Hedge Funds: Regulators and Market Participants Are Taking Steps 
to Strengthen Market Discipline, but Continued Attention Is	 
Needed (24-JAN-08, GAO-08-200). 				 
                                                                 
Since the 1998 near collapse of Long-Term Capital Management	 
(LTCM), a large hedge fund--a pooled investment vehicle that is  
privately managed and often engages in active trading of various 
types of securities and commodity futures and options--the number
of hedge funds has grown, and they have attracted investments	 
from institutional investors such as pension plans. Hedge funds  
generally are recognized as important sources of liquidity and as
holders and managers of risks in the capital markets. Although	 
the market impacts of recent hedge fund near collapses were less 
severe than that of LTCM, they recalled concerns about risks	 
associated with hedge funds and they highlighted the continuing  
relevance of questions raised over LTCM. This report (1)	 
describes how federal financial regulators oversee hedge	 
fund-related activities under their existing authorities; (2)	 
examines what measures investors, creditors, and counterparties  
have taken to impose market discipline on hedge funds; and (3)	 
explores the potential for systemic risk from hedge fund-related 
activities and describes actions regulators have taken to address
this risk. In conducting this study, GAO reviewed regulators'	 
policy documents and examinations and industry reports and	 
interviewed regulatory and industry officials, and academics.	 
Regulators only provided technical comments on a draft of this	 
report, which GAO has incorporated into the report as		 
appropriate.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-200 					        
    ACCNO:   A80111						        
  TITLE:     Hedge Funds: Regulators and Market Participants Are      
Taking Steps to Strengthen Market Discipline, but Continued	 
Attention Is Needed						 
     DATE:   01/24/2008 
  SUBJECT:   Commodity marketing				 
	     Federal funds					 
	     Financial institutions				 
	     Financial management				 
	     Funds management					 
	     Internal controls					 
	     Policy evaluation					 
	     Program evaluation 				 
	     Regulatory agencies				 
	     Risk management					 
	     Securities regulation				 
	     Strategic planning 				 
	     Transparency					 
	     Long Term Capital Management Fund			 

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GAO-08-200

   

     * [1]Results in Brief
     * [2]Background
     * [3]Hedge Funds Generally Are Subject to Limited Direct Oversigh

          * [4]With Limited Authority to Regulate Hedge Funds, SEC Largely

               * [5]SEC Examinations of Hedge Fund Advisers Identified Areas
                 of
               * [6]SEC Monitors Risk Management Practices at the Largest
                 Securi

          * [7]CFTC Can Monitor Hedge Fund Activities through Its Market Su
          * [8]Bank Regulators Have Conducted Some Examinations Relating to

     * [9]Investors, Creditors, and Counterparties Have Increased Effo

          * [10]Better Due Diligence and Greater Demand for Transparency fro
          * [11]Creditors and Counterparties Can Impose Some Market Discipli

     * [12]Regulators View Hedge Fund Activities as Potential Sources o

          * [13]Despite Intensified Market Discipline, Concerns about Hedge
          * [14]Regulators Are Taking Steps to Strengthen Market Discipline

     * [15]Agency Comments
     * [16]Appendix I: Scope and Methodology
     * [17]Appendix II: Pension Plan Investments in Hedge Funds Have In
     * [18]Appendix III: Various Hedge Fund Investment Strategies Defin
     * [19]Appendix IV: GAO Contacts and Staff Acknowledgments

          * [20]GAO Contact
          * [21]Staff Acknowledgments

               * [22]Order by Mail or Phone

Report to Congressional Requesters

United States Government Accountability Office

GAO

January 2008

HEDGE FUNDS

Regulators and Market Participants Are Taking Steps to Strengthen Market
Discipline, but Continued Attention Is Needed

GAO-08-200

Contents

Letter 1

Results in Brief 5
Background 9
Hedge Funds Generally Are Subject to Limited Direct Oversight, but
Regulatory Focus Has Increased since LTCM 11
Investors, Creditors, and Counterparties Have Increased Efforts to Impose
Discipline on Hedge Fund Advisers, but Some Limitations Remain 26
Regulators View Hedge Fund Activities as Potential Sources of Systemic
Risk and Are Taking Measures to Enhance Market Discipline and Prepare for
Financial Disruptions 33
Agency Comments 39
Appendix I Scope and Methodology 41
Appendix II Pension Plan Investments in Hedge Funds Have Increased but Are
Still a Small Percentage of Plans' Total Assets 44
Appendix III Various Hedge Fund Investment Strategies Defined 49
Appendix IV GAO Contacts and Staff Acknowledgments 50

Table

Table 1: Ten Defined Benefit Plans with the Largest Reported Hedge Fund
Investments for 2006 47

Figure

Figure 1: Investments in Hedge Funds Reported by Defined Benefit Plans for
the Period 2001-2006 48

Abbreviations

CDO collateralized debt obligation CEA Commodity Exchange Act of 1936
CFTC Commodity Futures Trading Commission
CPO commodity pool operator
CTA commodity trading advisor
CRMPG Counterparty Risk Management Policy Group
CSE Consolidated Supervised Entity
DB defined benefit
DOL Department of Labor
ERISA Employee Retirement Income Security Act of 1974
FCM futures commission merchant
FDIC Federal Deposit Insurance Corporation
FRBNY Federal Reserve Bank of New York
FSA Financial Services Authority (United Kingdom)
IOSCO International Organization of Securities Commissions
LTCM Long-Term Capital Management
LTRS large trader reporting system
MFA Managed Funds Association
NFA National Futures Association
OCC Office of the Comptroller of the Currency
OTC over-the-counter
OTS Office of Thrift Supervision
PPA Pension Protection Act of 2006
PPM private placement memorandum
PWG President's Working Group on Financial Markets
RADAR Risk Assessment Database for Analysis and Reporting
SEC Securities and Exchange Commission

This is a work of the U.S. government and is not subject to copyright
protection in the United States. The published product may be reproduced
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However, because this work may contain copyrighted images or other
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wish to reproduce this material separately.

