[Senate Hearing 109-1068]
[From the U.S. Government Publishing Office]



                                                       S. Hrg. 109-1068

 
                       REGULATION OF HEDGE FUNDS

=======================================================================

                                HEARINGS

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

THE INCREASED SCRUTINY OF THESE LIGHTLY-REGULATED FUNDS AND THE LACK OF 
            REPORTING REQUIREMENTS, AUDITS, AND INSPECTIONS

                               __________

                         TUESDAY, JULY 25, 2006

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs




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                            senate05sh.html




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel
     Steven B. Harris, Democratic Staff Director and Chief Counsel
                          Justin Daly, Counsel
                        Joe Cwiklinski, Counsel
                 Dean V. Shahinian, Democratic Counsel
                 Lee Price, Democratic Chief Economist
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor


                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 25, 2006

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Allard...............................................     3
    Senator Hagel................................................     3
    Senator Bunning..............................................     4
    Senator Crapo................................................     5
    Senator Sununu...............................................     5
    Senator Bennett..............................................     6
    Senator Stabenow
        Prepared statement.......................................    31

                               WITNESSES

Christopher Cox, Chairman, Securities and Exchange Commission....     7
    Prepared Statement...........................................    31
    Response to written questions of:
        Senator Bunning..........................................    44
        Senator Crapo............................................    47
Reuben Jeffery, III, Chairman, Commodity Futures Trading 
  Commission.....................................................    11
    Prepared Statement...........................................    35
    Response to written questions of:
        Senator Bunning..........................................    48
        Senator Crapo............................................    52
Randal K. Quarles, Under Secretary for Domestic Finance, 
  Department of the Treasury.....................................    13
    Prepared Statement...........................................    39


                       REGULATION OF HEDGE FUNDS

                              ----------                              


                         TUESDAY, JULY 25, 2006

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:11 a.m., in Room 538, Dirksen 
Senate Office Building, Hon. Richard C. Shelby, Chairman of the 
Committee, presiding.

              OPENING STATEMENT OF CHAIRMAN SHELBY

    Chairman Shelby. The Committee will come to order.
    Today the Committee will examine the operation and the 
regulation of hedge funds. This hearing is particularly timely, 
given last month's Federal Appeals Court decision invalidating 
the Securities and Exchange Commission's rule requiring that 
certain hedge funds advisers register with the agency.
    As the Senate panel with exclusive jurisdiction of hedge 
funds, the Banking Committee intends to continue its active 
role in overseeing the industry's activities and regulatory 
structure.
    Hedge funds are flourishing. Just 15 years ago the industry 
managed only $50 billion in assets. That number now exceeds $1 
trillion. Wealthy investors and large institutions, including 
pension funds and universities, have increasingly sought the 
portfolio diversification and returns in both bull and bear 
markets that hedge funds have been able to provide.
    This dramatic growth has attracted the attention of 
financial regulators including the SEC. In late 2004, the 
Commission adopted its Hedge Fund Rule on the three to two 
vote. The agency based its rulemaking on the industry's rapid 
growth, the perceived exposure of average investors to hedge 
funds, and an increase in enforcement actions brought against 
hedge funds.
    Now that the rule has been vacated, it is appropriate to 
once again consider whether there is a prudent basis for 
increased regulation of a dynamic industry that has delivered 
considerable returns for its investors and important liquidity 
benefits to the markets and has avoided a comprehensive 
regulatory scheme on the theory that its sophisticated investor 
base can fend for itself.
    We must conduct this review in a manner that is mindful of 
the context in which hedge funds currently operate in order to 
accurately assess the costs and benefits associated with the 
choices that we make.
    There is a common misperception that hedge funds are 
completely unregulated and absolutely secretive investment 
vehicles. It is important to note that hedge funds are 
currently subject to the market manipulation and anti-fraud 
provision of the Federal securities laws. On this point, I want 
to note the crucial importance of these laws. They are 
fundamental to the operation of the marketplace. It is 
absolutely essential for the SEC to uniformly apply these rules 
to every individual participating in the capital markets, 
without exception.
    While we are discussing the integrity of the marketplace 
generally, I would like to take a moment and digress from the 
topic of hedge funds to express my concern to Chairman Cox 
recording the manner in which stock options have been granted 
at some companies. I intend to explore these troubling 
revelations here further during the question and answer period.
    Returning to hedge funds, I would also add that thousands 
of funds are currently registered with the SEC and the 
Commodity Futures Trading Commission, and thus subject to 
oversight and inspections. Moreover, Government regulators have 
access to information relating to hedge funds.
    I look forward to hearing our witnesses discuss these 
issues in more detail.
    This morning we will hear testimony from the Honorable 
Christopher Cox, Chairman, the Securities and Exchange 
Commission; the Honorable Reuben Jeffery, III, Chairman, 
Commodity Futures Trading Commission; and the Honorable Randal 
K. Quarles, Under Secretary of the Treasury for Domestic 
Finance, U.S. Department of the Treasury.
    Senator Sarbanes.

                 STATEMENT OF SENATOR SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby.
    I want to commend Chairman Shelby for convening today's 
hearings to examine the hedge funds. Actually, in recent years 
this Committee has held several oversight hearings that focus 
on hedge funds or at which hedge funds issues were discussed 
and I think it is important to underscore that this is an 
important area of the Committee's jurisdiction.
    The hedge fund industry, as the Chairman has referenced, is 
a significant component of the Nation's financial landscape. It 
has grown rapidly in recent years. It has an estimated $1.2 
trillion of assets under management. Hedge funds have brought 
improved liquidity and price efficiency to financial markets. 
Millions of Americans are invested in hedge funds, either 
directly or more relevantly indirectly through retirement plans 
or fund the funds.
    Public interest in hedge funds has been growing. Recently, 
in a speech to the Federal Home Loan Bank of Atlanta, Chairman 
Bernanke of the Federal Reserve noted and I quote him ``The 
debate about hedge funds and their effects on financial markets 
has now resumed with vigor, spurred no doubt by the creation of 
many new funds, large reported in-flow to funds, and a 
broadening investor base.''
    As investment in hedge funds have grown, public concern has 
also grown. This recent article in the Washington Post, which 
read Hedge Funds Near Day of Reckoning--I am not quite sure 
what the reckoning was to being, but in any event--and a July 
20th column in the Wall Street Journal by its Deputy Washington 
Bureau Chief David Wessel said, ``How would hedge funds behave 
in a crisis? If there is a financial earthquake, will these new 
mechanisms turn it into a tsunami? Will we have fewer crises 
but bigger ones, that sort that jar whole economies, not just 
shake up a few leveraged investors? It is a good time for such 
questions.''
    Witnesses who previously have testified before this 
Committee and other observers have also voiced concerns about 
whether there is excessive leverage, the valuation and 
transparency of hedge funds assets, whether the standards for 
an accredited investor are too low, whether they need to be 
adjusted, a potential conflicts of interest involving managers 
of hedge funds and mutual funds, and the impact of hedge fund 
trading particularly short selling and its potential for market 
manipulation on the securities markets.
    I join the Chairman in welcoming Chairman Cox, Chairman 
Jeffery and Treasury Under Secretary Quarles to the Committee. 
We look forward to their testimony about these issues.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Senator Allard.

                  STATEMENT OF SENATOR ALLARD

    Senator Allard. Mr. Chairman, I would also like to thank 
you for holding this important hearing. Other committees have 
some oversight on this, but from my point of view this is the 
primary Committee that has oversight as far as hedge funds are 
concerned. And so I think this is an important hearing.
    Historically, hedge funds provide an investment vehicle for 
financially sophisticated investors with sizable capital to 
invest. The funds seek to profit in all kinds of markets 
through leveraging and other speculative investment practices 
that may increase the risk of investment loss. Not all mutual 
funds are required to register with the SEC and are not 
required to provide the same level of disclosure.
    However, as investors look for ways to maximize returns, 
more are turning to hedge funds. But do these investors, 
particularly those investing in the registered funds of hedge 
funds, adequately understand the risks involved? How does less 
regulation of hedge funds translate into the capital markets?
    This hearing will be a good opportunity to explore these 
and other matters. We have an excellent lineup of witnesses 
that will be able to provide helpful insight, Mr. Chairman. I 
thank them for being here today and look forward to their 
testimony.
    Thank you for holding this hearing.
    Chairman Shelby. Senator Hagel.

                   STATEMENT OF SENATOR HAGEL

    Senator Hagel. Mr. Chairman, thank you. And to our 
witnesses, good morning and thank you for your appearance this 
morning.
    I, like all members of the Committee, Mr. Chairman, will be 
interested in hearing what our witnesses have to say. Markets 
have, over the years, provided important liquidity for our 
economy. We have generally and overwhelmingly benefited from 
that liquidity, as we have enhanced our productivity and our 
competitive position in the world. There have been spikes of 
volatility, bubbles, excesses. We appreciate that.
    One of the issues that I know our witnesses will get into 
this morning, and it is an area that I would like to ask some 
questions on, is do our witnesses believe that hedge funds now 
are contributing to an unacceptable amount of volatility in our 
markets? What are your projections for the next couple of 
years? If we stay where we are, essentially with a very limited 
regulatory scheme, is that good? Do we risk continued 
volatility or deeper or wider volatility that may, in fact, 
impact on our economy and our competitive position in the 
world, our future investment opportunities?
    Those are the general areas I think, Mr. Chairman, that we 
are going to want to hear about today. And I will reserve 
further comments and questions until I have an opportunity to 
ask the questions.
    Thank you.
    Chairman Shelby. Senator Bunning.

                  STATEMENT OF SENATOR BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    There have been some major developments since the hearing 
on hedge funds in May. As the Chairman mentioned, the SEC rule 
requiring hedge funds advisers to register was thrown out by 
the D.C. Circuit. So I think it is appropriate to have another 
hearing.
    The biggest cause for concern about hedge funds is that we 
do not know a lot about them. Due to that lack of information, 
we cannot be sure how much risk they pose to our financial 
systems. I think we need to know more and hopefully we will get 
some good answers in this hearing.
    A lot of money is invested in hedge funds, some estimate as 
high as $1 trillion worldwide. In addition to being a popular 
investment option for the wealthy, hedge funds have also become 
popular for university endowments and pension funds. A lot of 
money and a lot of people's futures are riding on them, and 
that raises a lot of questions and concerns.
    Not only do hedge funds affect people who are directly 
invested in them, but because of their size and speed, they can 
affect the entire market when they move. We can all agree that 
it is important to take reasonable steps to protect investors.
    But even more importantly, we must be sure that we are 
keeping a close eye on threats to the stability of our 
financial markets. That is why we need to know more about what 
hedge funds are doing and what they are not doing. It is not 
our job to stop investors from taking any risk. But we need to 
address risk to our financial markets and the overall economic 
well-being of our country. I hope we can get a better picture 
of what is going on and what needs to be done.
    I look forward to the hearing, what the SEC has learned in 
the brief registration period, and what the agency's plans are 
now that the courts have acted. Hopefully, this hearing will 
help us to see where we need to go from here.
    Thank you very much.
    Chairman Shelby. Senator Crapo.

                   STATEMENT OF SENATOR CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman.
    I, too, join with everyone who has thanked you for holding 
this hearing. It is a very critical and important issue.
    It is no secret that I have been a strong critic of the 
SEC's Hedge Fund Rule, and it is going to be interesting to me 
today to hear from the SEC as to what their intentions are in 
terms of moving forward.
    I am not going to repeat the kinds of comments that have 
already been made by my colleagues here. I share the concerns 
that they have raised and the interest that they show.
    I do have an additional concern that in this arena, as well 
as in many others, I hope that we are going to be able to 
create an environment and to find that balance where we create 
an environment where business can thrive in the United States 
and where we do not get caught up in over regulating business 
to the point that we send it overseas. I think that all too 
often today we see kind of an overreaction to the need to 
assure that we have safety and soundness in our markets, which 
I think is a proper objective and which is the line we want to 
achieve.
    What we are, in my opinion, seeing a dangerous trend in 
terms of creating a situation in which the United States is not 
necessarily the most favorable climate in which to conduct 
business these days.
    And so I am going to be looking to see if the incredible 
increase in popularity and use of hedge funds has resulted in a 
changing dynamic in the marketplace such that it will require 
us to extend further regulatory controls and establish new 
regulatory regimes in order to assure the safety and soundness 
of our markets, or whether we are already at that point where 
we have the right balance in place and we simply need to see 
the kind of regulatory structure that currently exists properly 
and effectively enforced.
    It is those kinds of questions that are most interesting to 
me, because I believe we have not only the safety and soundness 
of our markets at stake here but the issue of whether our 
markets will stay our markets if we do not manage and regulate 
them properly.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you. Senator Sununu.

                  STATEMENT OF SENATOR SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    I think as we begin the hearing and prepare to hear from 
our witnesses, it is important to be clear about why we are 
here. We are here because the D.C. Circuit invalidated a very 
significant portion of the hedge fund regulations that the SEC 
promulgated in 2004. The D.C. Circuit invalidated this 
regulation because this regulation, like several others put 
forward by the SEC in the 2002 to 2004 timeframe, was not 
designed to address any specific problems that we were seeing 
in this area, the financial services industry. And no empirical 
evidence was ever provided to argue how, in fact, the proposed 
regulations might improve the performance, oversight and 
security of this part of the financial services industry, hedge 
funds.
    And in the absence of any clear definition of a problem 
that the regulatory infrastructure is trying to address, and in 
the absence of any empirical evidence purporting to demonstrate 
how this regulation will improve the efficiency of the markets, 
no one should be surprised that a court decides that the way in 
which the regulations were put forward was arbitrary or unfair.
    I think the lesson here is that in this case the hedge fund 
regulation, but in all cases we want the SEC to be clear and 
professional and thorough in its recommendation of new 
regulations. And that means identifying a problem, being clear 
about what we are trying to address, solve or improve in the 
financial services industry, make sure that that is consistent 
with the SEC's very important mission of protecting average 
investors, and then at least make an effort to put together 
some empirical data that will suggest that this regulation 
might actually solve the problem.
    I do not think that is too much to ask. I, and many other 
members of this Committee, asked for that very thing time and 
time again with regard to this regulation, with regard to other 
regulations that have also been struck down by the courts. And 
I think if we can make an effort, and I have full faith that 
Chairman Cox understands this and that he will make this 
effort. But if we can make that effort within the SEC, then I 
think we will be less and less likely to have hearings like 
this where we all get together and wonder exactly why courts 
are striking down regulations and how we proceed from here.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bennett.

                  STATEMENT OF SENATOR BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    My colleagues have covered the issues very well, so let me 
just focus on one very small item that is tied to the hedge 
fund thing, not suggesting that the other issues are not 
important.
    By the way, I want to recognize and welcome a fellow 
Utahan, Secretary Quarles, to the Committee.
    Hedge funds have been in the public eye because of their 
involvement in short selling. The whole short selling issue is 
a subsidiary issue, I think, of the question of regulation of 
hedge funds.
    I have engaged in short selling. It has never been 
profitable for me. And since I have been in the Senate I have 
discovered that there are some who find it profitable because 
they never have to cover, and the whole question of naked short 
selling has come out.
    And I think, in the pursuit of the practice of naked short 
selling, we have created an atmosphere where hedge funds may 
have been unfairly targeted and that the whole question of 
short selling has been attacked as an improper kind of 
activity. It is not an improper activity. It is part of the way 
the markets work.
    But I want to congratulate Chairman Cox on the SEC's 
vigilance in going after the naked short selling activity that 
has been going on. It was called to my attention by a Utah 
company, and frankly not the one that has been in the 
headlines, where the organizers of the company had identified 
every single share of the stock and had locked it up in such a 
fashion that it was not available to be borrowed and there were 
still short sales going on. And they said how is this possible 
that people are shorting our stock when we are not making any 
stock available for that purpose? And that was before the SEC 
got involved in chasing this issue.
    I may not be able to stay for the whole hearing. I have, 
unfortunately, two other conflicts today. But I wanted to use 
my opening statement as an opportunity to thank Chairman Cox 
for the work the SEC has been doing here, encourage him to 
continue to do it, and make it clear that my concern about this 
is not an attack on hedge funds as an industry who engage in 
short selling because I think, as an industry, there is a place 
for them to do that and we need to separate these two issues.
    With that, Mr. Chairman, I look forward to the hearing and 
the information we will get from our witnesses.
    Chairman Shelby. Thank you. Senator Reed.
    Senator Reed. Mr. Chairman, I simply want to welcome the 
witnesses and look forward to their testimony.
    Thank you.
    Chairman Shelby. All of your written testimony will be made 
part of the record in its entirety. Chairman Cox, we will start 
with you. Welcome.

