act and where it was done and regardless of whether the act had adirect impact on the country.) The problem is how to employ these ideas. Take,for example, the most popular idea of the territorial principle. It could beargued that legislative jurisdiction rests with the country in which thetransactions took place, with the country on which law the establishment of theactor is based, with the country where the actor's management headquarters islocated, with the country to which the nationality of the person in charge ofinvestment belongs or in which such person lives, or with the country in whichinvestors or ultimate beneficiaries from investment activities reside. As to theexecution of laws, it would be most effective to carry out execution first inthe United States, where most hedge funds have their bases in effect.
Given the fact that funds move freely andinstantly from one country to another, hedge funds would detect loopholes withhigh possibility even if regulations have been put in place. So, it is pointedout that it would be necessary for those countries with major financial marketsto take a concerted approach to the problem within the framework of their sharedobjectives of maintaining the transparency and stability of the markets. Itwould also be necessary for industrialized countries to seek the cooperation of"offshore centers" where many institutions have established and urgesuch countries and regions not to take steps that may be detrimental to theeffectiveness of their regulations. It is, therefore, important to promote closeinternational cooperation in order to cope with the problems among G-7 andother advanced countries as well as among countries with major money centers.The Financial Stability Forum as described in Chapter 1 would be a good place tocoordinate.
6. Policy issues in emerging countries
For an emerging country whose market size issmall compared with the amount of funds hedge funds and other institutionalinvestors can mobilize or the positions that such investors can build, it ismuch more vital than for advanced countries to take preventive measuresagainst a huge, abrupt shift of capital and promote the stability of its owncurrency and financial market. First of all, it would be important to take asound macroeconomic policy and strengthen the financial supervisory system bythoroughly implementing prudential rules for financial institutions. But at thesame time, emerging countries should explore the possibility of introducingregulations in accordance with the situations in each country from thestandpoint of stabilizing the financial system and keeping the market integrityin the same manner as discussed above regarding advanced countries. They shouldalso address the following problems unique to them: 1) how to proceed with theliberalization of capital transactions, 2) establishment of an appropriateexchange rate regime, and 3) capital controls in response to crises.
As will be described below, Japan has beentaking a realistic, and practical approach to the promotion of capitalliberalization and roles to be played by capital controls. It is true that thefree flow of capital has helped to increase the productivity and economicdevelopment of emerging and other capital-receiving countries and has broughtabout higher returns to the investors. But in theory as well as in the actualfinancial world, there is no assurance that leaving everything to the marketwould bring about the most efficient allocation of resources, or moresimply put, the optimal economic outcome. As a textbook on microeconomic theorydescribes, for the market to bring about the most efficient allocation ofresources, the following preconditions have to be met: that there is noasymmetry in information held by market participants, that there do not existany economic externality and that objects to be traded do not have thecharacteristics of public goods. However, in a financial market, asymmetry ininformation has often been observed as was described in the herd behaviorsection and a financial system has to a certain extent the characteristics ofpublic goods because the public "collectively" use it. It is,therefore, necessary to regulate domestic finance from the several standpointsdiscussed in chapter 5. In the area of international finance as well, it isimportant to pay attention to several caveats regarding the idea of the freeflow of international capital, which is different from the case of goods(trading). Moreover, it goes without saying that the market mechanism does notperform its full function when various market infrastructures (such as a properaccounting system and legal framework) are not properly organized.
It was once a dominant international viewthat the liberalization of capital transactions should be promoted asbroadly and speedily as possible. But now an international consensus is that theliberalization should be proceeded in a well-sequenced manner assuring whethercertain preconditions are in place. There would be preconditions to promote theliberalization of capital transactions: 1) a market economy system is firmlyestablished (in particular in countries whose economies are in transition), 2)liberalization of trade is in progress, and 3) the economy is mature in generaland has been integrated into the world economy to a certain extent. It is alsonecessary 4) to have a strong financial sector and a highly efficientsupervisory system. Regarding the last precondition, it is essential, forexample, to monitor the risks involved in exposure to foreigncurrency-denominated loans and maturity mismatches through appropriateimplementation of prudential regulations. Some also suggest that theliberalization of the more stable long-term direct investment should precedethat of short-term capital transaction. Japan has advocated the necessity of thewell-sequenced liberalization of capital transactions.