United States Government Accountability Office
Washington, DC 20548

January 24, 2008

The Honorable Barney Frank: 
Chairman: 
Committee on Financial Services: 
House of Representatives: 

The Honorable Paul E. Kanjorski: 
Chairman: 
Subcommittee on Capital Markets, Insurance and Government Sponsored 
Enterprises: 
House of Representatives: 

The Honorable Michael E. Capuano: 
House of Representatives: 

In recent years, hedge funds have grown rapidly.1 According to industry
estimates, from 1998 to early 2007, the number of funds grew from more
than 3,000 to more than 9,000, and assets under management from more than
$200 billion to more than $2 trillion globally.2 An estimated $1.5
trillion of these assets is managed by U.S. hedge fund advisers. Hedge
funds are key players in many financial markets. For example, hedge funds
reportedly account for more than 40 percent of the trading volume in the
U.S. leveraged loan market, more than 85 percent of the distressed debt
market, and more than 80 percent of certain credit derivatives markets.3
Institutional investors, such as endowments, foundations, insurance
companies, and pension plans, seeking to diversify their risks and
increase returns, have invested in hedge funds and contributed to the
rapid growth in these funds.

1 Although there is no statutory definition of hedge funds, the term is
commonly used to describe pooled investment vehicles that are privately
organized and administered by professional managers and that often engage
in active trading of various types of securities and commodity futures and
options contracts.

2 By comparison, assets under management in the mutual fund industry grew
from about $5.5 trillion in 1998 to about $10.4 trillion in 2006.

3 Greenwich Associates, "In U.S. Fixed Income, Hedge Funds Are The Biggest
Game In Town," August 30, 2007.

As active market participants, hedge funds generally are recognized to
provide benefits to financial markets by enhancing liquidity and promoting
market efficiency and price discovery.4 Especially in volatile markets,
hedge funds are generally willing to assume risks that more regulated
financial institutions are unwilling or unable to assume. Additionally,
they are recognized to spur financial innovation and help to reallocate
financial risk. Nevertheless, the rapid growth of funds that may adopt
similar investment strategies in interconnected markets with rapid trading
strategies raises questions as to whether large losses from one or more
hedge funds could cause widespread difficulties at other firms, in other
market segments, or in the financial system as a whole. For example, hedge
funds may impose losses on their creditors and counterparties and thereby
disrupt the credit availability to financial markets or through market
disruptions that could accompany liquidation of funds' positions.5

Market discipline plays a primary role, supplemented by indirect
regulatory oversight of commercial banks and securities and futures firms,
in constraining risk taking and leveraging by hedge fund managers
(advisers). Market participants (e.g., investors, creditors, and
counterparties) impose market discipline by rewarding well-managed hedge
funds and reducing their exposure to risky, poorly managed hedge funds.
However, according to several sources, for market discipline to be
effective, (1) investors, creditors, and counterparties must have access
to, and act upon, sufficient and timely information to assess a fund's
risk profile; (2) investors, creditors, and counterparties must have sound
risk management policies, procedures, and systems to evaluate and limit
their credit risk exposures to hedge funds; and (3) creditors and
counterparties must increase the costs or decrease the availability of
credit to their hedge fund clients as the creditworthiness of the latter
changes.

Inadequate market discipline is often cited as a contributing factor to
the near collapse in 1998 of Long-Term Capital Management (LTCM), a large
highly leveraged hedge fund. The subsequent 1999 report by the President's
Working Group on Financial Markets (PWG) questioned the adequacy of (1)
market discipline that some creditors and counterparties (commercial and
investment banks, including their prime brokerage business and futures
firms) imposed on LTCM's risk-taking activities, and (2) LTCM's disclosure
and risk management practices.6 The report also raised questions about the
risk management practices of these entities and the ability of federal
financial regulators to supervise effectively the large creditors and
counterparties that extended credit to hedge funds. In its 1999 report,
the PWG made recommendations to enhance market discipline and the risk
management practices of market participants.7 Since LTCM, other hedge
funds have experienced near collapses or failures.8 Despite a few notable
failures, hedge funds overall seem to have held up well, and their
counterparties have not sustained material losses in the market turmoil
that began in the summer of 2007.9 Although the market impacts of the
recent cases were less severe than that of LTCM, they recalled concerns
about risks associated with hedge funds and they highlighted the
continuing relevance of questions raised over LTCM.

4 Price discovery refers to the process by which market prices incorporate
new information.

5 A counterparty is the opposite party in a bilateral agreement, contract,
or transaction.

Given the growing importance and continuing evolution of the hedge fund
sector since LTCM, you asked us to study the risks hedge funds may pose to
the financial markets and how hedge fund creditors and counterparties and
the regulatory framework can address those risks. Accordingly, this report
(1) describes how federal financial regulators provide oversight of hedge
fund-related activities under their existing authorities; (2) examines
what measures investors, creditors, and counterparties have taken to
impose market discipline on hedge funds; and (3) explores the potential
for systemic risk from hedge fund-related activities and actions
regulators have taken to address this risk.10 In addition, we provide
information on pension plan investments in hedge funds in appendix II.

6 The PWG was established by Executive Order 12631, signed on March 18,
1988. The Secretary of the Treasury chairs the PWG, the other members of
which are the chairpersons of the Board of Governors of the Federal
Reserve System, Securities and Exchange Commission, and Commodity Futures
Trading Commission. The group was formed in 1988 to enhance the integrity,
efficiency, orderliness, and competitiveness of the U.S. financial markets
and maintain the public's confidence in those markets. Prime brokerage is
the name for a bundled package of services (e.g., clearance and settlement
of securities trades, margin loans, and risk management services) offered
by investment banks to hedge funds.