            STATEMENT OF CHRISTOPHER COX, CHAIRMAN,
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Cox. Thank you, Mr. Chairman, ranking member Sarbanes, 
members of the Committee. It is a pleasure to be here this 
morning. Thank you for inviting me to testify about the 
regulation of hedge funds.
    It is an especially welcome opportunity to be here with 
Secretary Quarles and Chairman Jeffery as representatives of 
the President's Working Group on Financial Markets.
    As you have recognized, each of us has responsibility for 
different but crucial aspects of the world in which hedge funds 
operate. That is why the Securities and Exchange Commission is 
working closely and cooperatively as a member of the 
President's Working Group on the questions of systemic market 
risk posed by hedge fund activity, and also the investor 
protection issues that stem from the increasing exposure of 
retail investors to opportunities for hedge fund investment.
    Senator Sarbanes. Mr. Chairman, I think if you would pull 
the mic a little closer it would be helpful.
    Chairman Shelby. Pull the mic just a little closer.
    Mr. Cox. I should emphasize at the outset, Mr. Chairman, 
that my testimony today reflects my views as Chairman of the 
Securities and Exchange Commission and does not represent the 
views of the five-member Commission. The views I am expressing 
this morning are solely my own.
    It has been 8 years since Long Term Capital Management 
collapsed. This spectacular hedge fund collapse left in its 
wake serious questions about the threat to our capital markets 
as a whole from such significant funds pursuing high risk 
strategies with what might be generally, not just in that case, 
excessive leverage. In the months that followed, President 
Clinton established the President's Working Group on Financial 
Markets, with the SEC as a member, to coordinate regulatory 
oversight of these issues, as well as other questions that 
broadly impact the national securities markets.
    Since then the President's Working Group has focused 
intently on the concern that the failure of one of more 
significant and highly leveraged investment pools, such as the 
Long Term Capital Management hedge fund, could threaten the 
stability of financial markets. We are more certain now than 
ever before that preventing future market instabilities will 
require a coordinated effort by all financial securities 
regulators.
    But given the recent invalidation of the SEC's Hedge Fund 
Rule by the United States Court of Appeals, we have been forced 
back to the drawing board. Now we have got to devise a new way 
to acquire even basic census data that would be necessary to 
monitor hedge fund activity in a way that could mitigate 
systemic risk.
    The current lack of such basic data requires me to hedge 
when I say that the SEC's best estimate is that there are now 
approximately 8,800 hedge funds, with approximately $1.2 
trillion in assets. If this estimate is accurate, it implies a 
remarkable growth in hedge fund assets of almost 3,000 percent 
in the last 16 years.
    Last year we believe an estimated 2,000 new hedge funds 
opened for business. And although even now hedge funds 
represent just 5 percent of all U.S. assets under management, 
they account for about 30 percent of all U.S. equity trading 
volume. They are particularly active in the convertible bond 
market and the credit derivatives market. We are also seeing 
hedge funds become more active in such varied activities as the 
market for corporate control, private lending, and the trade of 
crude petroleum.
    It is undeniable that in addition to raising questions, 
such as systemic risk and investor protection, hedge funds also 
provide investors and our national securities markets with 
tangible benefits. They contribute substantially to capital 
formation, market efficiency, price discovery, and liquidity. 
Some hedge funds provide a way for institutional investors to 
reduce their exposure to downside risk.
    But given the general lack of disclosure about the way 
hedge funds operate, the lack of standards for measuring a 
fund's valuation and its performance, the possibilities for 
undisclosed conflicts of interest, the unusually high fees, and 
the higher risk that accompanies a hedge funds' expected higher 
returns, these are not investments for mom and pop. They are 
generally risky ventures that simply do not make sense for most 
retail investors.
    While some refer to an alleged growing trend toward the 
retailization of hedge funds, the Commission staff are not 
aware of significant numbers of truly retail investors in the 
United States investing directly in hedge funds. In my view, 
such a development, were it to occur, should be viewed with 
alarm.
    Indeed, in the wake of the Court of Appeals decision in the 
Goldstein case, I intend to recommend to the full Commission 
that the SEC take further steps to further limit the marketing 
and availability of hedge funds to unsophisticated retail 
investors.
    The concerns about hedge funds that the SEC enunciated when 
we adopted our Hedge Fund Rule in December 2004 remain the same 
today. The remarkable pace of hedge fund growth, which we noted 
at the time, has continued unabated. The potential for retail 
investors to be harmed by hedge fund risk remains as serious a 
concern now as then. And the growth in hedge fund fraud that we 
have seen accompany the growth in hedge funds implicates the 
very basic responsibility of the SEC to protect investors from 
fraud, unfair dealing and market manipulation.
    And on that point, let me be very clear that 
notwithstanding the Goldstein decision hedge funds today remain 
subject to SEC regulations and enforcement under the antifraud, 
civil liability and other provisions of the Federal securities 
laws. We will continue to vigorously enforce the Federal 
securities laws against hedge funds and hedge fund advisers who 
violate those laws.
    Hedge funds are not, should not be, and will not be 
unregulated. The challenge for the Securities and Exchange 
Commission and the President's Working Group going forward is 
rather to what extent to add new regulations, particularly in 
light of the recent Court of Appeals ruling.
    The Securities Act, the Exchange Act, and the Advisers Act 
each provides the Commission with separate authorities to 
regulate fraud and unfair dealing by hedge funds. Using this 
still valid authority in recent years, the Commission has 
brought dozens of enforcement cases against hedge fund managers 
who have engaged in fraud or who have violated their fiduciary 
obligations.
    The number of enforcement cases against hedge fund advisers 
has grown from just four in 2001 to more than 90 since then. I 
have provided several recent examples of significant hedge fund 
cases brought by the Commission in my written testimony.
    But while our ability to bring enforcement actions against 
hedge funds and their managers remains intact following the 
Goldstein decision, the same cannot be said for the 
Commission's ability to require hedge fund advisers to register 
and submit to inspections. The Commission stated, when we 
adopted the Hedge Fund Rule in 2004, that its then-current 
program of hedge fund regulation was inadequate. With the 
rejection of the Hedge Fund Rule by the Court of Appeals, I 
believe that is once again the case. We must move quickly to 
address the gaping hole that the Goldstein decision has left.
    Immediately following the Goldstein ruling, I instructed 
the SEC's professional staff to promptly evaluate the Court's 
decision, and to provide me with a set of alternatives that the 
SEC could pursue without legislation. That evaluation is still 
underway, but I have already decided upon several urgent 
courses of action which I can report to this Committee today.
    Specifically, I intend to recommend to the full Commission 
the following emergency rulemakings and Commission actions: 
First, I will recommend that the SEC promulgate a new anti-
fraud rule under the Investment Advisers Act that would have 
the effect of looking through a hedge fund to its investors. 
This would reverse the effect of the D.C. Circuit's opinion 
that the antifraud provisions of Sections 206(1) and 206(2) of 
the Act apply only to clients as the Court interpreted that 
term, and not to investors in the hedge fund. I believe that 
such a rule is possible because the Court itself noted that 
another antifraud provision, Section 206(4), is not limited to 
fraud against clients.
    The result would be a rule that could withstand judicial 
scrutiny and which would clearly state that hedge fund advisers 
owe a fiduciary obligation to investors in the hedge funds. The 
staff is currently analyzing the Commission's authority to 
adopt such a rule to ensure that this interpretation is 
correct.
    Second, I am directing the SEC staff to take emergency 
action to ensure that the transitional and exemptive rules 
contained in the 2004 Hedge Fund Rule are restored to their 
full legal effect. This is necessary to ensure that hedge fund 
advisers who were relying on the now invalidated rule are not 
suddenly in violation of our regulatory requirements when the 
Court issues its final mandate in mid-August.
    Likewise, I am directing emergency action to restore to 
newly registered hedge fund advisers their qualified exemption 
from the recordkeeping requirement for performance data prior 
to their registration. They would still be required to maintain 
all records they have to substantiate their prior performance. 
Without this emergency action prior to mid-August, newly 
registered hedge fund advisers that remain registered, but that 
did not create records for the periods prior to their 
registration, will lose their ability to use their performance 
track record. Rather perversely, this would discourage hedge 
fund advisers from voluntarily remaining registered.
    Yet another emergency action I am directing will restore 
the extension of time that was given to advisers for funds of 
hedge funds to provide their audited financial statements. The 
underlying hedge funds do not typically supply their audited 
financials to the fund of funds manager until the 120 day 
deadline, so the fund of funds managers need extra time to 
complete their audit work and send out the reports. The Hedge 
Fund Rule gave it to them, but the Goldstein decision 
invalidated that relief. I intend for the Commission to restore 
the extension of time from 120 to 180 days.
    Similar action is needed to undo yet another effect of the 
Goldstein decision, which is to undo the Commission's 2004 
Hedge Fund Rule insofar as it applied to offshore advisers to 
offshore hedge funds. Those advisers had to register under the 
new rule, assuming their funds had more than 14 U.S. investors. 
But they would have been subject to different treatment under 
the Advisers Act because they could treat the offshore fund as 
their client for all other purposes.
    The Court's ruling, however, eliminated this aspect of the 
rulemaking. And by creating doubt whether registered offshore 
advisors will be subject to all of the provisions of the Act 
with respect to their offshore hedge funds, the ruling has 
created a disincentive for offshore advisers to remain 
voluntarily registered.
    I have directed the Commission staff to prepare legal 
guidance that might remove this disincentive to registration.
    Finally, to address my concerns with respect to the 
retailization of hedge funds, I have asked the staff to analyze 
and report to the Commission on the possibility of amending the 
current definitions of accredited investor for purposes of 
retail investment in hedge funds without registration. I am 
concerned that the current definitions, which are decades old, 
are not only out of date, but wholly inadequate to protect 
unsophisticated investors from the complex risks of investment 
in most hedge funds.
    The Commission's Hedge Fund Rule would have had the effect 
of increasing the suitability threshold to $1.5 million of net 
worth rather than $1 million for any hedge fund that charges a 
performance fee. This was an important change and I would like 
to see it restored.
    In California, the median home price is well over $500,000. 
So post-Goldstein, with barely more than $200,000 apiece in 
other assets, a California couple could qualify to buy a hedge 
fund in an unregistered offering even though that relatively 
small amount of assets might represent their entire life 
savings in the form of a teacher's or firefighter's retirement 
fund.
    Beyond these emergency rulemakings and other actions to 
restore as much of the pre-Goldstein rule as possible, I have 
directed the SEC staff to continue to conduct compliance 
examinations of investment advisers who remain registered with 
us or who register in the future. All registered hedge fund 
advisers are subject to SEC regulation and the SEC will 
continue to conduct risk-based examinations of hedge fund 
advisers that are registered with the SEC.
    While some number of hedge fund advisers will certainly 
deregister as a result of the Court's decision, our experience 
since Goldstein is that more hedge fund advisers have become 
newly registered than have deregistered. In other words, we 
have actually experienced a net increase in hedge fund adviser 
registrations since the Goldstein decision.
    Mr. Chairman, hedge funds are a significant and a growing 
part of our financial markets that yield not only risks but 
also many benefits for our economic system. Each of us at this 
table, as members of the President's Working Group, has an 
interest and responsibility to continue working collaboratively 
to evaluate both the systemic market risks and retail 
investment issues associated with hedge funds in order to 
maintain these overall benefits. I and the SEC, for our part, 
are committed to doing so.
    Thank you for inviting me to testify on this important 
subject and I am happy, after the panel concludes, to answer 
any questions that you might have.
    Chairman Shelby. Thank you, Chairman Cox.
    Chairman Jeffery.

 STATEMENT OF REUBEN JEFFERY, III, CHAIRMAN, COMMODITY FUTURES 
                       TRADING COMMISSION

    Mr. Jeffery. Chairman Shelby, Senator Sarbanes, members of 
the Committee, I am pleased to have the opportunity to testify 
today on behalf of the CFTC at today's hearing on hedge funds 
regulations.
    I will concentrate my remarks on how hedge funds intersect 
with two of the CFTC's core statutory responsibilities under 
the Commodity Exchange Act. They are: promoting market 
integrity and protecting the public from fraud in the sale of 
futures and commodity options.
    The trading in futures and options on commodities, 
including those based on physical commodities such as energy 
products, has grown at an astonishing pace. The growth in the 
trading of these contracts demonstrates that futures markets 
function as important risk management tools to an ever growing 
number of U.S. investors and businesses.
    Hedge funds, no less than other market participants, are 
covered by CFTC and exchange market surveillance programs to 
the extent that they participate actively in the regulated 
futures markets. The CFTC conducts market surveillance to 
preserve the important functions of risk management and price 
discovery that the futures markets perform in our economy.
    The backbone of the Commission's market surveillance 
program is its so-called large trader reporting system, with 
which many of you are familiar. This serves as an effective 
tool for detecting the types of concentrated and coordinated 
positions required by a trader or group of traders attempting 
to manipulate a market in a particular commodity or financial 
product.
    In addition, each futures exchange is required, under the 
Commodity Exchange Act to affirmatively and effectively monitor 
trading, prices and positions on its exchange.
    Separately, the CFTC's disclosure-oriented customer 
protection regime is key to protecting investors from fraud 
involving commodity pools and hedge funds. I should emphasize 
that the CFTC does not regulate hedge funds, per se. Rather, if 
a hedge fund trades futures or commodity options, the fund is a 
so-called ``commodity pool,'' as defined in our Act, and its 
operator and adviser may be required to register with the CFTC 
unless covered by a registration exemption based on, for 
example, the sophistication of its participants or the de 
minimis amount of commodity interest traded in the fund.
    The CFTC has a simplified regulatory framework for 
registered commodity pool operators and trading advisers who 
operate or advise pools with participants meeting certain 
criteria. The day-to-day oversight of commodity pools and 
commodity trading advisers is carried out by the National 
Futures Association, the futures industry analog to the NASD in 
the securities world.
    As part of its self-regulatory responsibilities, the NFA 
conducts onsite examinations of pool operators and trading 
advisers on a routine, periodic, and exception basis. Whether 
registered or unregistered, pool operators and trading advisers 
remain subject to the CFTC's anti-fraud authority. Over the 
past six fiscal years, the CFTC has brought some 49 enforcement 
actions involving commodity pools, hedge funds and CPOs. These 
enforcement actions typically involve fraudulent sales 
solicitations and/or misappropriation of investor or customer 
funds. In many instances, the CFTC works cooperatively with the 
NFA, state regulators, criminal authorities and the SEC in 
bringing such proceedings.
    In closing, the CFTC's mission under the Commodity Exchange 
Act involves ensuring market integrity and customer protection. 
Hedge funds that trade futures and commodity options implicate 
both of those functions. The CFTC will remain vigilant in 
utilizing the tools provided in the Act--market surveillance, 
disclosure and reporting, and the full force of its enforcement 
authority where necessary--to fulfill its statutory 
responsibilities as hedge fund participation in the futures 
markets continues to expand.
    This concludes my remarks and I look forward to your 
questions. Thank you.
    Chairman Shelby. Secretary Quarles.