Given the current huge and drastic movementof capital in the world economy, what kind of exchange rate regime anemerging country should decide to choose is very important. Of course, whatwould be the most suitable exchange rate regime for a country varies dependingon the country's economic size, the composition of its trading partners, thecomposition of its major trading items, the degree of capital liberalization andits inflation experience. But the Asian crisis has taught us that pegging acountry's currency to any one particular currency is highly risky. Generallyspeaking, an emerging market country can flexibly cope with exchangefluctuations by pegging its currency with, or referring to, a basket ofcurrencies of some advanced countries with which it has the closestinterdependent relationship in terms of trade and investment. In any case, thereis no simple formula. Therefore, it should be stressed here that it is importantfor every emerging country to choose a suitable exchange rate regime on a caseby case basis and implement an appropriate macroeconomic policy consistent withthe adopted exchange regime.
An inflow of capital into a country has sofar simply been regarded as merely a reflection of confidence in the country'spotential and its policy. But it is necessary for emerging market countries inparticular to monitor the size and content of capital inflow and adoptthe appropriate macroeconomic policy to cope with it. It is essential to beaware that the direction of short-term capital may change suddenly from aninflow to an outflow and that holding foreign currency-denominated debtscontains foreign exchange risk. During the Asian crisis, the amount of capitalthat once flew in and then flew out of Asian countries in one year amounted tomore than 10% of the combined gross domestic product of the countries involved.Therefore, there may be arguments for making best use of market friendly controlson capital inflow in a way that would not distort the market. Such capitalcontrols would include higher reserve ratios for deposits received fromnonresidents and stricter prudent regulations on borrowing from abroad andsecurities issuance by residents (in particular, by financial institutions).
Implementing controls on capital outflowat a time of crisis would inevitably have long-term adverse effects oninvestment in the country. And in view of the fact that financial transactionsare complicated and highly developed now, it is not easy to effectively controlcapital outflow and employing discretionary or arbitrary restrictions for a longtime would deteriorate the efficiency of the national economy. Having saidthese, however, implementing such controls may be justified in exceptional casessuch as when the country is facing a massive outflow of capital due to thecontagion of a crisis in another country despite the fact that the country'spolicy is basically sound, when there is a need to prevent IMF loans from beingused for the rescue of investors abroad, and when the country prevents theflight of residents' capital. Of course, these controls should not be viewed asa norm but as exceptional measures. It is also important that such restrictionsare carefully designed so that they would not have adverse effects on the inflowof stable and useful investments such as direct investment involving thetransfer of technology or management know-how.
In international field, most arguments arecautious about controls on capital outflow due to the many problems involved,including possible adverse effects on capital inflow, difficulty in ensuringeffectiveness and the interests of investors in advanced countries. However, itis noteworthy that there has emerged a fresh argument that capital and exchangecontrols are necessary in exceptional cases from the standpoint of promoting"private involvement in the prevention and settlement of crises."The recent string of crises in Asia is characteristic in that the private sectorwas both the main creditors and debtors and that the crises were caused whenthey became unable to maintain the massive inflow of capital. We should nottolerate the use of IMF and other public funds to help private creditors andinvestors withdraw their funds, from the standpoint of fairness and efficiency(from the viewpoint of moral hazard that similar incidents may occur in thefuture), since they invested in emerging countries seeking for high returns,knowing the risky nature of their investment. It is now increasingly called forthat, as preconditions for assistance from the IMF, private banks shouldmaintain a certain level of lending and that debtors, including bond holders,should restructure their debts. In an extension of this argument, some proposethat in order to give time for debt restructuring, temporary capital andexchange control should be considered to suspend payments of public debts orcurb debt repayments by the private sector.
We should study controls on capital inflowand outflow from a realistic perspective, including in what casesrestrictions would be justified and what restrictions would be appropriate toeach emerging country as a way of crisis management, taking into considerationcost and benefit of such measures. Reflecting strong requests from the JapaneseGovernment among others, the IMF will continue its comprehensive analysis andstudy of restrictions implemented so far by each country, which is expected tocome up with useful outcome.