7 See the President's Working Group on Financial Markets, Hedge Funds,
Leverage, and the Lessons of Long-Term Capital Management (April 28,
1999).

8 For example, in fall 2006, a fund operated by Amaranth Advisors, LLC,
lost more than $6 billion as a result of natural gas trading. In summer
2007, two hedge funds sponsored by Bear Stearns Asset Management
experienced losses from its holdings of collateralized debt obligations
(CDO) that contained subprime mortgages. A CDO is a security backed by a
pool of bonds, loans, or other assets.

9 Federal Reserve Chairman Ben S. Bernanke, The Recent Financial Turmoil
and Its Economic and Policy Consequence (Speech at the Economic Club of
New York, Oct. 15, 2007).

In conducting our work, we reviewed and analyzed relevant regulatory
examination documentation and enforcement cases from federal financial
regulators. This included examination documentation and enforcement cases
from the following federal banking regulators--Office of the Comptroller
of the Currency (OCC), Board of Governors of the Federal Reserve System
(Federal Reserve), Federal Reserve Bank of New York (FRBNY), and Federal
Deposit Insurance Corporation (FDIC); a federal securities
regulator--Securities and Exchange Commission (SEC); and futures markets
regulators--Commodity Futures Trading Commission (CFTC) and National
Futures Association (NFA).11 We also analyzed relevant laws and
regulations, speeches, testimonies, studies, and prior GAO reports, as
well as principles and guidelines that the PWG issued about private pools
of capital--including hedge funds, PWG protocols, and relevant industry
best practices for hedge fund advisers, creditors, and counterparties. We
interviewed officials representing the U.S. regulators identified above
and the Office of Thrift Supervision (OTS), the PWG, Department of Labor
(DOL), and the Department of the Treasury (Treasury).12 We also
interviewed officials of the United Kingdom's Financial Services Authority
(FSA), as well as representatives from market participants such as
commercial and investment banks, large hedge funds, pension industry
participants, credit rating agencies, a risk management firm, a hedge fund
law firm, trade groups representing hedge funds and institutional
investors, and academics. We conducted this performance audit from
September 2006 to January 2008 in accordance with generally accepted
government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide a
reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
Appendix I provides a detailed description of our scope and methodology.

10 Systemic risk generally is defined as the risk that a disruption (at a
firm, in a market segment, to a settlement system, etc.) could be
transmitted to and potentially pose risks to other firms, other market
segments, or the financial system as a whole.

11 NFA is a self-regulatory organization for the U.S. futures industry.

12 We do not discuss OTS's examination program in this report because at
the time of our review OTS officials noted that no thrifts were making
loans to hedge funds or serving in any significant trading counterparty
capacity.

Results in Brief

Under the existing regulatory structure, SEC and CFTC regulate those hedge
fund advisers that are registered with them, but SEC, CFTC, as well as the
federal bank regulators (collectively, financial regulators) monitor hedge
fund-related activities of other regulated entities such as broker-dealers
and commercial banks.13 Specifically, SEC regulates an estimated 1,991
hedge fund advisers that are registered as investment advisers, which
include 49 of the largest U.S. hedge fund advisers that account for about
one-third of hedge funds' assets under management in the United States.14
As registered investment advisers, hedge fund advisers are subject to SEC
examinations and reporting, record keeping, and disclosure requirements.
In fiscal year 2006, SEC examined 321 hedge fund advisers and identified
issues (such as information disclosure, reporting and filing, personal
trading, and asset valuation) that are not exclusive to hedge funds. Also,
in 2004 SEC established a program to oversee the large internationally
active securities firms on a consolidated basis. These securities firms
have significant interaction with hedge funds through affiliates
previously not overseen by SEC. One aspect of this program is to examine
how the securities firms manage various risk exposures, including those
from hedge fund-related activities such as providing prime brokerage
services and acting as creditors and counterparties. Similarly, CFTC
regulates those hedge fund advisers registered as commodity pool operators
(CPO) or commodity trading advisors (CTA).15 CFTC has authorized NFA to
conduct day-to-day monitoring of registered CPOs and CTAs; in fiscal year
2006, NFA examinations of CPOs included six of the largest U.S. hedge fund
advisers. In addition, SEC, CFTC, and bank regulators can use their
existing authorities--to establish capital standards and reporting
requirements, conduct risk-based examinations, and take enforcement
actions--to oversee activities, including those involving hedge funds, of
broker-dealers, of futures commission merchants, and of banks,
respectively. While none of the regulators we interviewed specifically
monitored hedge fund activities on an ongoing basis, generally regulators
have increased reviews--by such means as targeted examinations--of systems
and policies to mitigate counterparty credit risk at the large regulated
entities. For instance, from 2004 to 2007, FRBNY conducted various
reviews--including horizontal reviews--of credit risk management practices
that involved hedge fund-related activities at several large banks.16 On
the basis of the results, FRBNY noted that the banks generally had
strengthened practices for managing risk exposures to hedge funds, but the
banks could further enhance firmwide risk management systems and
practices, including expanded stress testing.17 Regulated entities have
the responsibility to practice prudent risk management standards, but
prudent standards do not guarantee prudent practices. As such, it will be
important for regulators to show continued vigilance in overseeing the
hedge fund-related activities of regulated institutions.