 STATEMENT OF RANDAL K. QUARLES, UNDER SECRETARY FOR DOMESTIC 
              FINANCE, DEPARTMENT OF THE TREASURY

    Mr. Quarles. Thank you. Thank you, Chairman Shelby, Senator 
Sarbanes, and members of the Committee for having me here today 
on this panel to contribute to the discussion of a topic that 
is of significance for our financial markets, which is the 
regulation of hedge funds.
    In considering the regulation of any area of financial 
activity, an important threshold matter is an understanding of 
the role that that activity plays in our financial markets. In 
May, before a Subcommittee of this panel I presented testimony 
regarding the role that hedge funds play, what hedge funds do 
in and for our financial markets. As I said then, if Government 
addresses the question of regulation of any financial 
institution or activity without a clear understanding of the 
place that it plays in our financial system, then we run the 
risk of imposing unnecessary or excessive or inappropriate 
regulation.
    Some of the facts about the hedge fund industry are well 
known. They have been referred to today. They are flexible 
investment vehicles. They are able to sell short, leverage 
their investments, use derivatives in a wide variety of 
markets. They have an incentive compensation structure that 
provides generous rewards for strong performance. They restrict 
their investor base to high net work and institutional 
investors. And the industry has grown rapidly, as has already 
been remarked this morning, in the last decade to about 9,000 
funds globally, managing well over $1 trillion in assets.
    What has been less discussed, although this panel has 
certainly been active in focusing on this issue, but what has 
been less discussed in Washington are the benefits that these 
funds bring to our financial markets as their role is evolved 
over the years.
    First and foremost is liquidity. Because of the varying and 
flexible strategies that these funds follow, they are often the 
willing buyers and sellers that add significantly to 
marketplace liquidity. That is particularly true in some of the 
less traditional markets such as the distressed debt and 
convertible bond markets where hedge funds represent the 
overwhelming majority of trading volume.
    Second is price efficiency. Many hedge funds seek to create 
returns by targeting discrepancies between two or more markets 
with wide bid/ask spreads. That has the unsurprising effect of 
narrowing them. And so this private profit-making activity 
produces the public good of better price discovery and more 
efficient markets.
    Third is risk distribution. Concentration of risk is one of 
the greatest threats to a smoothly functioning marketplace and 
hedge funds help to reduce that concentration through their 
willingness to be the counterparties in derivatives 
transactions through which financial institutions lay off some 
of the large risks that are inherent in their normal 
activities.
    Without market participants that are willing to trade these 
derivatives in significant volumes, which hedge funds have the 
flexibility to do, large complex financial institutions that 
have clear systemic significance would have to retain more 
risk.
    But hedge funds do not just continue to a more efficient 
marketplace. They can also directly benefit investors. Their 
increasing number, the diversity of strategies that they can 
follow gives investors more choice. That allows greater 
diversification. And their nimble structures can also create 
the possibility of seeking to outperform traditional 
benchmarks. That is often referred to as generating alpha or 
excess returns. That is a clear benefit, obviously, for the 
investor of a successful fund.
    But while hedge funds provide important benefits to our 
financial markets and market players, there are some open 
questions about how they might affect the financial systems' 
response to stress. Leverage can magnify losses in the 
financial system. And while the fund's balance sheet leverage 
seems contained, it is harder to measure the degree of so-
called embedded leverage that is involved in many of the 
complex structured instruments in which some hedge funds trade.
    So well, overconcentrated positions can strain liquidity. 
Valuation models that hedge funds use can be vulnerable to 
mischief. Some trading practices can present operational 
challenges to clearing and settlement systems.
    So we face a familiar conundrum: what is the proper 
response of Government to a significant marketplace development 
that brings clear and important benefits but raises some 
questions as it involves?
    The lens through which we examine the evolution of any 
institution's role in the financial markets often shapes our 
view of what, if anything, is the right response. And so it is 
important that that lens be as clear and as polished as 
possible.
    So to that end, the Treasury Department is beginning a 
series of meetings to review comprehensively the issues 
surrounding the role of hedge funds in our financial system. 
These meetings involve the regulatory and oversight community, 
fraud outreach to the financial committee including prime 
brokers, transaction counterparties, the funds themselves. And 
as part of this comprehensive review, we will be working with 
the SEC and other PWG members as Chairman Cox and the 
Commission consider alternative courses of action following the 
D.C. Circuit Court's recent decision.
    At the moment, it is too soon to say what, if any, 
initiatives will come from this focus. But we intend for it to 
be a cooperative and collegial effort with the private sector 
with the end being a clear understanding of a rapidly changing 
industry.
    Thank you and I look forward to your questions.
    Chairman Shelby. Thank you, Mr. Secretary.
    Chairman Cox, in your testimony you outline some 
recommended parameters for any hedge fund regulatory regime. 
You assert that there should be no Governmental interference 
with the hedge funds' investment strategies or operations, 
including its use of derivatives, trading, leverage, and short 
selling. In addition, you state there should be no disclosure 
requirements related to portfolio, composition or trading 
strategies. Finally, you caution that policymakers should pay 
careful attention to the cost of any such regulation.
    Chairman Cox, why is the avoidance of unnecessary 
regulations so important to the continued success of hedge 
funds?
    Mr. Cox. Mr. Chairman, as you have heard from each of the 
members of this panel, we believe, and the President's Working 
Group believes, that hedge funds, while posing risks 
particularly to retail investors, also provide benefits. They 
provide benefits in terms of liquidity, in terms of risk 
management, in terms of diversification. And all of these 
things are worth preserving.
    As a result, when we regulate the capital markets, we want 
to be sure that we are achieving the benefits that are 
necessary for investor protection or, in the case of other 
agencies, to deal with these concerns of systemic financial 
risk.
    In terms of the SEC, we have an interest directly in 
maintaining the integrity and the orderliness of the markets. 
But while we are achieving these objectives, we want to make 
sure that we do not interfere with the operations of the market 
itself.
    I should also point out that that list, that desiderata 
that comprises a portion of my written testimony, were norms 
outlined by Commissioner Goldschmidt in a speech that he made 
after the adoption of the Hedge Fund Rule. I think there is 
broad agreement among all of the Commissioners--although I 
cannot speak, as I said, for others who are not here--on those 
general principles.
    Chairman Shelby. Chairman Cox, risk and liquidity are what 
make markets are they not, in a sense? You cannot have a market 
without risk and some liquidity to propel it, can you?
    Mr. Cox. That is exactly right and maintaining pools of 
liquidity, maintaining overall the function of our capital 
markets as deep and liquid, is vitally important.
    Chairman Shelby. In your testimony, you also mentioned it 
was important for the SEC to have basic census data relating to 
hedge funds. What information is currently available to the 
Commission? And what additional information is important for 
the Commission's investor protection agenda?
    Mr. Cox. A fundamental aim of the Hedge Fund Rule that was 
invalidated by the Court of Appeals was to identify hedge fund 
advisers operating in the United States and hedge funds 
operating in the United States. The truth is that before the 
rule and now post-Goldstein neither we nor any Government 
agency has good data on hedge funds.
    As I indicated in my oral presentation just now, for that 
reason I have to hedge when I give you statistics. I believe 
these numbers to be approximately correct, but the truth is 
nobody knows.
    Chairman Shelby. Does the SEC currently have the requisite 
statutory authority to address the questionable activities that 
hedge funds may engage in?
    Mr. Cox. I am not prepared to say yes or no to that 
question today because, Mr. Chairman, as I indicated, our 
review of our authorities, different authorities than we have 
relied upon thus far, is still ongoing.
    I have already been able to identify, as I presented, 
several actions that I believe--although this is somewhat 
tentative--but I believe that we can take these steps. And we 
will have to see collectively what all of the remedial measures 
amount to and whether or not we think they are sufficient.
    But whether or not legislation is necessary or advisable is 
always within the prerogative of the Congress, of course.
    Chairman Shelby. Thank you.
    Secretary Quarles, what is your latest thinking on the 
systemic market risk posed by hedge funds? What is the 
principal risk involved? And are there new risks on the horizon 
that you have identified? And please comment, if you can, on 
the steps taken by the President's Working Group to address 
these dangers, if you see them out there.
    Mr. Quarles. Certainly. I think there is reason to believe 
that there is less risk that is posed by the hedge fund 
industry than may have been posed in the past, say around the 
time of LTCM. You do not have any individual fund that is 
nearly as large as LTCM, that has that many assets. You have a 
greater diversity of strategies. You have a larger number of 
funds.
    So at least on the face of it there are a number of factors 
that would suggest that this is a more stable industry than it 
might have been five or 6 years ago.
    On the other side, I think an issue is the question of 
embedded leverage. So while balance sheet leverage to hedge 
funds in the aggregate is less than it was some years ago, the 
leverage of some of these complex instruments is much harder to 
measure. I think that is something we need to look at and we 
are looking at that in the President's Working Group.
    Chairman Shelby. Chairman Cox, a lot of us have been 
troubled by the recent revelations relating to the backdating 
of stock options. There appears to be some confusion on this 
practice.
    Could you explain to the Committee today whether backdating 
is legal under certain circumstances, and when it is illegal, 
and so forth.
    In other words, this seems to be a big thing going on with 
a lot of companies that does not look very good.
    Mr. Cox. You are absolutely right, Mr. Chairman, and this 
is, for that reason, an area of special interest both from a 
policymaking standpoint and from an enforcement standpoint at 
the Securities and Exchange Commission.
    Undisclosed backdating, which is one of the ways in which 
backdating can be illegal, is a serious potential problem under 
the Federal securities laws. It implicates both our accounting 
rules and our disclosure rules.
    When not properly accounted for, backdated options can 
significantly overstate a company's earnings and conceal its 
true financial conditions. That potential impact exists both 
under the old accounting rule that most companies followed, 
which required companies to expense them in the money portion 
of option grants, and under the new accounting rules, FAS 
123(R).
    The Commission's contested civil fraud action against 
former executives of Brocade Communications Systems, which you 
may be aware of, we announced it last week, is an example of 
the serious accounting implications.
    In that case we allege that fraudulent option grants went 
on for more than 4 years. Brocade restated and revised its 
financial statements for 6 years, from 1999 through 2004, and 
it resulted in inflation of Brocade's net income by as much as 
$1 billion in 2004 alone.
    Chairman Shelby. Does that not undermine the integrity of 
the marketplace? In other words, the integrity of the 
marketplace, confidence in the marketplace, securities market, 
are of the utmost importance to all of us, are they not, as 
investors?
    Mr. Cox. Indeed, Mr. Chairman. And for that reason I 
believe that illegal backdating goes to the heart of investor 
confidence. And it is one of the reasons that the SEC will be 
vigilant in proceeding against it.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    On May 17th, the Washington Post reported, and I quote 
``Some regulators and analysts worry that some sort of market 
shock might prompt many investors to withdraw money from hedge 
funds at the same time, causing a run on the bank that would 
not leave the hedge funds enough cash to refund investors or 
make good on their financial contracts.''
    I am interested in how each of you would respond to these 
concerns about the destabilization that could occur if this 
sequence of events were to take place. How much are you 
concerned about it? Why don't we start with you, Secretary 
Quarles, and we will go across in the other direction.
    Mr. Quarles. I think that it is something that, in the 
President's Working Group, we are focused on, is ensuring we 
understand how the financial system would respond to various 
shocks. For the reasons that I described, there are prima facie 
some reasons to think that the hedge fund industry is better 
situated today than it might have been in the past, both to 
respond to shocks and for problems in the hedge fund industry 
not to metastasize into general problems in the financial 
sector.
    One of the main reasons is the emphasis that has been 
placed since LTCM on counterparty risk management, so that the 
regulated counterparties of the hedge funds, the prime brokers 
and the depository institutions that provide financing for the 
hedge funds, are more focused than they have been in the past 
and have more information than they have had in the past about 
overall exposures and about the quality of that credit.
    So both because of the increasing number and diversity of 
strategies, which in general ought to result in less 
correlation, although I think there are some reasons to look at 
that and ensure whether there really is significant diversity 
on some of these facially diverse strategies, as well as the 
emphasis that is placed on counterparty risk management, there 
is reason to believe the hedge fund industry is in better shape 
for a financial shock than it has been the past.
    But we are continuing to look at that question in the 
President's Working Group. We are not complacent.
    Senator Sarbanes. Anyone want to add to that?
    Mr. Cox. Mr. Chairman, I would just echo what Secretary 
Quarles said concerning some of the changes that have taken 
place in the industry and in the market since the collapse of 
Long Term Capital Management in 1998.
    Broker dealers have become much more sophisticated in 
managing their exposure to hedge funds, we believe, through 
secured financing transactions, for example. Prime brokers 
active in financing positions for hedge funds have, as a group, 
dramatically improved their capacity to monitor the value of 
collateral and liquidate positions quickly. And that, in turn, 
reduces their risk of loss.
    I would note that many of these enhancements are 
implementations of the recommendations of the reports issued by 
the Counterparty Risk Management Group in 1999 and 2005.
    But having said that, if there were, as is posited in the 
newspaper article from which you quoted, a systemic downturn, I 
am absolutely certain it would heighten the risk of fraud by 
hedge fund advisers because some managers would be tempted in 
those circumstances to hide losses and to falsify their returns 
in order to avoid losing their investors. And that, I think, 
places a premium on at least the aims of the approach that the 
Commission had taken in our Hedge Fund Rule because for the 
hedge fund advisers that are registered, and this will be true 
even post-Goldstein for those that remain registered, the 
oversight that we exercise through our examination program will 
potentially deter some fraud and expose other fraud before it 
can seriously harm investors.
    The same is true to the extent that all registered advisers 
have to implement compliance policies and procedures and 
designate a chief compliance officer. These are all important 
aspects of our approach that I think we look in other ways to 
maintain.
    Senator Sarbanes. The AFL-CIO, Richard Trumka, the 
Secretary-Treasurer, has written to the Chairman and me, as the 
ranking member, about their concern about the pension funds, 
worker pension assets, that are then placed in hedge funds. And 
they note that in the pension bill that is being considered in 
the Congress now there is a move afoot to allow substantially 
more pension assets to be invested in hedge funds that will not 
be subject to ERISA coverage.
    I am interested to know your view on this possibility of 
weakening ERISA protection over hedge fund assets and its 
implications for worker pension funds?
    Mr. Quarles. I can address that.
    With respect to the proposal, as I understand it, in the 
pension bill, obviously the Department of Labor has the lead 
with respect to that issue. But as I understand the proposal, 
what is at issue is not really whether pension funds, an 
individual pension fund, would have the capacity to increase 
its exposure to hedge funds but whether a hedge fund could have 
pension funds in the aggregate. You could have, in theory, 
1,000 pension funds, each investing $12.73. The question is 
what is the aggregate pension asset investment in the hedge 
fund?
    And the plan assets rules that are in question have never 
really dealt with the question of whether an individual pension 
fund was overconcentrated in a particular type of asset. There 
are other rules to deal with that.
    So when you look at the question that way, I think there is 
some scope for more flexibility in the aggregate amount of 
pension assets that a hedge fund could take given, as I 
outlined in my testimony, that again these diversity of 
strategies and the diversity of investments that allowing a 
pension fund to invest in hedge funds can bring that can be a 
benefit to the pension fund.
    I think there is some scope for some more flexibility 
there. My understanding is that with some refinements the 
Department of Labor is also open to that modification.
    Senator Sarbanes. Anyone want to add to that?
    Mr. Chairman, thank you.
    Chairman Shelby. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    I would like to direct a question to all of you as to how 
hedge funds play with offshore entities. We all know that FASB 
is trying to bring some convergence together on the accounting 
standards in recognition of some of these global markets, and 
hedge funds are certainly an example of a global market where 
we have domestic as well as offshore hedge funds.
    In what ways is the United States working with other 
countries to develop some joint regulation as far as hedge 
funds are concerned? And what kind of competitive environment 
are we in when we get into the international offshore funds? 
And what are the dynamics that are being played out there?
    Chairman Cox, maybe you would like to start with that?
    Mr. Cox. First, I should say that we are working very 
closely with the FSA and the United Kingdom on the question of 
hedge fund activity or monitoring of hedge fund risk and our 
regulatory approaches to hedge funds and their advisers. That 
is especially important because together the United States and 
the U.K. account for the vast majority of hedge fund activity 
and prime brokerage activity.
    With respect to accounting standards convergence, I would 
like to just remind all of us of some of the recent milestones 
that have taken place regarding IFRS since I last appeared 
before this Committee. Last year IOSCO announced plans to 
create a data base for cataloging interpretations and decisions 
in order to improve cross-border enforcement of the application 
of these standards. That data base is expected to be launched 
later this year.
    In February of this year, the FASB and the IASB announced a 
memorandum of understanding which provides a road map for the 
next 3 years for standard setting to converge the provisions of 
U.S. GAAP and IFRS. And I am completely committed to this road 
map.
    The SEC staff has recently begun reviewing the 2005 IFRS 
financial statements and the accompanying U.S. GAAP 
reconciliations that have been filed by about 300 foreign 
registrants. And that work, I think, is going to help us better 
understand how international financial reporting standards are 
applied in practice.
    Mr. Jeffery. Senator, from our perspective at the CFTC we, 
like the SEC, work closely with our fellow regulators, the FSA 
being one, elsewhere in the world, as well as through 
international forums such as IOSCO and CESR--in discussing 
issues related to hedge fund monitoring, evaluation, 
regulation, et cetera.
    One thing that comes up repeatedly in the world of the CFTC 
as it relates to hedge funds is the importance we place on 
making sure the things that we do at the agency--with respect 
to executing our core mission of maintaining, preserving and 
protecting open, competitive and financially sound markets--are 
done in a way that will continue to be attractive to financial 
institutions, hedge funds and other market participants.
    Other regulators certainly have that same view in mind as 
they look at their markets. And therefore, when trying to reach 
accommodations with regulators where we have differences of 
opinion, we tend to be respectful of their views, they of ours, 
given that we have a common objective of maintaining investor 
protections and market integrity but also making sure from a 
U.S. perspective that we maintain our lead as the leading, most 
liquid, robust capital markets in the world.
    Senator Allard. Mr. Secretary, do you have anything to add?
    Mr. Quarles. I think the only thing that I would add is 
that this is also a topic that is discussed in the Financial 
Stability Forum, the U.S. delegation there chaired by the 
Treasury. It also involves the SEC and the Fed. And 
international regulators and finance ministers and central 
banks come together twice a year and the Financial Stability 
Forum where, among other things, hedge funds and their 
contribution to financial stability are a frequent topic of 
review.
    Senator Allard. Chairman Cox, is there any interest or 
anything in the EU? As you mentioned in your statement, we do 
most of it with the British Commonwealth countries. But 
anything out of the EU that is emerging in this area?
    Mr. Cox. Indeed, I think that all of our counterpart 
regulators in Europe and around the world are interested at a 
minimum in acquiring basic census data to the degree that that 
is possible.
    As I mentioned, one of the emergency actions I have 
directed our staff to take relates directly to our ability to 
gain census data about offshore hedge funds and hedge fund 
advisers in order to undo one of the effects of the Goldstein 
decision.
    We have got to make sure that we do not deter the offshore 
advisers from remaining voluntarily registered. If we can have 
continued voluntary registration, we will be able, to that 
extent, to gain this kind of census information.
    Senator Allard. Thank you, Mr. Chairman. I see my time has 
expired.
    Chairman Shelby. Thank you.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Thank you, gentlemen, for your testimony.
    Chairman Cox, since the Court of Appeals decision only a 
few hedge fund advisers have deregistered; is that accurate?
    Mr. Cox. In fact, the number is 10. And I am advised by the 
staff that the vast majority of those are for stated reasons 
having nothing to do with the Goldstein decision, such as they 
have run out of assets or are going out of business.
    Senator Reed. Has anyone registered since the decision?
    Mr. Cox. Yes, and indeed the net new registrants as against 
deregistration is positive. That means we have more people 
registered post-Goldstein.
    Senator Reed. So despite the decision, you still have a 
significant number of advisers registered with the SEC and 
subject to your jurisdiction; is that correct?
    Mr. Cox. For the moment that is true. We will have to see 
how that plays out over time. But there is no question that is 
the case today.
    Senator Reed. You point out in your testimony, Chairman 
Cox, that the threat of retailization is one that you are 
concerned about. It would seem to me that is one I would be 
concerned about too, since the basic logic of the hands-off 
approach is that sophisticated investors can handle their own 
calculation of risk, but the retail market has to be protected 
vigorously.
    Can you outline, and I know you mentioned this in your 
testimony, how you are going to monitor the situation for us to 
see if it reaches a critical level? And what steps do you think 
you will pursue?
    Mr. Cox. At this point we are already beyond monitoring. I 
think we know what the situation is. Our suitability rules have 
not been changed since 1982. If we adjusted them for inflation, 
instead of the $1 million net worth test, for example, we would 
be at $1.8 million today. The Hedge Fund Rule, effectively, 
would have raised that figure to $1.5 million. So I think we 
have got to do what we can.
    But what I have asked the staff to do is to tell us what 
exactly that might be and under what authorities we might 
accomplish this objective.
    As you might imagine, in the wake of the Court of Appeals 
decision invalidating our rule, this has happened for other 
reasons in other cases, we are going to be particularly 
punctilious about acting on the basis of solid legal authority.
    Senator Reed. But you anticipate a very deliberate 
rulemaking process going forward as fast as possible?
    Mr. Cox. I do, but I have to add this caution. I am 
testifying here today, very clearly, in my own capacity as 
Chairman and as one of five Commissioners. We have not had the 
opportunity, because we are trying to give you the latest 
information of where we are, this is a work in progress, to get 
Commission consensus on some of the recommendations that I am 
making. So I am, to that degree, a little bit out ahead.
    Senator Reed. Thank you very much, Mr. Chairman.
    Chairman Jeffery, the Commodity Futures Trading Commission 
does monitor some hedge fund activity under your surveillance 
program. Can you give me a rough idea of the percentage of 
hedge funds that you are looking at?
    Mr. Jeffery. I would have to come back to you with specific 
answers, as to the percentage of hedge fund activity in our 
markets. But it is a very significant part of the exchange 
traded commodity and futures markets.

          In order to provide data on the extent of hedge fund 
        participation in U.S. futures markets, we reviewed market 
        surveillance information collected on a daily basis by the 
        Commission's large trader reporting system. While hedge funds 
        are not a separate reporting category, the positions of hedge 
        funds along with other managed money traders, such as, traders 
        registered as Commodity Pool Operators (CPO) and Commodity 
        Trading Advisors (CTA) are reported to the CFTC. A hedge fund 
        that trades commodity futures may be a commodity pool, and a 
        CPO is a registered entity that operates a commodity pool. CTAs 
        direct the trading of clients, including hedge funds and 
        commodity pools.
          The Commission recently reviewed managed money positions on 
        May 9, 2006. On that date, managed money traders held on 
        average about 19 percent of the open interest in the 21 largest 
        commodity futures markets, and about 30 percent of the open 
        interest in the 20 largest financial futures markets.
          Managed money positions are not all on one side of the 
        market. CFTC data for May 9, for instance, indicates that in 
        commodity futures markets, managed money traders held on 
        average about 23 and 16 percent of the long and short open 
        interest, respectively. In financial futures markets, they held 
        on average about 36 and 24 percent of the long and short open 
        interest, respectively.
          Trading volume and open interest are measures of market 
        activity. Volume is the total number of contracts traded for 
        the day. Open interest is the total number of contracts entered 
        into and not yet offset during the life of the contract. For 
        instance, if during the first trading day of any futures 
        contract A sells 1 contract to B and B buys the 1 contract from 
        A then sells 1 contract to C, then the volume of trading for 
        the day is two contracts, and the open interest is one 
        contract. A is short 1 and C is long 1. B is no longer in the 
        market.
          The CFTC's Large Trader Reporting System tracks open 
        positions of large traders in all actively traded futures 
        markets to identify potential market disruptions or 
        manipulations. For instance, at the close of trading in the 
        NYMEX Crude Oil contract on May 9 there were 1,090,810 open 
        contracts, each one representing an obligation to buy 1,000 
        barrels of crude oil by long traders and sell 1,000 barrels of 
        oil by short traders on certain future dates. The notional 
        value of a 1,000 barrel contract of crude oil was $70,690 on 
        May 9 and is approximately the same value today.
          Of these open contracts 200,949 to buy were held by 114 non-
        commercial traders each of whom owned at least 25 contracts. 
        That is, large non-commercial traders such as hedge funds, 
        other managed money traders and a small number of others held 
        18.4% of the long side of the market. Seventy-four large non-
        commercial traders held 10.5% of the short positions and 22.2% 
        of the open contracts were held by 117 large non-commercial 
        traders with spread positions, that is, long in one delivery 
        month and short in another. Summaries of this information are 
        published every week by the CFTC as the Commitments of Traders 
        Report on the Commission's website, www.cftc.gov.

    Mr. Jeffery. But again, let me stress something I tried to 
make clear in my testimony, and is that hedge funds are treated 
exactly like other market participants under the broad 
architecture of our statutory mandate. We provide vigorous 
market oversight, working with the exchanges, on the exchange 
traded markets of hedge funds and other financial institution 
and commercial users of those markets.
    We also oversee, importantly with the exchanges, the 
clearing and settlement function, which is really the 
backbone--the financial backbone--of the integrity of the 
futures and options trading system in the United States. It was 
one of the reasons, frankly, why the futures exchanges in the 
U.S. have been so robust and so successful in the recent past, 
and hopefully will continue to be so.
    And finally, on the enforcement side, we will look at hedge 
funds just like anybody else. When we see evidence of bad 
behavior, particularly with all the attention today on the 
activity in physical commodities markets, energy in particular, 
you can be sure that the vigilance of our market surveillance 
people and our enforcement attorneys in looking for possible 
attempts at manipulation, false reporting or actual 
manipulation are very vigorous and very robust.
    Again, hedge funds are treated just like every other market 
participants. But we are very mindful of their presence, 
substantial presence, in the marketplace.
    Senator Reed. On a constant basis you are over watching the 
markets. Is there any cause for concern about trends or 
concentration of manipulation that you are seeing?
    Mr. Jeffery. Not to the best of our knowledge. Occasionally 
we will find evidence of bad behavior by this or that entity, 
hedge fund or otherwise. But no evidence of systemic 
manipulation or attempts to influence market prices in a 
perverse or unfair way. No, sir.
    Senator Reed. Thank you very much.
    My time has expired, Mr. Chairman.
    Chairman Shelby. Senator Hagel.
    Senator Hagel. Thank you, Mr. Chairman.
    This is a question for Chairman Cox but I would be 
interested in receiving the responses of you, Chairman Jeffery, 
as well as you, Secretary Quarles.
    Chairman Cox, you note in your testimony, and I will read a 
very brief part of this on page five, ``As you consider the 
possibility of legislation'' and then you say some other things 
and then you get to the point, ``I would counsel that, to the 
maximum extent possible, our actions should be nonintrusive. 
There should be no interference with the investment strategies 
or operations of hedge funds, including their use of 
derivatives trading, leverage, or short selling. Nor should the 
Federal Government trample upon their creativity, their 
liquidity, or their flexibility.''
    In your mind, what kind of legislation should this 
committee be considering?
    Mr. Cox. I thought at first you wanted me to justify the 
desiderata that were set forth in the testimony, which I find 
much easier to do than to answer the harder question which you 
actually put, which is what kind of legislation----
    Senator Hagel. If I could help you a little bit, since you 
have mentioned it. Since you have talked about the possibility 
of legislation, what kind of legislation should there be? I 
assume then you believe we should pass legislation?
    Mr. Cox. That is not what I mean in my formal testimony, 
nor what I mean to say to you just now. What I mean to state 
very quickly is that, particularly as a former Member of 
Congress, I recognize that it is the prerogative of the 
legislative branch in addressing questions such as this, to 
pass legislation if you see fit.
    I also observe that that effort is already underway in this 
body and the other body. Whether that amounts to anything 
remains to be seen. But what I did offer in my formal testimony 
is the good offices of the Securities and Exchange Commission 
and our professional staff in providing any advice and 
technical expertise that you might request or require.
    But I am instead, as Chairman, in the meanwhile, focused on 
exercising to the maximum extent possible, our existing 
statutory authorities so that we can report more fully and 
robustly to you very soon on what we have been able to 
accomplish and where the gaps remain.
    Senator Hagel. Let me ask you this question.
    Mr. Cox. There are very big gaps, post-Goldstein, no 
question, that have to be filled.
    Senator Hagel. Mr. Chairman, recognizing what you said, 
your experience on both sides of the table, in light of your 
new responsibilities over the last year, what your colleagues 
have said this morning and what you have said, do you believe, 
in fact, the SEC has the adequate authority to deal with this 
issue and future issues that may arise?
    We have talked this morning about volatility, 
destabilization possibilities, derivatives, all of the dynamics 
that are part of the fabric of what we are talking about. Do 
you believe you have the authority? If you do not, then I 
assume you believe that you need additional authority through 
legislation? Is that correct? Not correct? Where are you on 
that?
    Mr. Cox. We are right in the middle of that river. We have 
swum halfway across and we are rapidly paddling to the other 
side.
    As I mentioned earlier, we have already got underway 
emergency measures, some rulemakings, some perhaps no action 
letters, perhaps legal advice that we might provide that will 
restore to some degree greater or less what was there pre-
Goldstein.
    I have also asked other divisions beyond the Investment 
Management Division to help us examine what legal authorities 
we might have. I do not have all of those answers yet. But I 
think very soon we will be able to fill out the rest of this 
picture so not only we but you can assess whether or not what 
we have got is adequate.
    But I can state categorically right now that the regulatory 
regime implemented by the Securities and Exchange Commission 
vis-a-vis hedge funds and their advisers is inadequate and we 
are working very quickly to fill that gap.
    Senator Hagel. And so it is still an open question whether 
you need additional authority to through legislation. Is that 
fair?
    Mr. Cox. That is correct.
    Senator Hagel. Gentleman, any additional comments you would 
like to offer on this issue of legislation and what would be 
required? Additional law or authority? Chairman Jeffery.
    Mr. Jeffery. Yes, Senator, thank you.
    As it relates to the futures world, the exchange-traded 
futures world and the Commodity Exchange Act, we have said on a 
number of cases that we believe the CFTC has the tools it needs 
that are necessary to supervise the markets we regulate. Again, 
hedge funds and all market participants.
    When one engages in a discussion like today's and other 
dialogs on hedge funds, the two recurring concerns one has, 
among others, is one of investor protection. And the other is a 
concern related to systemic risk.
    In the futures world, under the Commodity Exchange Act, the 
investor protection concerns, the way we get at those is 
through a disclosure-based regime, which is described in 
greater detail in the written submission for today, related to 
so-called commodity pool operators and commodity trading 
advisers.
    In terms of the more profound concern related to systemic 
risks where the Act and those of us involved with the Commodity 
Futures Trading Commission are active, is on these important 
areas of market and exchange oversight and that of clearing 
organization oversight. We feel that we have the tools 
necessary to effectively carry out our mission in that regard 
with respect to actual businesses that are engaged in markets 
for physical commodities and hedging transactions, and other 
market participants of a financial nature, hedge funds 
included.
    That does not mean that we cannot always find and look for 
ways to do our jobs better. Every day we try to do that.
    Senator Hagel. Thank you. Secretary Quarles.
    Mr. Quarles. Simply that I do think it would be premature 
for us to recommend any legislation, whether there is any need 
for legislation, until we have completed this comprehensive 
review that I have described. I think that is a necessary 
predicate.
    Senator Hagel. What is the timeline on the completion of 
the review?
    Mr. Quarles. We have not set a deadline but we are 
proceeding promptly with the various relevant groups to ensure 
we brought them together.
    Senator Hagel. End of the year?
    Mr. Quarles. As I said, we have not set a timeline but we 
are not considering that this is an extremely long process 
either.
    Senator Hagel. Thank you. Mr. Chairman, thank you.
    Senator Sarbanes. Is this the President's Working Group on 
Financial Markets that is doing this review?
    Mr. Quarles. At the moment it involves the members of the 
President's Working Group, but also other relevant regulars as 
well, such as the New York Fed and some of the other 
regulators.
    So technically it would say we are not viewing this as 
necessarily under the aegis of the President's Working Group 
but it is something the President's Working Group will be 
discussing.
    Senator Sarbanes. I appreciate Chairman Cox talking about 
the prerogatives of the legislative branch, but let us set that 
to one side for the moment and proceed on the premise that we 
look to the regulators who have, after all, a high degree of 
professionalism in dealing with these issues and staff that 
focus on this and not much beyond this for counsel and advice 
on how we ought to proceed.
    So I am anxious to pinpoint the responsibility. Who is the 
responsible person for informing the Congress on what you think 
needs to be done to cover any gaps with respect to inadequacy 
and how we deal with the hedge funds?
    So if something goes wrong down the road, we can say you 
know, we looked to you to tell us and you did not tell us. Are 
you in charge of this effort, Secretary Quarles?
    Mr. Quarles. Well, when you put it that way----
    [Laughter.]
    Mr. Quarles. The Treasury Department is being active in 
convening the regulators and others to form a view. Obviously, 
there are important areas of responsibility of each of the 
President's Working Group.
    So until you have asked your question, we have not viewed 
this as a sort of we are standing up and saying if you do not 
hear from us, you have not heard the last word. But we are 
being very active in attempting to form the view that you have 
requested.
    Senator Sarbanes. The SEC, as I understand it, is moving 
ahead in terms of following up on this court's decision.
    Mr. Cox. We are, indeed, and I see no reason for diffidence 
in answering the question as you put it. Our requirement that 
hedge fund advisers register, which went into effect in 
February but was then invalidated, rather unequivocally 
established the Commission as the primary national regulator of 
hedge fund advisers. That registration would have preempted 
most State law. It would have preempted the CFTC, or supplanted 
the CFTC, which had recently adopted exemptive rules, 
effectively vacating the space.
    It would have permitted the Commission to maintain a 
uniform national regime. And that would benefit not only 
investors, I think, but also the hedge fund industry and it 
would permit the SEC to work with foreign national regulators 
as a single U.S. regulator.
    So it is in the wake of the dismantling of that approach 
that we meet here today. And we are working as quickly as we 
can to try and, if not put Humpty Dumpty back together again, 
then to erect something more sturdy that will accomplish some 
of the same objectives.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Cox, yesterday you may have seen 
the Financial Times article.
    Mr. Cox. I read it every day.
    Chairman Shelby. The CFA Center for Financial Market 
Integrity and the Business Roundtable Institute for Corporate 
Ethics published a report focusing on the issuer, analysts, 
institutional investor, asset manager, and hedge fund manager 
communities. The report called for corporate leaders to end the 
practice of providing quarterly earnings guidance. This was the 
lead story.
    What is your reaction to this recommendation? There has 
been a lot of stuff written, a lot of pressure put upon 
executives to meet their quarterly earnings estimates, they 
made guidance market, rather than the long-term health of the 
company.
    Mr. Cox. Yes. I think that these are, in the main, healthy 
recommendations because concerns with short-termism have been 
with us for some time and there are many attendant pathologies.
    Obviously, the problems that we have seen with manipulating 
earnings, managing earnings, smoothing earnings and so on are 
derivative of that kind of short-termism.
    Chairman Shelby. This could be a step in the right 
direction, could it not?
    Mr. Cox. Yes. And I think if it amounts to nothing more 
than a contribution to the general ethos in which we all 
operate, these kinds of norms being enunciated at high levels, 
that is a good thing.
    Senator Sarbanes. A long time distinguished State Attorney 
General recently said ``Right now hedge funds are in a 
regulatory void without disclosure or accountability. States 
will fill the void.''
    I would be interested in your comments on this possibility 
and what its implications are.
    Mr. Cox. I believe you are referring to the comments of the 
Connecticut Attorney General. With respect to the Blue Sky 
authorities the SEC in this, as in virtually all securities 
regulatory instances, takes the view that we have got to 
exercise our authorities in a complementary way.
    Obviously, if one level of government does nothing, that 
leaves the others to act in a vacuum and that may be the 
prospect to which that comment refers.
    I think there is zero risk that that is going to be the 
future. Instead, I think you will see the SEC continue to 
operate in this sphere, as you will presumably see Connecticut 
and other States doing what they can.
    At minimum, in the area of anti-fraud activity, we have got 
to put our resources together. And as I indicated, Goldstein 
notwithstanding, the SEC has been increasingly active in moving 
against hedge fund and hedge fund adviser fraud. We have gone 
from just four cases in 2001 to over 90 since then.
    Senator Sarbanes. Recently Bloomberg News and Newsweek 
reported that the Bush Administration's Task Force on Corporate 
Crime will discuss hedge fund fraud at its next meeting at the 
end of this month. The Deputy Attorney General, Paul McNulty, 
spoke in strong terms about this as an emerging threat.
    Can you give us some idea where that task force is headed 
with regard to hedge funds?
    Mr. Cox. I will be in a much better position to tell you 
after the meeting takes place. I intend to attend that meeting.
    Senator Sarbanes. Anyone else have any information on it?
    Will Treasury be at that meeting?
    Mr. Quarles. We will be, through our General Counsel's 
office.
    Mr. Jeffery. As will the CFTC.
    Chairman Shelby. We need to get you back after the meeting.
    Senator Sarbanes. Do you have enough resources? In other 
words, budget, manpower, and so forth, to do what has to be 
done in this area? Or are you in need?
    Mr. Cox. With respect to the SEC, that is an area where 
legislation would make a difference. There are some things that 
we can do with regulatory authority. There are other things 
that we cannot do.
    Chairman Shelby. Legislation or money?
    Mr. Cox. I do not mean to make the authorizer/appropriator 
distinction, although with you, Chairman Shelby, I do not have 
to.
    Chairman Shelby. We will talk about money in another 
committee with you.
    Mr. Cox. All right, I will subside.
    Senator Hagel. You recognize the Chairman is both.
    Mr. Cox. I do, indeed.
    Chairman Shelby. Chairman of the other Committee, 
Appropriations.
    Senator Sarbanes. How about the CFTC and the Treasury?
    Mr. Jeffery. Well, resource allocation is a constant 
challenge in every organization, but as our statute is 
currently structured and our mission defined, subject to the 
goodwill of Congress and continued budget appropriations along 
the lines that have been requested, we believe we have the 
resources sufficient to our job as currently constituted.
    Senator Sarbanes. Treasury?
    Mr. Quarles. With respect to the Treasury, I mean I never 
want to say we have enough resources. But with respect to this 
issue, for what our role is, I think we are covered.
    Senator Sarbanes. Mr. Chairman, I just want to close out by 
saying I think it is very important that you carry through with 
these work programs. You have this uneasy feeling of the whole 
area here that we do not really know very well. We do not fully 
understand.
    And you constantly get--you know, Business Week had an 
article in May saying--and just listen to this, it may be a 
small thing but still. ``Smaller colleges are moving 
aggressively in the hedge funds. They may be putting their 
endowments in jeopardy.''
    The article identified some small colleges that invested 60 
or 80 percent of their endowments in hedge funds and was 
concerned that these institutions may lack financial 
sophistication to fully understand the risks.
    Is that a legitimate concern, would you say? Would you 
dismiss this concern?
    Mr. Quarles. I would not dismiss the concern. I would 
certainly note that if you have a small institution that is 
unlikely to have in-house expertise, there are a variety of 
ways to outsource that expertise, to hire professional 
advisers, to invest through funds of funds in order to ensure 
that you are not taking on more risk than you ought.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you.
    Chairman Cox, I wanted to ask a specific question, which 
you are well aware of the issue regarding the cases concerning 
Overstock and Biovale, where hedge funds are alleged to have 
paid securities analysts to issue misleading research to the 
marketplace.
    Do you believe the SEC has the authority to deal with a 
critical component of not just the hedge funds, but the entire 
investment environment and universe in the market of 
independent research and analysis? Obviously, we have two 
specific cases here.
    But as you are analyzing, as we have talked this morning, 
on future needs, if it comes to that through legislation, 
obviously this is a big part of it. If there is some question 
in the marketplace by investors about the independence, the 
actual independence of research and analysis, that obviously 
destabilizes everything. And it affects all decisions.
    So what is the SEC doing to deal with this? I think this is 
as critical a component of this issue as any one thing, the 
legitimate independence of research and analysis.
    The second part of that question is do you believe you have 
the authority to deal with it?
    Mr. Cox. Yes indeed, I believe we have both the resources 
and the authorities that we need to deal with this problem on a 
policy basis and on an enforcement basis. One of the ways that 
we are proceeding to attack this problem is through 
enforcement, as well as policymaking.
    Senator Hagel. What specifically can you tell us about 
these two cases?
    Mr. Cox. To the extent that they are ongoing, I cannot.
    Senator Hagel. What will you be recommending in the way of 
changes to not just deal with this but strengthen it? What can 
you tell us, aside from you think you have the authority?
    Mr. Cox. Well, we began from the premise that research is 
vitally important to the market, that there are pressures on 
independent research right now and that the SEC needs to 
examine its own rules to make sure that we are encouraging and 
not diminishing the provision of independent research.
    Second, we have a rubric of law and rules that need to be 
examined for opportunities to strengthen the requirements of 
independence and the freedom of research providers from 
interference or manipulation themselves.
    Senator Hagel. Do you believe that as you are analyzing all 
of the dynamics of authorities and hedge funds in particular 
that this is going to be something that you will come to the 
Committee with, with additional information as to not just 
needs in the area of authority, statutory authority? But again 
this is as critical a component of this, at least in my 
opinion. I suspect the market, if they have no confidence in 
this or if there is a question of the confidence of the quality 
of that analysis and research, then it skews everything.
    So how do you respondent then to that question? When will 
you--is this part of your overall analysis and review? When 
would you have been prepared?
    Mr. Cox. Well, with respect to enforcement actions and 
ongoing investigations, we can report the moment that those 
become public or that we take actions in a public venue, in 
court, before in ALJ, before the Commission.
    With respect to the findings of our respective divisions 
and offices concerning this problem, we can report on an 
ongoing basis. And I would be more than pleased to do so.
    Senator Hagel. Thank you.
    Secretary Quarles, a question for you. The issue of Long 
Term Capital Management has been raised. It was raised at the 
beginning of Chairman Cox's testimony this morning, referencing 
the Federal Reserve and Chairman Greenspan in particular, what 
Greenspan said about that issue and how it could have 
destabilized our markets for all of the reasons you understand 
if we had not interfered.
    Using that Long Term Capital Management as an example, here 
is the question: obviously, the excessive leverage that we saw 
in that case, it posed a very real systemic risk for all our 
markets. And you three this morning have talked about systemic 
risk, which is not unimportant obviously in your roles as 
regulators. The markets are the markets, and we recognize that. 
We do not want to tie down a market to the point where we lose 
the point of a market.
    But specifically, as you know, and the Treasury has been 
very deeply involved in the GSE issue. This issue has arisen, 
in particular with Fannie and Freddie, on their significant use 
of derivatives. And we have talked about this here.
    With the LTCM issue as an example, here is the question. Do 
you think there are corollary lessons to be learned here as we 
review the specific environment of hedge funds and the larger 
universe of the market with excessive leverage in particular?
    And in particular to that, derivatives where Fannie and 
Freddie use, to a great extent, and then the systemic risk 
associated with that?
    Mr. Quarles. I think absolutely. I think the lessons of 
LTCM are as you have noted. They are one, leverage. They are 
two, concentration of risk. And they are three, counterparty 
risk management, market discipline, if you will. The reason 
that you had the problems with LTCM is that you did not have 
adequate market discipline because counterparties did not have 
sufficient transparency in order to appropriately evaluate 
their risks. And so you had excessive leverage for an entity 
that turned out then to have systemic consequence.
    I think you can walk through--right now when you look at 
the hedge fund industry, you are actually in a better situation 
than you were at that time on all three of those fronts. I do 
not want to say that there is no possibility of problem. Not at 
all. But you are in a better situation on leverage, on 
counterparty risk management, and on market discipline than you 
were at the time of LTCM.
    For the GSEs, by contrast, you have the problem of lack of 
market discipline because of the perceived Government backstop, 
the misperception of Government backstop. You have lack of 
market discipline. You have lack of counterparty risk 
management, again because of the perception of the Government 
standing behind those companies.
    As a consequence, you have the ability to buildup excessive 
leverage in a way that creates systemic risk. I think that is a 
concern. And that is the fundamental reason that we have been 
proposing what we have proposed for the GSEs.
    Senator Hagel. Thank you. Mr. Chairman, thank you.
    Chairman Shelby. Thank you, Senator Hagel.
    I want to thank the panel for your participation today. We 
have a vote on the floor now.
    The Committee is adjourned.
    [Whereupon, at 11:50 a.m. the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

             PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

    Thank you, Mr. Chairman for scheduling this hearing today.
    Although hedge funds have been around for a long time, they have 
certainly grabbed my attention in the last 5 years. In 2001, there were 
only 2,000 hedge funds and today, that number has grown more than 300%.
    As we all know--there is simply too little known about the 
estimated 9,000 hedge funds and their investments totaling $2.4 
trillion according to the SEC.
    What concerns me even more is that pension funds, charities, and 
university endowments are investing in hedge funds despite the lack of 
information. The problem is that when something goes wrong, no one is 
able to obtain any information about the fund's assets or activities.
    Unfortunately, in Michigan, we know about pension failures. The 
idea of creating more harm to working families who have contributed 
their own earnings to a pension plan is extremely concerning to me. We 
need to make sure that everyone understands what is at stake with hedge 
fund investments.
    As a committee, I believe we should not be guessing about what 
would happen if something went wrong with a $2.4 trillion industry. We 
should do all we can to protect investors and those families who have 
worked hard to retire with a pension.
    I look forward to hearing the panel's recommendations.
    Thank you, Mr. Chairman.
                                 ______
                                 
                 PREPARED STATEMENT OF CHRISTOPHER COX
              Chairman, Securities and Exchange Commission
                             July 25, 2006