13 The hedge funds themselves are not registered with any regulators.

14 We were not able to find any estimate of the total number of hedge fund
advisers.

15 Except as may otherwise be provided by law, a CPO is an individual or
organization that operates an enterprise, and who, in connection
therewith, solicits or receives funds from third parties, for the purpose
of trading in any commodity for future delivery on a contract market or
derivatives execution facility. 7 U.S.C. S 1a(5). A CTA is, except as
otherwise provided by law, any person who, for compensation or profit, (1)
directly or indirectly advises others on the advisability of buying or
selling any contract of sale of a commodity for future delivery, commodity
options or certain leverage transactions contracts, or (2) as part of a
regular business, issues analyses or reports concerning the activities in
clause (1). 7 U.S.C. S 1a(6). In addition to statutory exclusions to the
definition of CPO and CTA, CFTC has promulgated regulations setting forth
additional criteria under which a person may be excluded from the
definition of CPO or CTA. See 17 C.F.R. SS 4.5 and 4.6 (2007).

Since the near collapse of LTCM in 1998, investors, creditors, and
counterparties have increased their efforts to impose market discipline on
hedge funds. However, regulators and market participants also identified
issues that limit the effectiveness of these efforts. Investors,
creditors, and counterparties impose market discipline on hedge funds by
providing more funding or better terms to those hedge funds willing to
disclose credible information about the fund's risks and prospective
returns. According to market participants doing business with larger hedge
funds, hedge fund advisers have improved disclosure and become more
transparent about their operations, including risk management practices,
partly as a result of recent increases in investments by institutional
investors with fiduciary responsibilities, such as pension plans, and
guidance provided by regulators and industry groups. Despite the
requirement that fund investors be sophisticated, some market participants
suggested that not all prospective investors have the capacity or retain
the expertise to analyze the information they receive from hedge funds,
and some may choose to invest in a hedge fund largely as a result of its
prior returns and may fail to fully evaluate its risks. Regulators and
market participants also said creditors and counterparties have been
conducting more extensive due diligence and monitoring risk exposures to
their hedge fund clients since LTCM. The creditors and counterparties we
interviewed said that they have exercised market discipline by tightening
their credit standards for hedge funds and demanding greater disclosure.
However, several factors limit the effectiveness of market discipline or
illustrate failures to properly exercise it. For example, most large hedge
funds use multiple prime brokers as service providers. Thus, no one broker
may have all the data necessary to assess the total leverage used by a
hedge fund client. Further, the actions of creditors and counterparties
may not fully prevent hedge funds from taking excessive risk if these
creditors' and counterparties' risk controls are inadequate. For example,
the risk controls may not keep pace with the increasing complexity of
financial instruments and investment strategies that hedge funds employ.
Similarly, regulators have been concerned that in competing for hedge fund
clients, creditors sometimes relaxed credit standards. These factors can
contribute to conditions that create the potential for systemic risk if
breakdowns in market discipline and the risk controls of creditors and
counterparties are sufficiently severe that losses by hedge funds in turn
cause significant losses at key intermediaries or in financial markets.

16 A horizontal review is a coordinated supervisory review of a specific
activity, business line, or risk management practice conducted across a
group of peer institutions.

17 Stress testing measures the potential impact of various scenarios or
market movements on an asset, counterparty exposure, or the value of a
firm's portfolio.

Although financial regulators and market participants recognize that the
enhanced efforts by investors, creditors, and counterparties since LTCM
impose greater market discipline on hedge funds, some remain concerned
that hedge funds' activities are a potential source of systemic risk.
Counterparty credit risk arises when hedge funds enter into transactions,
including derivatives contracts, with regulated financial institutions.18
Some regulators regard counterparty credit risk as the primary channel for
potentially creating systemic risk. As discussed earlier, some regulators
questioned whether some creditors and counterparties could manage
counterparty credit risk effectively. In addition to counterparty credit
risk, other factors such as trading behavior can create conditions that
contribute to systemic risk. Given certain market conditions, the
simultaneous liquidation of similar positions by hedge funds that hold
large positions on the same side of a trade could lead to losses or a
liquidity crisis that might aggravate financial distress. Recognizing that
market discipline cannot eliminate the potential systemic risk posed by
hedge funds and others, regulators have been taking steps to better
understand the potential for systemic risk and respond more effectively to
financial disruptions that can spread across markets. For instance, they
have examined particular hedge fund activities across regulated entities,
mainly through international multilateral efforts. The PWG has issued
guidelines that provide a framework for addressing risks associated with
hedge funds and implemented protocols to respond to market turmoil.
Finally, the PWG recently established two private sector committees
comprising hedge fund advisers and investors to address investor
protection and systemic risk concerns, including counterparty credit risk
management issues. We view these actions as positive steps to address
systemic risk, but it is too soon to evaluate their effectiveness.

18 Counterparty credit risk is the risk that a loss will be incurred if a
counterparty to a transaction does not fulfill its financial obligations
in a timely manner.

We provided a draft of this report to CFTC, DOL, Federal Reserve, FDIC,
OCC, OTS, SEC, and Treasury for their review and comment. None of the
agencies provided written comments. All except for FDIC and OTS provided
technical comments, which we have incorporated into the report as
appropriate.

Background

Hedge funds typically are organized as limited partnerships or limited
liability companies, and are structured and operated in a manner that
enables the fund and its advisers to qualify for exemptions from certain
federal securities laws and regulations that apply to other investment
pools, such as mutual funds.19 In addition, hedge funds operate to qualify
for exemptions from certain registration and disclosure requirements of
federal securities laws (including the Securities Act of 1933 and the
Securities Exchange Act of 1934). For example, hedge funds must refrain
from advertising to the general public and can solicit participation in
the fund from only certain large institutions and wealthy individuals.20
Although certain advisers may be exempt from registration requirements,
they remain subject to anti-fraud (including insider trading),
anti-manipulation, and large trading position reporting rules. For
example, upon acquiring a significant ownership position in a particular
publicly traded security or holding a certain level of futures or options
positions, a hedge fund adviser may be required to file a report
disclosing the adviser's or hedge fund's holdings with SEC or positions
with CFTC, as applicable.

19 To avoid being required to register as an investment company under the
Investment Company Act of 1940 (Investment Company Act), hedge funds
typically rely on sections 3(c)(1) or 3(c)(7) of that act. Section 3(c)(1)
excludes from the definition of "investment company" under the Investment
Company Act hedge funds that do not make or propose to make a public
offering of their shares and whose share are not beneficially owned by
more than 100 investors. 15 U.S.C. S 80a-3(c)(1). Section 3(c)(7) excludes
from the definition of "investment company" hedge funds that do not make
or propose to make a public offering of their shares and whose shares are
offered exclusively by "qualified purchasers" and is exempt from most of
the provisions of the Investment Company Act. 15 U.S.C. S 80a-3(c)(7).
Generally, "qualified purchasers" are individuals who own at least $5
million in investments or companies that own at least $25 million in
investments. 15 U.S.C. S 80a- 2(a)(51).

Hedge fund advisers also typically satisfy the "private manager" exemption
from registration under section 203(b)(3) of the Investments Advisers Act
of 1940 (Advisers Act). Section 203(b)(3) exempts from registration an
adviser (1) that has had fewer than 15 clients in the 12 months preceding
the claim of exemption and (2) that neither holds himself out generally to
the public as an investment adviser nor acts as an investment adviser to
any registered investment company or any "business development company" as
defined under the Investment Company Act. 15 U.S.C. S 80b-3. Unless its
falls within an exclusion from the definition of CPA or CTA, a hedge fund
or hedge fund adviser that trades on U.S. commodity futures or option
markets, may be subject to the registration requirement under the
Commodity Exchange Act (CEA) for CPOs or CTAs, respectively. CFTC has
promulgated regulations setting forth criteria for exemption from
registration under the CEA. See 17 C.F.R. SS 4.13 and 4.14 (2007).
However, a person claiming to fall outside of the definition of CPO or
CTA, as well as those CPOs and CTAs claiming an exemption from
registration must file with the NFA a notice of eligibility for the
claimed exclusion or exemption, as the case may be, and must submit to any
special calls the CFTC may make to require the person to demonstrate its
eligibility for such exclusion or exemption.

Hedge funds have significant business relationships with the largest
regulated commercial and investment banks. Hedge funds act as trading
counterparties for a wide range of over-the-counter (OTC) derivatives and
other financing transactions. They also act as clients through their
purchase of clearing and other services and as borrowers through their use
of margin loans from prime brokers.

Hedge funds generally are not restricted by regulation in their choice of
investment strategies, as are mutual funds. They may invest in a wide
variety of financial instruments, including stocks and bonds, currencies,
OTC derivatives, futures contracts, and other assets. Most hedge fund
trading strategies are dynamic, often changing rapidly to adjust to fluid
market conditions. To seek to generate "absolute returns" (performance
that exceeds and has low correlation with stock and bond markets returns),
advisers may use leverage, short selling, and a variety of sophisticated
investment strategies and techniques.21 However, while hedge funds
frequently borrow or trade in products with leverage to magnify their
returns, leverage also can increase their losses. Appendix III provides
examples of investment strategies used by hedge funds.

20 Under the Securities Act of 1933, a public offering or sale of
securities must be registered with SEC, unless otherwise exempted. In
order to exempt an offering or sale of hedge fund shares (ownership
interests) to investors from registration under the Securities Act of
1933, most hedge funds restrict their sales to accredited investors in
compliance with the safe harbor requirements of Rule 506 of Regulation D.
See 15 U.S.C. S 77d and S 77e; 17 C.F.R. S 230.506 (2007). Such investors
must meet certain wealth and income thresholds. SEC generally has proposed
a rule that would raise the accredited investor qualification standards
for individual investors (natural persons) from $1 million in net worth to
$2.5 million in investments. See Revisions to Limited Offering Exemptions
in Regulation D, 72 Fed. Reg. 45116 (Aug. 10, 2007) (proposed rules and
request for additional comments). In addition, hedge funds typically limit
the number of investors to fewer than 500, so as not to fall within the
purview of Section 12(g) of the Securities Exchange Act of 1934, which
requires the registration of any class of equity securities (other than
exempted securities) held of record by 500 or more persons. 15 U.S.C. S
78l(g).

21 Leverage is the use of various financial instruments or borrowed capital
to increase the potential return of an investment. Short selling is the
selling of a security that the seller does not own, or any sale that is
completed by the delivery of a security borrowed by the seller.

Advisers of hedge funds commonly receive a fixed compensation of 2 percent
of assets under management plus 20 percent of the fund's annual profits.
Some fund advisers can command higher fees. Since this compensation scheme
rewards hedge fund advisers for exceptional performance, but does not
directly penalize them for inferior performance, advisers could be tempted
to pursue excessively risky investment strategies that might produce
exceptional returns. To discourage excessive risk taking, investors
generally insist that the advisers and principals also personally invest
in their funds to more closely align principals' interests with those of
fund investors.

Hedge Funds Generally Are Subject to Limited Direct Oversight, but Regulatory
Focus Has Increased since LTCM

SEC's ability to directly oversee hedge fund advisers is limited to those
that are required to register or voluntarily register with SEC as
investment advisers. Recent examinations of registered advisers raised
concerns in areas such as disclosure, reporting and filing, personal
trading, and asset valuation. Also, under a program established in 2004,
SEC oversees, on a consolidated basis, some of the largest internationally
active securities firms that engage in significant hedge fund-related
activities. CFTC directly oversees registered CPOs and CTAs (some of which
may be hedge fund advisers) through market surveillance, regulatory
compliance surveillance, an examination program delegated to NFA, and
enforcement actions. The banking regulators also monitor hedge
fund-related activities at the institutions under their jurisdiction. For
instance, in recent years regulators conducted targeted examinations and
horizontal reviews that have focused on areas such as stress testing,
leverage, liquidity, due diligence, and margining practices as well as
overall credit risk management.