    Chairman Shelby, Ranking Member Sarbanes and Members of the 
Committee:
    Thank you for inviting me to testify today about the regulation of 
hedge funds. It is an especially welcome opportunity to appear on this 
panel with other members of the President's Working Group on Financial 
Markets, including the Department of the Treasury and the Commodity 
Futures Trading Commission.
    As you have recognized, each of us has responsibility for 
different, but crucial aspects of the world in which hedge funds 
operate. That's why the Securities and Exchange Commission is working 
closely and cooperatively with the other members of the President's 
Working Group on the questions of the systemic market risks posed by 
hedge fund activity, and the investor protection issues that stem from 
the increasing exposure of retail investors to hedge fund investment 
opportunities.
    I should emphasize at the outset, Mr. Chairman, that my testimony 
today reflects my views as Chairman of the SEC, and does not represent 
the position of the five-member Commission. The views I am expressing 
this morning are solely my own.
    It has been eight years since Long Term Capital Management 
collapsed, after losing $4 billion in just five weeks. Then-Fed 
Chairman Alan Greenspan said at the time that, had the Federal Reserve 
Bank of New York not intervened to organize a $3.6 billion bailout by 
the fund's creditor banks, the bankruptcy of LTCM ``could have 
potentially impaired the economies of many nations, including our 
own.'' LTCM was effectively liquidated by early 2000.
    This spectacular hedge fund collapse left in its wake not only 
ruined investors, but also serious questions about the threat to our 
capital markets as a whole from such significant funds pursuing high 
risk strategies with excessive leverage. In the months that followed, 
President Clinton established the President's Working Group on 
Financial Markets, with the SEC as a member, to coordinate regulatory 
oversight of these issues as well as other questions that broadly 
impact the national securities markets.
    Since then, the President's Working Group has focused intently on 
the concern that the failure of one or more significant and highly 
leveraged investment pools, such as the Long Term Capital Management 
hedge fund, could threaten the stability of financial markets. We are 
more certain now than ever before that preventing future market 
instabilities will require a coordinated effort by all financial 
securities regulators.
    But given the recent invalidation of the SEC's hedge fund rule by 
the United States Court of Appeals, we have been forced back to the 
drawing board to devise a workable means of acquiring even basic census 
data that would be necessary to monitor hedge fund activity in a way 
that could mitigate systemic risk.
    The current lack of such basic data requires me to hedge when I say 
that the SEC's best estimate is that there are now approximately 8,800 
hedge funds, with approximately $1.2 trillion of assets. If this 
estimate is accurate, it implies a remarkable growth in hedge fund 
assets of almost 3,000% in the last 16 years. Much of this growth is 
attributable to increased investment by institutions. This includes not 
only investment companies and investment banks, but also private and 
public pension plans, endowments, and foundations.
    Last year, we believe an estimated 2,000 new hedge funds opened for 
business. There were just over 2,500 hedge fund advisers registered 
with the Commission at the end of June 2006. Half of those registered 
following the Commission's hedge fund rule. The vast majority of the 
registered hedge fund advisers, 88% of them, are domiciled in the 
United States.
    Although hedge funds represent just 5% of all U.S. assets under 
management, they account for about 30% of all U.S. equity trading 
volume. They are particularly active in the convertible bond market and 
the credit derivatives market. We are also seeing hedge funds becoming 
more active in such varied activities as the market for corporate 
control, private lending, and the trading of crude petroleum.
    It is undeniable that in addition to raising questions such as 
systemic risk and investor protection, hedge funds also provide 
investors and our national securities markets with tangible benefits. 
They contribute substantially to capital formation, market efficiency, 
price discovery, and liquidity. By actively participating in 
derivatives markets, hedge funds can help counterparties reduce or 
manage their own risks. Some hedge funds provide a way for 
institutional investors to reduce their exposure to downside risk by 
allocating a portion of their portfolio to an investment with a low 
correlation to overall market activity.
    But given the general lack of public disclosure about the way hedge 
funds operate, the lack of standards for measuring a fund's valuation 
and its performance, the possibilities for undisclosed conflicts of 
interest, the unusually high fees, and the higher risk that accompanies 
a hedge fund's expected higher returns, these are not investments for 
Mom and Pop. They are generally risky ventures that simply don't make 
sense for most retail investors.
    While some refer to an alleged growing trend toward the 
``retailization'' of hedge funds, the Commission's staff are not aware 
of significant numbers of truly retail investors investing directly in 
hedge funds. In my view, such a development, were it to occur, should 
be viewed with alarm. Indeed, in the wake of the Court of Appeals 
decision in the Goldstein case, I intend to recommend to the full 
Commission that the SEC take formal steps to further limit the 
marketing and availability of hedge funds to unsophisticated retail 
investors.
    In addition to the threat of retailization, the increased 
investment in hedge funds by institutional investors with retail 
constituencies, such as public and private pension plans, fund of funds 
investments, universities, endowments, foundations and other charitable 
organizations, carries with it the potential for retail exposure to 
hedge fund risk. This trend, however, is still in its infancy. A recent 
industry report by Greenwich Associates indicates that 80% of public 
pension funds, and 82% of corporate funds, have little or no investment 
in hedge funds. Those corporate pensions that actively invest in hedge 
funds allocate on average only 5.3% of their assets to this entire 
investment class. Public pensions that actively invest in hedge funds 
allocate 5.1%.
    The trend among endowments toward hedge fund investments is more 
pronounced. Nearly two-thirds of endowments invest in hedge funds, and 
those that do allocate an average of 18% to them. Whether or not this 
sort of institutional investment directly impacts retail investors, it 
surely is increasing the potential impact that hedge funds might have 
on our capital markets.
    The concerns about hedge funds that the SEC enunciated when we 
adopted our hedge fund rule in December 2004 remain the same today. The 
remarkable pace of hedge fund growth, which we noted at the time, has 
continued unabated. The potential for retail investors to be harmed by 
hedge fund risk remains as serious a concern now as then. And the 
growth in hedge fund fraud that we have seen accompany the growth in 
hedge funds implicates the very basic responsibility of the SEC to 
protect investors from fraud, unfair dealing and market manipulation.
    And on that point, let me make very clear that notwithstanding the 
Goldstein decision, hedge funds today remain subject to SEC regulations 
and enforcement under the antifraud, civil liability, and other 
provisions of the federal securities laws. We will continue to 
vigorously enforce the federal securities laws against hedge funds and 
hedge fund advisers who violate those laws. Hedge funds are not, should 
not be, and will not be unregulated. The challenge for the SEC and the 
President's Working Group going forward is, rather, to what extent to 
add new regulations, particularly in light of the recent Court of 
Appeals ruling.
    The fact that hedge funds remain subject to the same prohibitions 
against fraud as other market participants, and their managers have the 
same fiduciary obligations as other investment advisers, directly 
addresses the Commission's concern with the growth in hedge fund fraud. 
The Securities Act, the Exchange Act, and the Advisers Act each 
provides the Commission with separate authorities to regulate fraud and 
unfair dealing by hedge funds. Using this still valid authority over 
the past several years, the Commission has brought dozens of 
enforcement cases against hedge fund managers who have engaged in fraud 
or have violated their fiduciary obligations.
    The number of enforcement cases against hedge funds has grown from 
just four in 2001 to more than 60 since then. These cases involve hedge 
fund managers who have misappropriated fund assets; engaged in insider 
trading; misrepresented portfolio performance; falsified their 
experience and credentials; and lied about past returns. We have 
brought cases for inaccurate disclosure of trading strategies; 
undisclosed preferential treatment of hedge fund clients at the expense 
of other clients; market manipulation; illegal short selling; and 
improper valuation of assets. In some cases we have worked side-by-side 
with criminal authorities who have brought criminal actions as well.
    Recent examples of significant hedge fund cases brought by the 
Commission include:

 SEC v. CMG-Capital Management Group Holding Company, LLC and 
    Keith G. Gilabert, Litigation Release No. 19680 (May 1, 2006)--In 
    April 2006, the SEC filed an action in federal court charging a 
    California hedge fund manager and his advisory firm with 
    misappropriating more than $14 million in funds and misleading 
    investors about the hedge fund's returns. The Commission is seeking 
    permanent injunctions, disgorgement, and civil penalties against 
    the defendants.

 SEC v. Nelson J. Obus, Peter F. Black, Thomas Bradley 
    Strickland, Wynnefield Partners Small Cap Value L.P., Wynnefield 
    Partners Small Cap Value L.P. I, Wynnefield Partners Small Cap 
    Value Offshore Fund, Ltd., Litigation Release No. 19667 (Apr. 25, 
    2006)--In April 2006, the SEC filed an insider trading case in 
    federal court against a hedge fund manager and two others in 
    connection with trading for three hedge funds in advance of the 
    public announcement of a merger agreement, resulting in illicit 
    gains of over $1.3 million. The Commission is seeking injunctions 
    against the defendants, as well as disgorgement, civil penalties, 
    and orders barring the hedge fund manager from acting as an officer 
    or director of a public company.

 SEC v. Kirk S. Wright, et al., Litigation Release No. 19581 
    (Feb. 28, 2006)--In February 2006, the Commission obtained a 
    temporary restraining order and other emergency relief in federal 
    court to halt an ongoing offering fraud involving the sale of 
    investments in seven hedge funds by an Atlanta-based promoter and 
    investment advisers controlled by him. The Commission alleged that 
    the defendants raised as much as $185 million from up to 500 
    investors through the fraudulent investment scheme, and that the 
    advisers provided investors with statements that misrepresented the 
    amount of assets in the hedge funds and the returns earned by the 
    funds. The Commission is seeking permanent injunctions against the 
    defendants, an accounting and disgorgement of ill-gotten gains, and 
    civil penalties.

 SEC v. Deephaven Capital Management, LLC and Bruce Lieberman, 
    Litigation Release 19683 (May 2, 2006) (also see Investment 
    Advisers Act Release No. 2517 (May 26, 2006))--In May 2006, the SEC 
    charged hedge fund adviser Deephaven Capital Management, LLC and 
    its former portfolio manager with insider trading based on 
    information that 19 PIPE offerings were about to be publicly 
    announced. Deephaven has agreed to disgorge $2.7 million in 
    unlawful profits and to pay $343,000 in prejudgment interest and a 
    $2.7 million civil penalty. The portfolio manager agreed to pay a 
    $110,000 civil penalty and agreed to be barred from associating 
    with an investment adviser for three years.

    But while our ability to bring enforcement actions against hedge 
funds and their managers remains intact following the Goldstein 
decision, the same cannot be said for the Commission's ability to 
require hedge fund advisers to register and submit to inspections. The 
Commission stated, when we adopted the hedge fund rule in 2004, that 
its then-current program of hedge fund regulation was inadequate. With 
the rejection of the hedge fund rule by the Court of Appeals, I believe 
that is once again the case. We must move quickly to address the hole 
that the Goldstein decision has left. Some improvements will be 
possible through administrative action. Others, however, may well 
require legislation.
    As you consider the possibility of legislation, which is of course 
the prerogative of the Congress, the SEC stands ready to assist you 
with technical advice and assistance should you request it. As a 
general principle, which I would apply both to the Commission's future 
regulatory actions in this area as well as to any potential 
legislation, I would counsel that to the maximum extent possible our 
actions should be non-intrusive. There should be no interference with 
the investment strategies or operations of hedge funds, including their 
use of derivatives trading, leverage, and short selling. Nor should the 
federal government trammel upon their creativity, their liquidity, or 
their flexibility. The costs of any regulation should be kept firmly in 
mind. Similarly, there should be no portfolio disclosure provisions. A 
hedge fund's ability to keep confidential its trading strategies and 
portfolio composition should be protected. And hedge funds should be 
able to continue to charge their clients performance fees, just as they 
do now.
    Immediately following the Goldstein ruling, I instructed the SEC's 
professional staff to promptly evaluate the court's decision, and to 
provide me with a set of alternatives that the SEC could pursue without 
legislation. That evaluation is still underway, but I have already 
decided upon several urgent courses of action which I can report to 
this Committee today. Specifically, I intend to recommend to the full 
Commission the following emergency rulemakings and Commission actions:
    First, I will recommend that the SEC promulgate a new anti-fraud 
rule under the Investment Advisers Act that would have the effect of 
``looking through'' a hedge fund to its investors. This would reverse 
the side-effect of the Goldstein decision that the anti-fraud 
provisions of Sections 206(1) and 206(2) of the Act apply only to 
``clients'' as the court interpreted that term, and not to investors in 
the hedge fund. I believe that such a rule is possible because the 
court itself noted that another anti-fraud provision, Section 206(4), 
is not limited to fraud against ``clients.'' The result would be a rule 
that could withstand judicial scrutiny, and which would clearly state 
that hedge fund advisers owe serious obligations to investors in the 
hedge funds. The staff is currently analyzing what the contours of such 
a rule might be, given the Commission's authority to adopt such a rule 
under Section 206(4).
    Second, I am directing the SEC staff to take emergency action to 
insure that the transitional and exemptive rules contained in the 2004 
hedge fund rule are restored to their full legal effect. This is 
necessary to insure that hedge fund advisers who were relying on the 
now-invalidated rule are not suddenly in violation of our regulatory 
requirements when the court issues its final mandate in mid-August.
    For example, among the provisions of the hedge fund rule that the 
court invalidated was a section governing the Advisers Act's 
restrictions on performance fees for hedge fund adviser contracts that 
were entered into before the hedge fund rule went into effect. This 
section of the hedge fund rule was designed to prevent a hedge fund 
adviser from having to renegotiate the terms of its existing advisory 
contracts, or from having to expel from the fund (including venture 
capital and private equity funds as well as hedge funds) pre-existing 
investors who are not ``qualified clients.''
    Likewise, I am directing emergency action to restore to newly 
registered hedge fund advisers their qualified exemption from the 
recordkeeping requirement for performance data prior to their 
registration. (They would still be required to maintain all records 
they have to substantiate their prior performance.) Without this 
emergency action prior to mid-August, newly registered hedge fund 
advisers that remain registered, but that did not create records for 
the periods prior to their registration, will lose the ability to use 
their performance track record. Rather perversely, that would 
discourage hedge fund advisers from voluntarily remaining registered.
    Yet another emergency action I am directing will restore the 
extension of time that was given to advisers for funds of hedge funds 
to provide their audited financial statements. The underlying hedge 
funds do not typically supply their audited financials to the fund of 
funds manager until the 120-day deadline, so the fund of funds managers 
need extra time to complete their audit work and send out the reports. 
The hedge fund rule gave it to them, but the Goldstein decision 
invalidated that relief. I intend for the Commission to restore the 
extension of time from 120 to 180 days.
    Similar action is needed to undo yet another effect of the 
Goldstein decision, which is to undo the Commission's 2004 hedge fund 
rule insofar as it applied to off-shore advisers to off-shore hedge 
funds. Those advisers had to register under the new rule (assuming 
their funds had more than 14 U.S. investors), but they would have been 
subject to different treatment under the Advisers Act because they 
could treat the off-shore fund as their ``client'' for all other 
purposes. The Court's ruling, however, eliminated this aspect of the 
rulemaking; and by creating doubt whether registered offshore advisers 
will be subject to all of the provisions of the Act with respect to 
their offshore hedge funds, the ruling has created a disincentive for 
offshore advisers to remain voluntarily registered. I have directed the 
Commission staff to address this disincentive to registration.
    Finally, to address my concerns with respect to the retailization 
of hedge funds, I have asked the staff to analyze and report to the 
Commission on the possibility of amending the current definition of 
``accredited investor'' as applied to retail investment in hedge funds 
without registration. I am concerned that the current definition, which 
is decades old, is not only out of date, but wholly inadequate to 
protect unsophisticated investors from the complex risks of investment 
in most hedge funds. Under the Commission's Regulation D, for example, 
one definition of an ``accredited investor'' is ``Any natural person 
whose individual net worth, or joint net worth with that person's 
spouse, at the time of his purchase exceeds $1,000,000.'' This does not 
exclude one's residence. The Commission's hedge fund rule would have 
had the effect of increasing this suitability threshold to $1.5 million 
of net worth, rather than $1 million, for any hedge fund that charges a 
performance fee.
    This was an important change, and I would like to see it restored. 
In California, the median home price is well over one-half million 
dollars. So post-Goldstein, with barely more than $200,000 apiece in 
other assets, a California couple could qualify to buy a hedge fund in 
an unregistered offering--even though that relatively small amount 
might represent their entire life savings in the form of a teacher's or 
fire fighter's retirement fund.
    Beyond these emergency rulemakings and other actions to restore as 
much of the pre-Goldstein rule as possible, I have directed the SEC 
staff to continue to conduct compliance examinations of investment 
advisers who remain registered with us, or register with us in the 
future. All registered hedge fund advisers are subject to SEC 
regulation, and the SEC will continue to conduct risk-based 
examinations of hedge fund advisers that are registered with the SEC. 
The purpose of these exams will be to evaluate the hedge fund adviser 
compliance programs, and to detect violations of the securities laws.
    Our continuing oversight of hedge fund advisers who remain 
registered with the SEC post-Goldstein will cover the majority of the 
over 2,500 of the hedge fund advisers of which we are aware. Because 
fully half of these advisers were registered with the SEC before the 
hedge fund rule required it, we anticipate that at least this number 
will voluntarily remain registered. And while some number of hedge fund 
advisers will certainly de-register as a result of the court's 
decision, our experience since Goldstein is that more hedge fund 
advisers have become newly registered than have de-registered. In other 
words, although these are early returns and may not be indicative of 
the final outcome, we have actually experienced a net increase in hedge 
fund registrations since the Goldstein decision.
    We are also working with other regulators, including the CFTC and 
the other members of the President's Working Group, to coordinate our 
hedge fund oversight efforts. As I have noted, each member agency of 
the President's Working Group has a unique responsibility and provides 
a critical perspective when it comes to the efficient and effective 
functioning of our capital markets. In addition, we are working in 
close coordination with the Financial Services Authority in the United 
Kingdom, since together the U.S. and the U.K. account for the vast 
majority of the world's hedge fund activity, including prime brokerage.
    As we move forward, it will be important that we view the whole 
picture as we work to evaluate both the systemic market risks and the 
retail investment issues associated with the growing presence of hedge 
funds in our capital markets. Hedge funds are a significant and growing 
part of our financial markets that yield not only risks but also many 
benefits for our economic system. Each of us at this table, as members 
of the President's Working Group, has an interest and responsibility to 
continue working collaboratively to evaluate both the systemic market 
risks and retail investment issues associated with hedge funds in order 
to maintain these overall benefits. I and the SEC are committed to 
doing so.
    Thank you for inviting me to testify on this important subject. I 
am happy to answer any questions you may have.
                                 ______
                                 
               PREPARED STATEMENT OF REUBEN JEFFERY, III
             Chairman, Commodity Futures Trading Commission
                             July 25, 2006

    Chairman Shelby, Senator Sarbanes, and Members of the Committee, I 
am pleased to have an opportunity to testify on behalf of the CFTC on 
the regulation of hedge funds.
    I will focus my remarks today on how hedge funds intersect with the 
CFTC's statutory responsibilities under its governing statute, the 
Commodity Exchange Act (the CEA). At the outset, I should emphasize 
that the CFTC does not regulate ``hedge funds'' per se. However, the 
CFTC encounters hedge funds as it performs two of its critical missions 
under the CEA: promoting market integrity and protecting the public 
from fraud in the sale of futures and commodity options. Hedge funds 
are on the CFTC's market surveillance radar when they trade in the 
regulated futures and commodity options markets. With respect to 
investor protection, if a collective investment vehicle, such as a 
hedge fund, trades futures or commodity options, the fund is a 
``commodity pool'' and its operator and advisor may be required to 
register with the CFTC and meet certain disclosure, reporting, and 
recordkeeping requirements.
    My testimony today will address four topics. First, I will share 
some observations regarding the participation of hedge funds in the 
regulated futures markets. Second, I will describe the CFTC's 
surveillance methods used to monitor large traders, including many 
hedge funds. Third, I will describe the CFTC's investor protection 
regime aimed at protecting investors from fraudulent practices in the 
sale of commodity pools, including hedge funds. Finally, I will comment 
on our recent enforcement activities involving commodity pools and 
hedge funds.