With Limited Authority to Regulate Hedge Funds, SEC Largely Monitors Hedge Fund
Activities and Related Risks through Consolidated Supervision of Large
Securities Firms

Registered hedge fund advisers are subject to the same disclosure
requirements as all other registered investment advisers. These advisers
must provide current information to both SEC and investors about their
business practices and disciplinary history. Advisers also must maintain
required books and records, and are subject to periodic examinations by
SEC staff. Meanwhile, hedge funds, like other investors in publicly traded
securities, are subject to various regulatory reporting requirements. For
example, upon acquiring a 5 percent beneficial ownership position of a
particular publicly traded security, a hedge fund may be required to file
a report disclosing its holdings with SEC.22 Also, any institutional
investment adviser with investment discretion over accounts holding
certain publicly traded equity securities valued at $100 million or more
must file on a quarterly a report with SEC.23 SEC also plans to propose
new rule making that would require a registered adviser sponsoring a hedge
fund to identify and provide some basic information to SEC about the hedge
fund's gatekeepers, i.e., auditor, prime broker, custodian, and
administrator.

In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which had
the effect of requiring certain hedge fund advisers that previously
enjoyed the private adviser exemption from registration to register with
SEC as investment advisers.24 In June 2006, a federal court vacated the
2004 amendment to Rule 203(b)(3)-1.25 According to SEC, when the rule was
in effect (from February 1, 2006, through August 21, 2006), SEC was better
able to identify hedge fund advisers. In August 2006, SEC estimated that
2,534 advisers that sponsored at least one hedge fund were registered with
the agency. Since August 2006, SEC's ability to identify an adviser that
manages a hedge fund has been further limited due to changes in filing
requirements and to advisers that chose to retain registered status. As of
April 2007, 488, or about 19 percent of the 2,534 advisers, had withdrawn
their registrations. At the same time, 76 new registrants were added and
some others changed their filing status, leaving an estimated 1,991 hedge
fund advisers registered. While the list of registered hedge fund advisers
is not all-inclusive, many of the largest hedge fund advisers--including
49 of the largest 78 U.S. hedge fund advisers--are registered. These 49
hedge fund advisers account for approximately $492 billion of assets under
management, or about 33 percent of the estimated $1.5 trillion in hedge
fund assets under management in the United States.26

22 See 15 U.S.C. S 78m(d), (g) and 17 C.F.R. SS 240.13d-1 et seq. (2007).

23 See 15 U.S.C. S 78m(f) and 17 C.F.R. 240.13f-1 (2007). For purposes of
this provision "institutional investment manager" is defined as "any
person, other than a natural person, investing in or buying and selling
securities for its own account, and any person exercising investment
discretion with respect to the account of any person."

24 See Registration under the Advisers Act of Certain Hedge Fund Advisers,
69 Fed. Reg. 72087 (Dec. 10, 2004). The rule essentially amended the
definition of "client" so that rather than viewing a hedge fund as a
single client of the hedge fund advisers, all limited partners investing
in the hedge fund were deemed to be a client, thereby putting the number
of clients well above the 14-client limit for the private adviser
exemption. The new rule did not require the registration of advisers to
funds with certain characteristics, such as a lockup periods of 2 years or
more--typically venture capital and private equity funds.

25 See Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C.
Cir. 2006). In Goldstein, the U.S. Circuit Court of Appeals for the
District of Columbia held that SEC's hedge fund rule was arbitrary because
it departed, without reasonable justification, from SEC's long-standing
interpretation of the term "client" in the private adviser exemption as
referring to the hedge fund itself, and not to the individual investors in
the fund. See footnote 19, supra, for a description of the private adviser
exemption from registration under the Advisers Act.

  SEC Examinations of Hedge Fund Advisers Identified Areas of Concern

In fiscal year 2006, SEC took additional steps to oversee hedge fund
advisers by creating an examination module specifically for hedge fund
advisers and providing training for examiners in hedge fund-related
topics. The new examination module outlines how the examination of a hedge
fund adviser generally begins with an analysis of the adviser's compliance
program and the work of its chief compliance officer and uses a control
scorecard as a guide. As part of this review of compliance programs,
examiners inspect the typical activities of advisers and are expected to
obtain a clear understanding of all activities of affiliates and how these
activities may affect or conflict with those of the hedge fund adviser
being examined. Examiners are to focus primarily on the following
activities during their examinations of hedge fund advisers:

           o portfolio management;
           o brokerage arrangements and trading;
           o personal trading by access persons;
           o valuation of positions and calculations of net asset value;
           o leverage;
           o safety of clients' and funds' assets;
           o performance calculations;
           o fund investors and capital introduction;
           o violations of domestic or foreign laws that may directly harm
           fund investors or other market participants, or cause harm to
           prime brokers;
           o books and records, fund financial statements, and investor
           reporting;
           o chief compliance officer, compliance culture, and program; and
           o boards of directors for offshore funds (fiduciary duties to
           shareholders of the hedge funds and consistent disclosure to its
           investors).
			  
26 According to the May 2007 edition of Institutional Investor's Alpha
Magazine, which lists the largest 100 global hedge funds based on assets
as of December 31, 2006, 78 of the largest 100 hedge funds are U.S.-based
hedge funds. According to HedgeFund Intelligence, $1.5 trillion in hedge
fund assets were under management in the United States as of March 2007.
			  