Participation of Hedge Funds in Futures Markets
    Futures markets serve an important role in our economy by providing 
a means of transferring risk from those who do not want it to those 
willing to accept it for a price. Traders who are trying to reduce 
their exposure to price risks, that is, ``hedgers,'' typically include 
those who have an underlying commercial interest in the commodity upon 
which the futures contract is based. For example, futures contracts 
allow a bank to transfer its risk exposure to rising interest rates, a 
grain merchant to hedge an expected purchase of corn, or an oil refiner 
to lock in the price of its heating oil and gasoline output. In order 
for these hedgers to reduce the risk they face in their day-to-day 
commercial activities, they need to trade with someone willing and able 
to accept the risk. Data from the CFTC's Large Trader Reporting System 
indicate that hedge funds, and other professionally managed funds, 
facilitate the needs of commercial hedgers to mitigate their price 
risks, and add to overall trading volume, which contributes to the 
formation of liquid and well-functioning markets.
    CFTC large trader data also show that hedge funds and other 
professionally managed funds hold significant arbitrage positions 
between related markets. These arbitrage positions are structured to 
profit from temporary mispricing between related contracts (e.g., 
prices for October delivery vs. prices for November delivery) and, when 
structured as such, are unrelated to the overall level of futures 
prices. These arbitrage trades play a vital role in keeping prices of 
related markets (and prices of related contracts within the same market 
complex) in proper alignment with one another.
    One notable market development in recent years has been increased 
participation by hedge funds and other financial institutions in 
futures markets for physical commodities. These institutions view 
commodities as a distinct ``asset class'' and have allocated a portion 
of the portfolios they manage into futures contracts tied to commodity 
indexes. The total investment in commodity-linked index products by 
pension funds, hedge funds and other institutional investors has been 
estimated by industry observers to exceed $100 billion in assets. A 
significant portion of this amount finds it way into the regulated 
futures markets, either through direct participation by those whose 
commodity investments are benchmarked to a commodity index, or through 
participation by commodity index swap dealers who use futures markets 
to hedge the net risk associated with their dealing activities. 
Notably, although the percentage of participation by hedge funds has 
increased in recent years, commercial traders in these markets remain, 
by far, the largest segment of trading category.

Surveillance Methods Used by the CFTC to Monitor Large Traders--
        Including Hedge Funds
    In the CFTC's world of regulated futures exchanges, market 
integrity is essential to preserving the important functions of risk 
management and price discovery that the futures markets perform in the 
U.S. economy. The CFTC relies on a program of market surveillance to 
ensure that markets under CFTC jurisdiction are operating in an open 
and competitive manner, free of manipulative influences or other price 
distortions. The backbone of the CFTC's market surveillance program is 
its Large Trader Reporting System. This system captures end-of-day 
position-level data for market participants meeting certain criteria. 
Positions captured in the Large Trader Reporting System typically make 
up 70 to 90 percent of all positions in a particular exchange-traded 
market. The Large Trader Reporting System is a powerful tool for 
detecting the types of concentrated and coordinated positions required 
by a trader or group of traders attempting to manipulate the market. 
For surveillance purposes, the large trader reporting requirements for 
hedge funds are the same as for any other large trader.
    Using large trader reports, CFTC economists monitor futures market 
trading activity, looking for large positions that might be used to 
manipulate prices. Each day, for all active futures and option 
contracts traded on the regulated exchanges, surveillance staff members 
monitor the daily activities of large traders and key price 
relationships. In addition, CFTC market analysts maintain close 
awareness of supply and demand factors and other developments in the 
underlying cash markets through review of trade publications and 
government reports, and through industry and exchange contacts. Staff 
also closely tracks the net positions of managed money traders as a 
class to monitor for any market irregularities or trends. The CFTC's 
surveillance staff routinely reports to the Commission on surveillance 
activities at weekly surveillance meetings.
    Market surveillance, however, is not conducted exclusively by the 
CFTC. Each futures exchange is required under the CEA to affirmatively 
and effectively supervise trading, prices, and positions. The CFTC 
examines the exchanges to ensure that they have devoted appropriate 
resources and attention to fulfilling this important responsibility. 
The CFTC staff's findings from these rule enforcement reviews are 
reported to the CFTC, and are publicly posted on the CFTC Website 
(www.cftc.gov). Furthermore, exchanges impose position limits, where 
appropriate, to guard against manipulation. For example, NYMEX imposes 
spot month speculative limits on its energy contracts.
    When the CFTC's surveillance staff identifies a potentially 
problematic situation, the CFTC engages in an escalating series of 
communications with the largest long- and short-side traders--which may 
be hedge funds--to address the concern. Typically, the CFTC's staff 
consults and coordinates its activities with exchange staff. This 
targeted regulatory oversight by CFTC staff and the exchanges is quite 
effective in resolving most potential problems. However, hedge funds 
normally roll out of positions prior to the expiration month when 
manipulation is most likely to occur, because most do not have the 
capabilities to make or take delivery of the underlying commodity.
    Given the CFTC's statutory role as an oversight regulator, and the 
exchanges' statutory responsibility to monitor trading to prevent 
manipulation, the law requires that the exchanges take the lead in 
resolving problems in their markets, either informally or through 
emergency action. If an exchange fails to take actions that the CFTC 
deems necessary, the CFTC has broad emergency powers to direct the 
exchange to take such action which, in the CFTC's judgment, is 
necessary to maintain or restore orderly trading in, or liquidation of, 
any futures contract. Fortunately, most issues are resolved without the 
need for the CFTC's emergency powers, as the CFTC has had to take 
emergency action only four times in its history.
    Just as the CFTC's market surveillance program monitors the 
activity of all large traders on the regulated futures exchanges to 
maintain an orderly operation of the markets, the system of financial 
safeguards in the futures industry is focused on ensuring that the 
financial distress of any single futures market participant, whether it 
be a hedge fund or any other participant, does not have a 
disproportionate effect on the overall market. This is primarily 
accomplished through a clearinghouse's financial safeguards. This 
includes the margin deposited by clearing member firms and guarantee 
funds. Futures clearinghouses perform periodic risk evaluations of 
clearing member firms in an attempt to detect potential weaknesses in 
financial condition or risk controls. In addition, each firm has its 
own financial and capital safeguards in place to protect itself from 
the financial distress of a customer--including a hedge fund customer.

CFTC's Oversight Authority With Respect to Operators and Advisors of 
        Commodity Pools, Including Hedge Funds
    Of no less importance is the CFTC's responsibility to protect 
investors who participate--whether directly or through participation in 
a professionally managed fund--in the futures markets through a diverse 
array of commodities products. To that end, the CFTC maintains a 
customer protection regime that, pursuant to the CEA, relies on full 
and timely disclosure to protect investors from abusive or overreaching 
sales practices. This encompasses participation in commodity pools, 
including hedge funds.
    Registration is the cornerstone of the CFTC's customer protection 
scheme. As of June 30, 2006, there were approximately 1,600 Commodity 
Pool Operators (CPOs) and 2,600 Commodity Trading Advisors (CTAs) 
registered with the CFTC, operating and advising approximately 2,300 
commodity pools. In annual reports filed for 2005, these CPOs reported 
total assets under management for commodity pools of approximately $700 
billion, of which less than five percent represent direct investments 
in the futures markets.
    The primary purposes of registration are to ensure a person's 
fitness to engage in business as a futures professional and to identify 
those persons whose activities are covered by the CEA. Generally 
speaking, those who operate or manage a commodity pool must register 
with the CFTC as CPOs, and those who make trading decisions on a pool's 
behalf must register as CTAs. Registration is not dependent on whether 
commodity interests are traded for speculative or hedging purposes, or 
on whether they are the predominant investment traded or advised. 
Notable exclusions or exemptions are available for operators of pools 
that are otherwise regulated; that have only sophisticated participants 
and de minimis commodity interest trading; and that have only the very 
highest level of sophisticated participants, regardless of the amount 
of commodity interests traded. Hedge fund operators frequently fall 
within one of the latter two exemptions from CPO registration.
    Once registered, a CPO or CTA must comply with certain disclosure, 
reporting, and recordkeeping requirements designed to ensure that 
prospective and current participants in commodity pools receive all the 
information that is material to their decision to make, or maintain, an 
investment in the pool. For example, prospective participants must 
receive information regarding the pool's investment program, risk 
factors, conflicts of interests, and performance data and fees. 
Thereafter, a CPO must provide pool participants with an account 
statement at least quarterly, and an annual report containing specified 
financial statements which must be certified by an independent public 
accountant and presented in accordance with Generally Accepted 
Accounting Principles (GAAP).
    The CFTC has established a simplified regulatory framework for 
registered CPOs and CTAs who operate or advise pools whose participants 
meet certain criteria. Relief from full compliance with the disclosure, 
reporting, and recordkeeping requirements is available where, for 
example, pool participants are CFTC or SEC registrants, ``inside 
employees'' of the CPO or CTA, or persons who earn $200,000 annually 
and who have assets worth at least $2 million. Many of the pools for 
which CPOs are exempt from disclosure, reporting, and recordkeeping 
regulations are likely to be hedge funds.
    Having outlined what CFTC regulation involves, it is important to 
note the limits of that regulation. The CFTC's mandate under the CEA 
does not include imposing limits on the pool's market risk or leverage 
parameters, or the instruments that may be traded, or imposing capital 
requirements or risk assessment procedures.
    Finally, day-to-day oversight functions of CPOs and CTAs are 
carried out by the National Futures Association (NFA), the futures 
industry analogue of the National Association of Securities Dealers. 
NFA's responsibilities include the registration processing function and 
review of CPO and CTA disclosure documents and pool financial 
statements. Consistent with the disclosure-based regulatory regime 
under the CEA, review of pool financial statements focuses on ensuring 
that they include all required information and conform to applicable 
accounting standards, but does not include an analysis of the pool's 
underlying transactions themselves. As part of its self-regulatory 
responsibilities, NFA conducts on-site examinations of CPOs and CTAs on 
a routine, periodic basis. NFA generally examines all CPOs and CTAs 
within two years of their becoming active, and every four years 
thereafter.

CFTC Enforcement Overview: Commodity Pools, Hedge Funds and CPOs
    The CFTC takes its enforcement responsibilities with respect to 
CPOs, CTAs, and commodity pools very seriously. Whether registered or 
unregistered, exempt or not exempt, CPOs and CTAs remain subject to the 
CFTC's anti-fraud authority.
    Over the past 6 fiscal years, the CFTC has brought 49 enforcement 
actions involving commodity pools, hedge funds and CPOs. These 
enforcement actions typically involve investments in commodity pools, 
including self-styled hedge funds, in which the investors' funds were 
misappropriated or misused, or where investors were victimized by 
solicitation fraud involving misrepresentations of assets under 
management and/or profitability. The CFTC's Division of Enforcement 
currently has 55 pending investigations of commodity pools, hedge funds 
and CPOs.
    The majority of the CFTC's pool fraud cases have been brought 
against unregistered CPOs. These cases tend to involve ponzi schemes or 
outright misappropriation, as opposed to legitimate hedge fund 
operations. Sanctions in CFTC enforcement actions can include permanent 
injunctions, asset freezes, prohibitions on trading on CFTC-registered 
entities, disgorgement of ill-gotten gains, restitution to victims, 
revocation or suspension of registration, and civil monetary penalties.
    The CFTC has taken enforcement action in several well-publicized 
recent hedge fund frauds. While the futures activities of these funds 
were not necessarily the primary cause of the problems, the CFTC took 
action against its registrants to punish their illegal conduct, deter 
future violations, and seek recovery of monies taken from innocent 
victimized investors. The following cases filed during the past year 
are illustrative:
    On June 21, 2005, the CFTC filed an enforcement action against 
Philadelphia Alternative Asset Management Co., LLC (PAAM), a registered 
CPO, and Paul M. Eustace, a registered associated person and president 
of PAAM, alleging fraudulent solicitation and false reporting involving 
hedge funds and commodity pools. On the day that the complaint was 
filed, the CFTC froze approximately $70 million of the defendants' 
assets.
    On September 29, 2005, the CFTC filed an enforcement action 
alleging misappropriation and fraud involving Connecticut hedge fund 
manager and registered CPO Bayou Management, LLC (Bayou Management), 
its principals Samuel Israel III (a registered associated person) and 
Daniel E. Marino, and Richmond Fairfield Associates, Certified Public 
Accountants. The complaint alleges that the defendants misappropriated 
customer funds, acquired funds through false pretenses, engaged in 
unauthorized trading, and misrepresented material facts to actual and 
prospective investors, including the rates of return the hedge funds 
earned, the value of assets under management, and the existence and 
identity of the accounting firms that had purportedly audited the hedge 
funds.
    In many instances, the CFTC works cooperatively with NFA, state 
regulators, criminal authorities and/or the SEC in bringing such 
actions. In Bayou, for example, Israel and Marino, based upon the same 
conduct alleged by the CFTC, pleaded guilty to criminal charges brought 
by the U.S. Attorney's Office for the Southern District of New York. 
The CFTC also coordinated its Bayou investigation with the SEC, which 
filed a parallel enforcement action under the federal securities laws.

Conclusion
    In closing, the CFTC's primary mission under the CEA includes 
ensuring market integrity and customer protection. Hedge funds that 
trade futures and commodity options on CFTC-regulated exchanges 
implicate both. Thus, the CFTC monitors participation by hedge funds in 
the regulated futures markets, as it does with other large traders, in 
order to ensure that these markets operate free of price distortions. 
The CFTC also administers a disclosure-based regime designed to ensure 
that investors participating in commodity pools receive all the 
information that is material to their decision to invest in pools; when 
problems are uncovered, the full force of the CFTC's enforcement 
authority is devoted to prosecuting those responsible. The CFTC will 
remain vigilant in utilizing the tools provided in the CEA--market 
surveillance, disclosure, reporting and recordkeeping, and enforcement 
authority--to fulfill its statutory responsibilities as hedge fund 
participation in the futures markets continues to expand.
    This concludes my remarks. I look forward to your questions.
                                 ______
                                 
                PREPARED STATEMENT OF RANDAL K. QUARLES
    Under Secretary for Domestic Finance, Department of the Treasury
                             July 25, 2006

    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
good morning, it is a pleasure to be here today. I would like to thank 
you for holding this hearing and allowing the Treasury Department to 
present its views. I am pleased to be here today to contribute to a 
discussion of a topic that is of critical importance to our financial 
markets, namely the regulation of hedge funds.
    In May, before a subcommittee of this panel, I presented testimony 
regarding the role that hedge funds play; that is, what hedge funds do 
for and in our financial markets. As I said then, if government 
addresses the question of regulation of any financial institution or 
activity without a clear understanding of the place it plays in our 
financial system, we run the risk of imposing unnecessary, excessive, 
or inappropriate legislation.
    As we consider the regulation of hedge funds, we should keep in 
mind that the role they fulfill in our financial markets is 
continuously evolving; and in recent years it has been evolving 
rapidly. Therefore, before I turn to the subject of today's hearing, I 
would like to reiterate some of the key points from the testimony I 
gave in May 2006, in which I discussed some of the characteristics of 
hedge funds and some of the potential benefits and risks that they can 
present.