           In preparation for the registration of hedge fund advisers and
           because SEC does not have a dedicated group of examiners that
           focus on hedge funds, SEC and hedge fund industry officials noted
           the need for more experience and ongoing training of examiners on
           hedge funds' investment strategies and complex financial
           instruments. SEC developed a specialized training program to
           better familiarize its examiners with the operation of hedge funds
           to improve effectiveness of examinations of hedge fund advisers.
           In that regard, from October 2005 through October 2006, SEC held
           about 20 examiner training sessions on hedge fund-related topics.
           Industry participants were instructors in many of these sessions.
           These sessions covered topics such as hedge fund structure, hedge
           fund investment vehicles, identification and examination of
           conflicts of interests at hedge fund advisers, risk management,
           prime brokerage, valuation, current and future regulation,
           examination issues, and investment risk. SEC continues to offer
           hedge fund training to examiners and other staff on an ongoing
           voluntary basis.

           SEC uses a risk-based examination approach to select investment
           advisers for inspections. Under this approach, higher-risk
           investment advisers are examined every 3 years.27 One of the
           variables in determining risk level is the amount of assets under
           management. SEC officials told us that most hedge funds, even the
           larger ones, do not meet the dollar threshold to be automatically
           considered higher-risk. As part of the overall risk-based approach
           for conducting oversight of investment advisers, SEC uses a
           database application called Risk Assessment Database for Analysis
           and Reporting (RADAR), to identify the highest-risk areas
           designated by examiners and to develop and recommend regulatory
           responses to address these higher-risk areas. In fiscal year 2006,
           RADAR identified a number of hedge fund-related risk areas, which
           although not exclusive to hedge funds require additional
           regulatory attention, including the following:

           o soft dollars (e.g., paying for a hedge fund's office space
           without disclosing it);
           o market manipulation (e.g., the dissemination of false
           information to inflate the price of a stock);
           o hedge fund custody and misappropriation (e.g., theft of hedge
           fund assets by its advisers);
           o complexity of hedge fund products and suitability (e.g.,
           inadequacy of policies and procedures to assess the complexity of
           financial instruments and the suitability of products for
           investors);
           o prime brokerage relationships (e.g., potential conflicts of
           interest where prime brokers give hedge fund clients--who often
           pay large dollar amounts of commissions--priority over non-hedge
           fund clients regarding access to information/research);
           o performance fees (e.g., incorrect calculation of performance
           fees);
           o hedge fund valuation (e.g., inadequate policies and procedures
           to ensure that asset valuations are accurate);
           o fund of funds' conflicts of interest (e.g., conflicts of
           interest between fund of funds advisers and their recommendation
           to a fund of hedge fund to invest in certain hedge funds);
           o insider trading (e.g., trading on nonpublic information); and
           o hedge fund suitability (e.g., inadequate policies and procedures
           to ensure the financial qualification of investors).

27 See GAO, Securities and Exchange Commission: Steps Being Taken to Make
Examination Program More Risk-Based and Transparent, [24]GAO-07-1053
(Washington, D.C.: Aug. 14, 2007).

           According to SEC officials, they plan to address these risks by
           primarily focusing on these areas during subsequent examinations.

           As part of its fiscal year 2006 routine inspection program, SEC
           conducted examinations of 1,346 registered investment advisers, of
           which 321 were believed to have involved hedge fund advisers. SEC
           used its new hedge fund module, along with other modules as
           appropriate, to conduct the 321 examinations, which included 5 of
           the largest 78 U.S. hedge funds.28 According to SEC officials, the
           321 hedge fund advisers' examinations found that these advisers
           had the greatest deficiencies in the following areas: (1)
           information disclosures, reporting, and filing--e.g., private
           placement memorandum was outdated; (2) personal trading--e.g.,
           quarterly reports were not filed or filed late for personal
           trading accounts; and (3) compliance rule--e.g., policies and
           procedures were inadequate to address compliance risks. Examiners
           also cited concerns with performance advertising and marketing of
           portfolio management, brokerage arrangement and execution,
           information processing and protection, safety of clients' funds
           and assets, pricing of clients' portfolios, trade allocations, and
           anti-money laundering.

           In our review of 9 of the 321 examinations of hedge fund advisers,
           we found that examiners cited deficiencies in 8 of these
           examinations. Deficiencies found included all of the above
           mentioned categories except for trade allocations. For example,
           examiners identified concerns in 5 of the examinations regarding
           disclosures and in one of the examinations, for instance, the
           hedge fund adviser's marketing package did not disclose any
           material conditions, objectives, or investment strategies used to
           obtain the performance result portrayed. In another examination,
           the hedge fund adviser failed to adequately disclose to investors
           that a conflict of interest may be present when the hedge fund
           adviser places transactions through broker-dealers who have
           invested in the hedge fund.

           According to SEC officials, 294 (or approximately 92 percent) of
           the 321 hedge fund advisers examined received deficiency
           letters.29 Some 292 of them provided satisfactory responses to SEC
           that they had taken or would take appropriate corrective actions.
           Such actions can include advisers implementing policies and
           procedures to address deficiencies. Those hedge fund advisers that
           do not take or propose to take corrective actions for a material
           deficiency may be referred to SEC's Division of Enforcement
           (Enforcement) for enforcement actions. According to SEC, 23 of the
           321 examinations resulted in enforcement referrals, and most of
           these referrals regarded situations in which the adviser appeared
           to have engaged in fraud that harmed its clients.

28 SEC did not identify the largest U.S. hedge funds cited in industry
reports prior to conducting these hedge fund adviser examinations.
Twenty-seven of the largest hedge fund advisers were examined by SEC from
fiscal years 2005 to 2007.