Background
    Despite the fact that hedge funds are today the subject of everyday 
discussion in the financial press and among policymakers, there is no 
universally accepted definition of a hedge fund. A recent report by the 
International Organization of Securities Commissions (IOSCO) on the 
results of a survey of the regulatory approaches toward hedge funds of 
20 IOSCO members revealed that none of the survey respondents had a 
formal definition of ``hedge fund.'' In the late '90s, the President's 
Working Group on Financial Markets (PWG) defined a hedge fund as ``any 
pooled investment vehicle that is privately organized, administered by 
professional investment managers, and not widely available to the 
public.'' Though this was a useful working definition for the PWG's 
purposes, it is limited in how widely it can be applied, in large part 
because it does not distinguish hedge funds from other forms of 
unregistered capital pools that are generally recognized to have 
distinctive features, such as private equity funds and venture capital 
funds. In my May testimony I suggested that there are a number of 
features that can help to distinguish hedge funds from other capital 
pools, including: legal structure; investment objective and strategy; 
compensation scheme; investor base and capital commitment; and 
disclosure.
    As I testified in May, hedge funds have experienced dramatic 
growth, especially in recent years. They have grown from an estimated 
$50 billion in assets in 1988 to about $300 billion in 1998 to over $1 
trillion in assets today.\1\ Current estimates suggest that there are 
about 9,000 hedge funds.
---------------------------------------------------------------------------
    \1\ The data about the hedge fund industry are not precise. 
Therefore, many of the figures noting the size and growth of the 
industry are estimates and Treasury has not independently verified 
them.
---------------------------------------------------------------------------
    Hedge funds employ a variety of investment strategies that vary 
considerably depending on the goals and needs of the investors and the 
types of instruments in which the fund invests. Much, if not all, of 
this growth has been market driven, and, as a consequence, it has been 
subject to a significant amount of market discipline. As hedge funds 
have grown, their investor base has evolved, bringing increasing levels 
of professional analysis to the investor side of the relationship. Each 
new group of investors has imposed certain forms of discipline on hedge 
funds, resulting in the hedge fund market becoming much more 
``institutionalized'' as it has developed. In addition, since the 
failure of Long Term Capital Management (LTCM) in 1998 hedge fund 
investors--and creditors--have recognized the need for more discipline 
regarding the use of leverage and collateral, and hedge fund investors 
now demand more transparency of their fund managers. Therefore, while 
the hedge fund market has grown dramatically in the past twenty years, 
there is at least some reason to believe this growth has been subject 
to reasonable private sector discipline.
    Hedge funds clearly provide certain benefits to the financial 
markets. At the same time, they can also put stresses on it that need 
attention. In my May testimony, I discussed at length many of the 
benefits and potential risks that can arise from the activities of 
hedge funds. Hedge funds impart potential benefits both to the 
financial marketplace, in general, as well as to investors.
    In the financial marketplace, hedge funds provide liquidity, price 
efficiency, and risk distribution, and contribute to the further global 
integration of markets. Because of the varying strategies employed by 
hedge funds, they are often the willing buyers or sellers that provide 
additional liquidity to financial markets. Hedge funds contribute even 
more significantly to marketplace liquidity in less traditional 
markets. Many hedge funds seek to create returns by targeting price 
inefficiencies, including wide bid/ask spreads. While this activity 
certainly benefits the hedge funds that are profiting from the trades, 
it has the salutary effect of creating narrower spreads and more 
efficient markets. Hedge funds can help mitigate market-wide 
concentrations of risk by transferring and distributing market risk 
through their willingness to be counterparties in derivatives trades. 
Today, there is no question that hedge funds are among the dominant 
participants in the re-distribution of market risk. In their search for 
the next profit opportunity, hedge funds often lead the way to 
identifying new and emerging markets. These markets often provide 
opportunities that no longer exist in more mature marketplaces. This, 
in turn, leads to further globalization of our marketplace which 
provides more choice for investors and greater efficiency of markets 
globally.
    Hedge funds can have a direct positive impact on the investing 
community. Speaking broadly, hedge funds can provide investors with 
opportunities for diversification, ``alpha'' or excess returns, and 
capital protection in down markets. Hedge funds provide investors with 
more choices of both instruments and investment strategies. More 
choices allow investors the ability to diversify their investment 
portfolios, which is a common goal of many investors. In contrast to 
conventional investment vehicles employing traditional ``go-long'' 
strategies, the flexibility in the hedge fund structure enables 
strategies that attempt to produce positive returns in both bull and 
bear markets; that is, providing opportunities for generating ``alpha'' 
or excess returns, even in thriving years, and for capital protection 
(or better) in declining markets. It is worth noting that as the hedge 
fund industry grows and becomes more mature and institutionalized, 
excess returns have become harder to find. In addition, a common 
technique employed by many hedge funds attempting to generate excess 
returns is employing leverage, which, of course, presents its own 
specific set of concerns.
    While hedge funds can provide benefits to investors and the overall 
marketplace, they present some risk as well. There are risks that hedge 
funds' aggregate employment of large amounts of leverage or over-
concentration of certain positions could have negative consequences for 
the marketplace. Certain valuation risks also are present in the hedge 
fund industry. Other risks involve operational challenges associated 
with the over-the-counter (OTC) clearance and settlement systems. Many 
of these risks, however, are not unique to hedge funds.
    Leverage refers to the use of repurchase agreements, short 
positions, derivative contracts, loans, margin, and other forms of 
credit extension to amplify returns. With increased leverage, of 
course, comes increased risk. As discussed by the PWG in its report 
after the LTCM failure, excessive leverage can greatly magnify negative 
effects of market conditions. Linked closely with the issue of leverage 
and the potential for impaired liquidity in a period of market stress 
is the issue of concentration of market positions or ``crowded 
trades.'' Sometimes referred to as ``herding,'' crowded trades can 
arise to the extent that hedge fund managers are inclined to pursue the 
same or similar investment strategies. If numerous market participants 
establish large positions on the same side of a trade, especially in 
combination with a high degree of leverage, this concentration can 
contribute to a liquidity crisis if market conditions compel traders 
simultaneously to seek to unwind their positions. The risk, of course, 
is market disruption and illiquidity, possibly exacerbating the risk of 
a systemic financial market crisis.
    As hedge funds become larger, their valuation policies and 
procedures become more important to the marketplace as a whole. 
Valuation is often dependent on complex proprietary models, but because 
of their proprietary nature, these models have not been subject to 
broad-based scrutiny and there is a concern that there could be 
unanticipated changes that might only present themselves in certain 
market conditions. Moreover, valuation concerns are exacerbated in the 
hedge fund industry because hedge fund adviser compensation is tied to 
period returns which, of course, requires periodic asset valuations. 
With respect to OTC settlement and clearance systems, hedge funds as a 
group do not pose a greater operational risk than any other group of 
market participants. However, operational risks can be posed by certain 
market conditions and certain technological conditions in certain 
products, particularly new products, where technological and legal 
infrastructures tend to lag product development and volume growth. 
These acute ``growing pains'' have developed most recently in the 
credit derivatives market across a wide spectrum of participants.
    Thus, hedge funds, or any other group of participants, potentially 
could have a disruptive impact if there were concentrations of 
positions or attempted mass liquidation in illiquid markets. However, 
many of these issues and concerns have been or are actively being 
addressed--outside of a formal scheme of direct regulation of hedge 
funds--both by policymakers and by private sector groups.
    In its report on LTCM, the PWG cautioned that problems can arise 
when financial institutions do not employ sufficient discipline in 
their credit practices with customers and counterparties. To this end, 
the PWG made several recommendations designed to help buttress the 
market-discipline approach to constraining leverage. Numerous public 
and private sector groups, such as Counterparty Risk Management Group 
II (also known as the Corrigan Group), also took up the cause of 
enhancing counterparty credit risk management, and many have continued 
to focus on emerging developments such as the growth of products 
containing embedded leverage. These efforts and others have had the 
positive effects that I alluded to earlier.
    Valuations and correlations also can change rapidly in unexpected 
ways and these changes can have a ripple effect in the marketplace, 
especially if the instruments are concentrated and illiquid. In July 
2005, the Corrigan Group issued a number of ``guiding principles'' and 
recommendations for all types of participants. It recommended that: (1) 
investment in risk management systems should continue, with full model 
testing and validation and independent verification; and (2) analytics 
should include stress testing, scenario analysis, and expert judgment, 
with special attention to the inputs and assumptions.
    The Federal Reserve Bank of New York, Counterparty Risk Management 
Group II, Bank for International Settlements, International Swap and 
Derivatives Association, The Bond Market Association, and Depository 
Trust & Clearing Corporation all have made recommendations or 
undertaken efforts to strengthen the technological and legal aspects of 
the settlement and clearance systems for all market participants. The 
International Monetary Fund has also raised issues generally related to 
market concentrations and illiquidity and the potential for systemic 
risk in its recent ``Global Financial Stability Report,'' and member 
countries and regulators continue to develop and coordinate policies 
and approaches to deal with these issues globally.
    Treasury and the PWG can contribute significantly to these policy 
debates in the first instance by facilitating communication in the 
official sector and with industry participants and academics regarding 
credit risk management, concentration of risks, valuation techniques 
and models, and clearance and settlement systems. While the PWG 
continues to discuss these issues and formulate and coordinate actions 
and plans, we are encouraged by these positive developments noted 
above.

Regulation of Hedge Funds
            The PWG's position on direct regulation of hedge funds
    In its 1999 report on LTCM, the PWG was mainly concerned about the 
systemic risks posed by hedge funds and other highly leveraged 
institutions. Specifically, the PWG was concerned that excessive and 
unconstrained leverage could, in an episode of unusual market stress, 
lead to a general breakdown in the functioning of the financial 
markets. Accordingly, the PWG made a series of recommendations designed 
to encourage hedge funds, hedge funds' counterparties, and regulators 
to focus on enhancing market-wide practices for counterparty risk 
management. A number of the private sector initiatives I have already 
mentioned were initiated in direct response to the PWG's 
recommendations.
    One recommendation the PWG did not make, however, was for the 
direct regulation of hedge funds. The PWG stated that, ``if further 
evidence emerges that indirect regulation of currently unregulated 
market participants is not working effectively to constrain leverage,'' 
then direct regulation of hedge funds, among other measures, ``could be 
given further consideration to address concerns about leverage.'' Even 
with that caveat, the PWG took care to emphasize that it believed its 
recommendations ``would best address concerns related to systemic risk 
without the potential attendant costs of direct regulation of hedge 
funds.'' To date, the PWG has not observed evidence that ``indirect'' 
methods of constraining leverage are not working effectively.

            SEC Hedge Fund Adviser Registration Rule

    In late 2004, the Securities and Exchange Commission (SEC) issued a 
final rule that required hedge fund advisers to register with the 
Commission, mainly out of a perceived need to address increasing 
instances of hedge fund fraud and a concern that less sophisticated 
investors were becoming increasingly exposed to hedge fund investments, 
either directly or indirectly through their pension plans. The rule 
went into effect on February 1, 2006, prompting more than 1,100 
previously unregistered hedge fund advisers to register with the SEC.
    Neither Treasury nor the PWG ever took a formal position on the 
rule. We did work with the SEC, however, both bilaterally and through 
the PWG, to make sure we understood the SEC's rationale for their rule, 
and what their goals and expectations were regarding its 
implementation. Although we did not formally comment on the SEC's 
proposed rule, we did ask the SEC to work with the Commodity Futures 
Trading Commission (CFTC) to avoid potential duplicative registration 
requirements for CFTC-registered commodity pool operators and commodity 
trading advisers.
    This past June, the U.S. Court of Appeals for the D.C. Circuit 
ruled that the SEC's hedge fund adviser registration rule was arbitrary 
in the way it redefined the term ``client'' so as to bring hedge fund 
advisers under the registration requirements of the Investment Advisers 
Act, and the court therefore vacated the rule. SEC Chairman Cox, in his 
statement on the Court's decision, expressed a very pragmatic approach 
to dealing with this decision. He noted that the SEC will continue to 
work with the PWG as it reevaluates its approach to hedge fund activity 
and as the SEC considers alternative courses of action. We look forward 
to working with Chairman Cox and the SEC staff on these issues.

Conclusion
    Thank you again for allowing the Treasury Department to participate 
this afternoon. As I have mentioned, the question of the regulation of 
hedge funds must be carefully considered in light of the important role 
they play in our financial markets.
    It is for that reason that Treasury is examining in detail the 
issues I have discussed this morning, with a view to evaluating whether 
the growth of hedge funds--as well as other phenomena such as 
derivatives and additional alternative investments and investment 
pools--hold the potential to change the overall level or nature of risk 
in our markets and financial institutions. This examination will 
involve bringing key government officials together to review their 
approaches to these financial market issues. The first such meeting was 
held last week, chaired by Assistant Secretary of the Treasury Emil 
Henry, and will be followed by further discussions in the future. We 
are also beginning a broad outreach to the financial community to help 
us examine these questions. As part of this comprehensive review 
chaired by the Treasury, we will be working with the SEC--both 
bilaterally and through the PWG--as Chairman Cox and the Commission 
consider alternative courses of action following the D.C. Circuit 
Court's recent decision.
    Looking forward, we will be focused on seeking to understand in the 
most comprehensive way possible whether and how changes in the 
structure of the financial services industry--of which the rapid growth 
of new forms of capital accumulation, such as hedge funds, is just one 
example--have materially affected the efficiency with which markets 
intermediate risk, whether risk is pooled in different ways or in 
different places than it has been in the past--and if so, what 
appropriate policy responses might be. We will seek to be forward 
looking and to think about these changes not in a fragmented fashion, 
but in a comprehensive way. At the moment it is too soon to say what 
initiatives will result from this focus, but this is the lens through 
which we will filter the various ideas and efforts with which we will 
all be grappling over the next few years.
                                 ______
                                 
     RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM 
                        CHRISTOPHER COX

Q.1. I read last week that at least 10 hedge fund managers have 
filed to de-register since the D.C. Circuit struck down the 
S.E.C.'s registration requirement. How many fund advisers have 
moved to deregister since the ruling last month, and did you 
get any valuable information from those who did register?

A.1. As of September 14, 106 investment advisers to hedge funds 
have withdrawn from SEC registration since the Court of Appeals 
for the District of Columbia Circuit issued the Goldstein 
opinion. Information filed by these investment advisers 
indicates that almost 40% of them withdrew for reasons 
unrelated to the Court's ruling. Some 1260 hedge fund advisers 
registered with the Commission because of the rulemaking, and 
we have no reliable way to estimate how many of them will 
eventually withdraw their SEC registrations, or for what 
reasons. We suspect that withdrawals will continue for the next 
several months as hedge fund advisers evaluate their options. 
Many hedge fund advisers and their attorneys have informed us 
that they plan to remain registered; some have changed their 
business model or accepted new clients so that they must remain 
registered, while some others are choosing to remain registered 
because their investors demand it. To smooth the transition, 
the Commission's staff provided no-action and interpretive 
responses to a letter from the American Bar Association that 
addressed many issues that arose from the Court's decision. The 
staffs response is available at http://www.sec.gov/divisions/
investment/noaction/aba081006.pdf.
    The Commission did get valuable information from the hedge 
fund advisers that registered. First, as the Commission pointed 
out in the adopting release, prior to the rule's adoption no 
government agency had any reliable data on basic census 
information on hedge fund managers. From the information hedge 
fund advisers filed with us, we were able to construct the most 
comprehensive picture to date of hedge fund advisers operating 
in the United States or managing money for U.S. investors. Data 
included the number of advisers, number of funds, hedge fund 
adviser disciplinary information, and the advisers' financial 
industry affiliations. The information that we have collected 
has also assisted the Commission's Office of Compliance 
Inspections and Examinations in carrying out its risk-based 
examination program, which has lead to several referrals to our 
Division of Enforcement for further review. We will continue to 
collect data from registered hedge fund advisers, but as some 
hedge fund advisers withdraw their registrations and some new 
hedge fund advisers choose not to register the data will be 
incomplete.

Q.2. As the hedge fund industry has evolved, even more people 
are getting in to hedge funds through different investment 
vehicles such as funds of funds. Without unified regulation, do 
people have an unfair advantage in the market by being able to 
choose an investment that is unregulated? And does the current 
system of regulation give the larger investor such as the 
university endowment fund an unfair advantage over a small 
individual investor?

A.2. In many cases, both Congress and the Commission have 
operated under a long-standing principle that wealthy or 
sophisticated investors have the ability to protect themselves 
(or hire experts to help them protect themselves) and therefore 
have access to certain investments that others may not have. I 
think this approach has served both retail and institutional 
investors well, and am uncertain of the benefits of alternative 
approaches that might need to either (i) treat all investors as 
institutional investors and thus eliminate important investor 
protections afforded to retail investors, or (ii) treat all 
investors as retail investors and deny institutional and 
similar investors access to useful investments such as hedge 
funds.

Q.3. I asked Mr. Quarles this question at the last hearing on 
hedge funds, so now I am going to ask Chairman Cox and Chairman 
Jeffery. In a regulated mutual fund industry, many questionable 
practices that were not in the best interest of the individual 
investor and the markets had to be regulated by government 
intervention. Why would we assume in a lightly regulated hedge 
fund industry that we wouldn't encounter similar indiscretions 
by managers? And do you think transparency requirements should 
be similar for mutual funds and hedge funds?

A.3. The Commission has not assumed that hedge fund managers 
would be less likely to participate in questionable or illegal 
practices. Indeed, one reason for the Commission's rulemaking 
was the growing number of enforcement actions we were bringing 
against hedge fund managers. We remain concerned about 
malfeasance in this area and are considering how to address it 
through further rulemaking. While there may be a need for some 
amount of greater transparency of hedge funds (such as that 
suggested by the President's Working Group on Financial Markets 
in 1999), I believe that requiring transparency similar to that 
required of mutual funds would be unwise. Disclosure of 
portfolio positions could undermine some of the types of 
investment strategies pursued by hedge funds.

Q.4. Have you seen evidence of market manipulation by hedge 
funds?

A.4. Yes. In fact, the Commission has brought enforcement cases 
against hedge fund managers that have involved either market 
manipulation or illegal short-selling.
    The Commission has brought an action alleging that hedge 
fund advisers manipulated the market by creating the appearance 
of greater demand for two stocks than actually existed. SEC v. 
Scott Sacane et al. (Oct. 2005). The individual defendants in 
that case both pled guilty to related criminal charges and have 
been barred by the Commission from associating with an 
investment adviser. One defendant has settled the Commission's 
civil action, paying disgorgement and a civil penalty.
    The Commission has also brought an enforcement action 
against a hedge fund manager for scalping. SEC v. Berton M. 
Hochfeld (Nov. 2005). The Commission alleged that the 
defendant, while employed as a research analyst with a broker-
dealer, failed to disclose in research reports distributed to 
the broker's clients, that a hedge fund he controlled 
maintained positions in stocks that were the subjects of his 
research reports. On numerous occasions, he allegedly directed 
trades in the subject stocks immediately after the issuance of 
his research reports that was contrary to the information in 
the reports.
    In another case, SEC v. Michael Lauer, Lancer Management 
Group, LLC, et al., (July 23, 2003), the Commission alleged 
that the defendants systematically manipulated the month end 
closing prices of certain securities held by their funds to 
overstate the value of the funds' holdings. The complaint 
alleged that the manipulative trading practices employed by the 
defendants were designed to attract new investors and to induce 
current investors to stay in the funds and to raise the value 
of the funds, both of which resulted in increased management 
fees paid to the defendants.
    The short selling cases can be generally categorized into 
two groups. The first group involved allegations of illegal 
activities in connection with ``PIPE'' (``Private Investment in 
Public Equity'') transactions. SEC v. Hilary Shane (May 2005); 
SEC v. Langley Partners (March 2006); and SEC v. Deephaven 
Capital Management (May 2006). While the specific facts alleged 
in each case vary, the general pattern is as follows: In these 
cases, the Commission has alleged that hedge fund advisers have 
agreed to buy public company shares in a private offering from 
the issuer on a confidential basis. The PIPE transaction will 
dilute the public float, which may decrease the issuer's share 
price. The hedge fund adviser then misuses its knowledge of the 
impending PIPE to sell shares of the public company short, 
profiting when the share price decreases due to the dilutive 
effect of the PIPE transaction that it entered into. The second 
group involved allegations of rule violations regarding the 
source of shares used to cover short sales. In the Matter of 
Galleon Management (May 2005); In the Matter of Oaktree Capital 
(May 2005); and In the Matter of DB Investment Managers (a 
subsidiary of Deutsche Bank) (May 2005). These actions allege 
violations of a rule that prohibits covering a short sale with 
securities obtained in a public offering if the short sale 
occurred within five business days before the pricing of the 
offering.

Q.5. Have you seen evidence of systemic risks or instability 
caused by hedge funds?

A.5. There were two episodes over the past two years during 
which a significant number of hedge funds experienced losses. 
In May 2005, credit rating agencies' downgrade of the U.S. 
automobile manufacturing sector precipitated a painful period 
for a number of hedge funds that traded credit derivatives. A 
year later, in May 2006, a spike in equity and emerging market 
debt volatility resulted in losses for a number of hedge funds 
trading in those markets. During neither of these events did we 
see any evidence that hedge funds were having difficulty in 
meeting collateral calls from prime brokers or over-the-counter 
derivatives counterparties. Such difficulties would be early 
warning signs of events that might have systemic implications 
for the broader financial system.
    Nonetheless, we continue to encourage the major securities 
firms that we supervise on a consolidated basis to strengthen 
their credit and operational risk management infrastructure, 
which will further reduce the likelihood of systemic 
instability. A useful blueprint in this regard remains the 
report published by the Counterparty Risk Management Policy 
Group in July 2005 entitled ``Toward Greater Financial 
Stability: A Private Sector Perspective.'' We have regular 
discussions with firms under our supervision regarding their 
progress in implementing the recommendations regarding the 
management of exposures to hedge funds produced by that 
industry group.

                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM CHRISTOPHER 
                              COX

Q.1. Chairman Cox, will the SEC appeal the Goldstein decision 
or seek a rehearing? When does the SEC intend to make public 
its position with respect to the decision? Will advisers who 
registered under the rule be required to file a Form ADV-W to 
withdraw their registrations?

A.1. On August 7, 2006, I issued a statement (available at 
http://www.sec.gov/news/prcss/2006/2006-13S.htm) indicating 
that the Commission would not seek en banc review of the 
Goldstein decision or petition the U.S. Supreme Court for a 
writ of certiorari. Any adviser that wishes to withdraw its 
registration with the Commission must file Form ADV-W. As noted 
earlier, we believe a substantial number of hedge fund advisers 
will need to, or choose to, remain registered.

Q.2. In the past, the PWG has rejected direct regulation of 
hedge funds. Can you tell us a little more about what is 
involved in fostering market discipline in the hedge fund 
context and if this is a superior approach to direct 
regulation?

A.2. Market discipline in the hedge fund context relies on 
adequate information reaching participants, including 
counterparties and investors. The Commission has always 
supported dissemination of adequate information so that 
investors and counterparties can make informed decisions and 
the market can act efficiently. Because hedge funds are offered 
privately, this information exchange is often privately 
negotiated. The Commission, of course, would take appropriate 
action in the event of fraud.

Q.3. The media and the press always tend to suggest that hedge 
funds are unregulated or that hedge funds are the wild west of 
capital markets. It that true? It is my understanding that 
hedge funds are subject to the same anti-fraud and anti-
manipulation requirements as any other market participant, as 
well as a host of other rules and regulations. Can you please 
clarify this for the record by providing a list of all the 
rules and regulations hedge funds and their activities therein, 
are subject?

A.3. Press articles typically refer to hedge funds as ``lightly 
regulated'' investment pools. In a sense, they are correct. 
Hedge funds are organized and operated so that they are not 
subject to the Investment Company Act of 1940. In addition, 
hedge funds issue securities in ``private offerings'' that are 
not registered with the Commission under the Securities Act of 
1933, and hedge funds are not required to make periodic reports 
under the Securities Exchange Act of 1934. After the Goldstein 
decision some hedge fund advisers will not be registered under 
the Advisers Act. Further, until the Commission adopts a new 
rule, hedge fund advisers may not have the same fiduciary 
obligations as other advisers.
    However, hedge funds are subject to the same prohibitions 
against fraud as are other market participants. In addition, 
they are or may be--depending upon their investment and 
offering activities--subject to provisions of state, federal 
and foreign securities laws too numerous to comprehensively 
list. These include:

 Registration with and regulation by the Commission as 
    a broker-dealer, as an investment adviser, or registration 
    of the hedge fund or its securities);

 Compliance with Regulation D in making the private 
    placements of their securities.

 Compliance with position and transaction reporting 
    under rules of the SEC, CFTC and Federal Reserve Board.

 Compliance with commodities laws and regulations, 
    including registration requirements, that may apply if the 
    hedge fund is trading in futures.

                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM REUBEN 
                          JEFFERY, III

    Q.1. I asked Mr. Quarles this question at the last hearing 
on hedge funds, so now I am going to ask Chairman Cox and 
Chairman Jeffery. In a regulated mutual fund industry, many 
questionable practices that were not in the best interest of 
the individual investor and the markets had to be corrected by 
government intervention. Why would we assume in a lightly 
regulated hedge fund industry that we wouldn't encounter 
similar indiscretions by managers? And do you think 
transparency requirements should be similar for mutual funds 
and hedge funds?

A.1. As the Committee is aware, the Commodity Futures Trading 
Commission (``CFTC'') does not regulate mutual funds and I will 
defer to Chairman Cox to respond with respect to issues 
concerning them. Under the Commodity Exchange Act (``Act''), 
the CFTC has jurisdiction over persons who operate and advise 
collective investment vehicles that trade CFTC-regulated 
commodity futures and options contracts. Generally speaking, 
those who operate or manage a commodity pool must register with 
the CFTC as CPOs, and those who make trading decisions on a 
pool's behalf must register as CTAs. Some of these commodity 
pools, or collective investment vehicles, have been commonly 
referred to as ``hedge funds.'' The CFTC does not use that term 
because neither the Act nor CFTC regulations refer to that term 
nor define it.
    Pursuant to the Act's investor protection mandate, the CFTC 
has implemented a regulatory scheme for CPOs and CTAs that 
fosters full and timely disclosure intended to protect 
investors from abusive or overreaching sales practices by 
persons who operate or advise commodity pools. Registration is 
the cornerstone of this scheme. The primary purposes of 
registration are to ensure a person's fitness to engage in 
business as a futures professional and to identify those 
persons whose activities are covered by the CEA. Notable 
exclusions or exemptions from registration are available for 
operators of pools that are otherwise regulated; that have only 
sophisticated participants and de minimis commodity interest 
trading; and that have only the very highest level of 
sophisticated participants, regardless of the amount of 
commodity interests traded. Hedge fund operators frequently 
fall within one of the latter two exemptions from CPO 
registration. Irrespective of registration status, all CPOs and 
CTAs are subject to the anti-fraud and anti-manipulation 
prohibitions of the Act and CFTC regulations and they must make 
their books and records available to the CFTC and National 
Futures Association (``NFA''), a futures industry's analogue to 
the National Association of Securities Dealers, upon request.
    Registration triggers certain disclosure, reporting, and 
recordkeeping requirements designed to ensure that prospective 
and current participants in commodity pools receive all the 
information that is material to their decision to make, or 
maintain, an investment in the pool. For example, prospective 
participants must receive information regarding the pool's 
investment program, risk factors, conflicts of interests, and 
performance data and fees. Thereafter, a CPO must provide pool 
participants with an account statement at least quarterly, and 
an annual report containing specified financial statements 
which must be certified by an independent public accountant and 
presented in accordance with Generally Accepted Accounting 
Principles.
    The oversight functions of CPOs and CTAs are carried out by 
the NFA. In this capacity, NFA is responsible for registration 
processing, review of CPO and CTA disclosure documents, review 
of commodity pool annual reports and related extension filings, 
and processing of exemption notices under Part 4 of the 
Commission's regulations. In addition, NFA monitors CPO and CTA 
sales practices and conducts periodic examinations of CPOs and 
CTAs.
    The CFTC maintains an oversight role with respect to NFA's 
performance. CFTC staff engages in ongoing communication and 
coordination with NFA with regard to NFA's supervision of CPO 
and CTA compliance. For example, NFA and CFTC staff members 
meet quarterly to discuss registration issues, meet as needed 
to discuss CPO and CTA oversight issues, and communicate 
frequently on issues that must be handled promptly. In 
addition, Commission staff conducts periodic oversight 
examinations of NFA's compliance program for CPOs and CTAs. The 
most recent oversight examination was completed in early 2006.
    The CFTC takes very seriously its responsibility to protect 
investors--whether directly or through participation in a 
professionally managed fund--in the futures markets. Toward 
that end, the CFTC works to ensure that investors participating 
in commodity pools receive all the information that is material 
to their decision to invest in pools, and when problems are 
uncovered, devotes the full force of the CFTC's enforcement 
authority to prosecuting those responsible.

Q.2. Since we are talking about hedge funds today, how much do 
you think hedge fund activity in the commodities sector has 
contributed to a hike in energy and commodity prices?

A.2. The energy market is perhaps one of the most difficult 
commodity sectors in which to isolate individual factors that 
influence prices. These markets are subject to significant 
geopolitical influences, they involve complex inter-product 
pricing structures due to the large number of refined products 
that are derived from crude oil and natural gas, and there have 
been extensive changes and shifts in the underlying demand and 
supply fundamentals over the past 5 years, which have 
significantly impacted prices.
    In a study of large traders in energy markets first issued 
last year by the CFTC's Office of the Chief Economists, the 
staff concluded that overall, the exchange-traded futures-
trading of hedge funds does not appear to have exerted 
appreciable upward pressure on energy prices. This study 
indicates that non-commercial traders, a category of traders 
that generally includes ``speculators'' and hedge funds, are 
more likely than not are responding to position changes by 
commercial traders (i.e., companies or individuals with 
commercial interests in the commodity underlying the futures 
contracts). In other words, when a commercial trader sells, it 
will often be a non-commercial trader who takes the other side 
of the transaction as the buyer. When a commercial trader buys, 
it will often be a non-commercial trader who is the seller. 
This observation is consistent with the notion that non-
commercial traders respond to price changes and are not the 
cause of price changes.
    Surveillance data on large non-commercial traders also does 
not infer a significant price impact by hedge funds. Large non-
commercial traders typically hold positions on both sides of 
the market, although they have tended to be slightly net long 
in their overall positions. For example, as of September 5, 
2006, large non-commercial traders held 15.3% of long open 
interest and 11.3% of short open interest in the NYMEX crude 
oil contract. In the unleaded gasoline contract, they held 
12.8% of long open interest and 10.1% of short open interest. 
An exception to this pattern is the gasoline blendstock, or 
RBOB, contract where non-commercials held 16.1% of the long 
open interest, but only 1.1% of short open interest. 
Nonetheless, despite being net long in these contracts, prices 
have fallen significantly over the period. This observation is 
contrary to the argument that the net long positions of non-
commercials, and hedge funds in particular, have lifted prices. 
It should also be noted that that typically well over half of 
the open interest in these markets is held by large commercial 
entities.
    In addition to holding outright long and short positions in 
energy markets, large non-commercials hold significant calendar 
spread positions. Such positions tend to be neutral in their 
effect on price levels. Spread positions are structured to 
speculate on relative price differences (e.g., prices for 
October delivery vs. prices for November delivery), and when 
structured as such, are unrelated to the overall level of 
futures prices for individual commodities and therefore are not 
responsible for changes in the level of these prices. As of 
September 5, 2006, large non-commercial traders held spread 
positions equal to 20% of the crude oil market, 13.1% of the 
heating oil market and 38.6% of the natural gas market.
    In addition to calendar spreads, it is unknown what portion 
of the outright positions reflected in the surveillance data 
are positions held by large non-commercials that represent 
product spreads, such as the crack spread, which is a position 
between related products (crude oil and refined products). 
Again, positions related to such spreads would not tend to 
influence the overall level of prices in the energy complex.

Q.3. Have you seen evidence of market manipulation by hedge 
funds?

A.3. Commission surveillance staff monitors on an ongoing basis 
trading activity in all futures contracts on the regulated 
futures exchanges to detect and prevent market manipulation. 
The backbone of the CFTC's market surveillance program is its 
Large Trader Reporting System. This system captures end-of-day 
position-level data for market participants meeting certain 
criteria. Positions captured in the Large Trader Reporting 
System typically make up 70 to 90 percent of all positions in a 
particular exchange-traded market. The Large Trader Reporting 
System is a powerful tool for detecting the types of 
concentrated and coordinated positions required by a trader or 
group of traders attempting to manipulate the market. For 
surveillance purposes, the large trader reporting requirements 
for hedge funds are the same as for any other large trader.
    The Commission's surveillance staff closely monitors large 
positions, particularly in expiring futures contracts, to 
detect and deter manipulation, market abuses, market 
disruptions and other sources of price distortion. Surveillance 
seeks to prevent these problems before they occur and 
surveillance staff has been involved in all actively traded 
exchange futures contracts with a very wide assortment of 
traders. Should the Commission suspect that there is evidence 
that manipulation has occurred, or even has been attempted; the 
matter may be referred to the Commission's enforcement staff. 
While the Commission staff has reviewed the activities in the 
futures markets of certain hedge funds as part of inquiries and 
analysis of whether certain activity was legal, the Commission 
has not filed a complaint alleging manipulation against a hedge 
fund.

Q.4. Have you seen evidence of systemic risks or instability 
caused by hedge funds?

A.4. The activities of managed money accounts in the futures 
markets regulated by the CFTC have not created systemic risk to 
date. Although managed money accounts have incurred substantial 
losses in futures markets, these situations have not had 
systemic effects. In such cases, losses have not spilled over 
as brokerage firms and clearing organizations continued to meet 
all their obligations. The CFTC has noted however, that 
potential risk is increasing as managed money accounts 
establish larger and more complex positions in the futures 
markets. Consequently, CFTC financial surveillance efforts have 
focused increasingly on such accounts.
    Through the large trader reporting system, staff can 
identify the traders with the largest positions. Using 
internally-developed tools, staff can stress test the positions 
to identify potential losses the account might incur in extreme 
market moves. These potential losses can be compared to the 
margin requirements for the positions and to the capital 
resources of the brokerage firm carrying the account. To the 
extent these comparisons raise concerns; staff can contact the 
clearing organization, the brokerage firm, and/or the trader to 
determine what steps are being taken to mitigate the risks. 
Staff continues to work to refine its techniques.

                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM REUBEN 
                          JEFFERY, III

Q.1. Chairman Jeffrey, in a Financial Times article on July 
20th, you were quoted responding to a Permanent Subcommittee on 
Investigation's staff report titled: ``The Role of Market 
Speculation in Rising Oil and Gas Prices: A Need to Put the Cop 
Back on the Beat.'' You were quoted as saying: ``I can't resist 
taking exception to the notion that the cop has not been on the 
beat. Our enforcement experience over the past several years 
belies that notion and shows a strong record of commitment and 
vigilance in the area of anti-manipulation and false reporting 
in the energy sector.'' Would you please expand upon these 
comments?

A.1. The Commission maintains its commitment to addressing 
potential problems in the energy markets through a combination 
of vigilant surveillance and vigorous enforcement.
    Commission surveillance staff monitors on an ongoing basis 
trading activity in all futures markets to detect and prevent 
market manipulation. Commission staff also routinely consults 
with staff from the Federal Energy Regulatory Commission (FERC) 
and the Energy Information Administration in analyzing events 
in these energy markets.
    The Commission's Division of Enforcement has broad 
authority to conduct investigations to determine whether any 
persons have violated, are violating, or are about to violate 
the provisions of the Commodity Exchange Act. For example, 
since December 2002 the Enforcement Program has investigated 
energy market conduct that potentially involved: (1) false 
reporting of natural gas trading to companies that compile and 
publish natural gas index prices for delivery hubs throughout 
the United States; and/or 2) attempts to manipulate and/or 
manipulation of natural gas index prices. In addition, the 
Enforcement Program's investigation of the TET physical propane 
market resulted in the Commission's filing of an enforcement 
action against BP Products North America, Inc. charging 
manipulation and attempted manipulation.
    From December 2002 to date, the Commission has filed a 
total of 34 enforcement actions charging a total of 54 
respondents/defendants (30 companies and 24 individuals). The 
Commission has settled 25 of these enforcement actions and 
obtained $298,263,500 in civil monetary penalties. Nine CFTC 
energy market-related enforcement actions remain pending. 
Complementing the effect of its direct enforcement action, the 
Commission has also achieved great success in this program area 
by working cooperatively with the Department of Justice on 
criminal actions.
    The Commission's energy market enforcement actions only 
tell a part of the story, however, because certain Enforcement 
Program investigations conclude that no misconduct occurred and 
the energy markets were operating properly. For example, while 
it is the Commission's policy to not publicly comment on its 
investigations, in August 2004 the Commission announced the 
completion of its seven-month investigation of the sharp upward 
movement in prices in the natural gas market that occurred in 
late 2003 when natural gas futures contracts more than doubled 
in price within a short period. The Commission's investigation 
did not uncover evidence that any entity or individual engaged 
in activity with an intent to cause an artificial price in 
natural gas. According to the information obtained during the 
investigation, the increase in natural gas prices during that 
time was the result of distinct factors, including market 
reaction to colder than expected weather in the northeast 
United States during the first week in December 2003, and 
market statements and projections regarding the inventory of 
natural gas in underground storage caverns made in late 
November/early December 2003.
    The Commission's 25 settled energy market enforcement 
actions include: In re Dynegy Marketing & Trade, et al., CFTC 
Docket No. 03-03 (CFTC filed Dec. 18, 2002) ($5 million civil 
monetary penalty); CFTC v. Enron Corp., et al., No. H-03-909 
(S.D. Tex. filed March 12, 2003) ($35 million civil monetary 
penalty; CFTC v. Hunter Shively, No. H-03-909 (S.D. Tex filed 
March 12, 2003) ($300,000 civil monetary penalty); In re El 
Paso Merchant Energy, L.P., Docket No. 03-09 (CFTC filed March 
26, 2003) ($20 million civil monetary penalty); In re WD Energy 
Services Inc., Docket No. 03-20 (CFTC filed July 28, 2003) ($20 
million civil monetary penalty); In re Williams Energy 
Marketing And Trading, et al., Docket No. 03-21 (CFTC filed 
July 29, 2003) ($20 million civil monetary penalty); In re 
Enserco Energy, Inc., Docket No. 03-22 (CFTC filed July 31, 
2003) ($3 million civil monetary penalty); In re Duke Energy 
Trading And Marketing, L.L.C., Docket No. 03-26 (CFTC filed 
Sept. 17, 2003) ($28 million civil monetary penalty); CFTC v. 
American Electric Power Company, Inc., et al., No. C2 03 891 
(S.D. Ohio filed Sept. 30, 2003) ($30 million civil monetary 
penalty); In re CMS Marketing Services and Trading Company, et 
al., Docket No. 04-05 (CFTC filed Nov. 25, 2003) ($16 million 
civil monetary penalty); In re Reliant Energy Services, Inc., 
Docket No. 04-06 (CFTC filed Nov. 25, 2003) ($18 million civil 
monetary penalty); In re Harmon, Docket No. 03-25 (CFTC filed 
Jan. 16, 2004) ($8,500 civil monetary penalty); In re Aquila 
Merchant Services, Inc., Docket No. 04-08 (CFTC filed Jan. 28, 
2004) ($26.5 million civil monetary penalty); In re Calpine 
Energy Services, L.P., CFTC Docket No. 04-11 (CFTC filed Jan. 
28, 2004) ($1.5 million civil monetary penalty); In re ONEOK 
Energy Marketing And Trading Company, L.P., et al., Docket No. 
04-09 (CFTC filed Jan. 28, 2004) ($3 million civil monetary 
penalty); In re Entergy-Koch Trading, LP, Docket No. 04-10 
(CFTC filed Jan. 28, 2004) ($3 million civil monetary penalty); 
In re e prime, Inc., Docket No. 04-12 (CFTC filed Jan. 28, 
2004) (a wholly-owned subsidiary of Xcel Energy, Inc.; $16 
million civil monetary penalty); In re Knauth, Docket No. 04-15 
(CFTC filed May 10, 2004) ($25,000 civil monetary penalty); In 
re Western Gas Resources, Inc., Docket No. 04-17 (CFTC filed 
July 1, 2004) ($7 million civil monetary penalty); In re Coral 
Energy Resources, L.P., Docket No. 04-21 (CFTC filed July 28, 
2004) ($30 million civil monetary penalty); In re Biggs, Docket 
No. 04-22 (CFTC filed Aug. 11, 2004) ($30,000 civil monetary 
penalty); In re BP Energy Co., Docket No. 05-02 (CFTC filed 
Nov. 4, 2004) ($100,000 civil monetary penalty); In re Cinergy, 
CFTC Docket No. 05-03 (CFTC filed November 16, 2004) ($3 
million civil monetary penalty); In re Mirant, CFTC Docket No. 
05-05 (CFTC filed Dec. 6, 2004) ($12.5 million civil monetary 
penalty); In re McKenna, CFTC Docket No. SD 05-03 (CFTC May 20, 
2005) (registration revocation); and In re Shell Trading US 
Company, et al., CFTC Docket No. 06-02 (CFTC filed Jan. 4, 
2006) ($300,000 civil monetary penalties).
    The Commission's nine pending energy market enforcement 
actions include: CFTC v. NRG Energy, Inc., No. 04-cv-3090 MJD/
JGL (D. Minn. filed July 1, 2004) (charging false reporting); 
CFTC v. Bradley, et al., No. 05CV62-CVE-FHM (N.D. Okla. filed 
Feb. 1, 2005) (charging false reporting and attempts to 
manipulate); CFTC v. Johnson, et al., No. H-05-0332 (S.D. Texas 
filed Feb. 1, 2005) (charging false reporting and attempts to 
manipulate); CFTC v. McDonald, et al., No. 1:05-CV-0293 (N.D. 
Ga. filed Feb. 1, 2005) (charging false reporting and attempts 
to manipulate); CFTC v. Whitney, No. H 05-333 (S.D. Texas filed 
Feb. 1, 2005) (charging false reporting and attempts to 
manipulate); CFTC v. Reed, et al., No. 05-D-178 (D. Colo. filed 
Feb. 1, 2005) (charging false reporting and attempts to 
manipulate); CFTC v. Richmond, No. 05-M-668 (OES) (D. Colo. 
filed April 12, 2005) (charging false reporting and attempts to 
manipulate); CFTC v. Foley, No. 2:05 849 (S.D. Ohio filed Sept. 
14, 2005) (charging false reporting and attempted 
manipulation); and CFTC v. BP Products North America, Inc., No. 
06C 3503 (N.D. Ill. filed June 28, 2006 (charging manipulation, 
cornering the market, attempts to manipulate).

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