29 For non-hedge fund investment advisers, the percentage that received a
deficiency letter is 84 percent.

           As part of its oversight activities, SEC has brought a number of
           enforcement actions involving hedge fund advisers. Sources of
           information that led to SEC enforcement cases included
           examinations, self-regulatory organizations, referrals, and tips.
           From October 1, 2001, to June 12, 2007, SEC brought a total of
           3,937 enforcement cases, of which 113, or 2.9 percent, were hedge
           fund-related. These cases involve hedge fund advisers who
           misappropriated fund assets, engaged in insider trading,
           misrepresented portfolio performance, falsified their experience
           and credentials, or lied about past returns. As an example, in
           2006, SEC brought a case against a hedge fund adviser and its
           former portfolio manager and charged them with making investment
           decisions based on nonpublic insider information that certain
           public offerings were about to be publicly announced. The hedge
           fund adviser agreed to pay approximately $5.7 million in
           disgorgement, prejudgment interest, and civil money penalty, and
           the former portfolio manager agreed to pay a civil money penalty
           of $110,000 and be barred from associating with an investment
           adviser for 3 years. SEC also has brought cases for inaccurate
           disclosure of trading strategies, undisclosed preferential
           treatment of hedge fund clients at the expense of other clients,
           market manipulation, insider trading, illegal short selling, and
           improper valuation of assets. During the same period, nine insider
           trading cases were brought against hedge fund advisers, of which
           five have been settled and four remain in litigation. The five
           settled cases resulted in disgorgements ranging from $2,736 to
           $7.05 million, civil penalties ranging from $8,208 to $4.7
           million, a suspension, and bars from the securities industry.

           According to an SEC enforcement official, SEC recognized that
           hedge funds were becoming a prominent force in the financial
           industry, and in anticipation that certain hedge fund advisers
           would be required to register with SEC as investment advisers when
           the now vacated amendment to Rule 203(b)(3)-1 was under
           consideration, SEC created a hedge fund working group composed
           primarily of Enforcement and Office of Compliance Inspections and
           Examinations staff and participants from other divisions. The
           goals of this group are to enhance SEC's staff knowledge about the
           hedge fund industry to aid in its oversight role and coordinate
           and strengthen the agency's efforts to combat insider trading at
           hedge funds. Currently, SEC is conducting investigations into
           potential insider trading by hedge fund advisers.
			  
			    SEC Monitors Risk Management Practices at the Largest Securities
				 Firms with Significant Hedge Fund Activities

           SEC also conducts oversight over hedge fund activities through the
           supervision of the regulated securities firms that transact
           business with hedge funds as brokers, creditors, and
           counterparties. SEC staff oversees some large, internationally
           active U.S. securities firms with significant hedge fund
           activities through its Consolidated Supervised Entity program
           (CSE), which was established in June 2004.30 Between December 2004
           and November 2005, five large securities firms have elected to
           become CSEs.31 The CSE program consists of four components: (1) a
           review of the firm's application to become a CSE; (2) a review of
           monthly, quarterly, and annual filings, such as consolidated
           financial statements and risk reports, substantially similar to
           those provided to the firm's senior management; (3) monthly
           meetings with senior management (senior risk managers and
           financial controllers) at the holding company level to review
           financial and risk reports and share written results of these
           meetings among staff and commissioners; and (4) an examination of
           books and records of the ultimate holding company, the
           broker-dealer, and material affiliates.32 SEC relies on a number
           of regulatory tools, including margin, capital, and reporting
           requirements to oversee CSEs. Margin rules within the
           broker-dealer help protect against losses resulting from defaults
           by requiring its hedge fund clients to provide collateral in
           amounts that depend on the risk of the particular position and
           help maintain safety and soundness of their firms. Capital
           requirements are minimum regulatory required levels of capital
           that a firm must hold against its risk-taking activities. These
           requirements can help a firm withstand the failure of a
           counterparty or a period of market or systemic stress.
			  
30 See Supervised Investment Bank Holding Companies, 69 Fed. Reg. 34472
(Jun. 21, 2004) [codified primarily at 17 C.F.R. S 240.17i-1 et seq.].
Section 17(i) of the Securities Exchange Act authorizes SEC to supervise
investment bank holding companies (IBHCs) on a consolidated basis. An IBHC
is any person (other than a natural person) that owns or controls one or
more brokers or dealers, and the associated persons of the IBHC. 15 U.S.C.
S 78q(i)(5)(A). The CSE program implements section S 17(i). The purpose of
the CSE program is to reduce the likelihood that weaknesses in the holding
company or an unregulated affiliate (such as a CSE-owned hedge fund)
endangers a regulated entity or the broader financial system, to provide
consolidated oversight for internationally active firms required to meet
international consolidated supervisor requirements established by the
European Union's Financial Conglomerates Directive, and to meet a PWG
recommendation to expand risk assessment authority for the unregulated
affiliates of broker-dealers.

31 The five CSEs are: Merrill Lynch & Co., Inc.; Morgan Stanley Inc.; Bear
Stearns Companies Inc.; Goldman Sachs Group, Inc.; and Lehman Brothers
Holdings Inc.

32 SEC is required by statute: (1) to focus its CSE examinations to the
holding company, its associated registered broker-dealers and any
affiliates that could have a material adverse effect on the operational or
financial condition of the broker or dealer; and (2) with respect to
affiliates of the holding company that are banks, licensed insurance
companies and certain other financial institutions, to defer to the
appropriate federal banking agencies and state insurance regulators with
regard to all interpretations of, and the enforcement of applicable
federal banking laws and state insurance laws relating to the activities
and operations of such affiliates. 15 U.S.C. S 78a(i)(3)-(4).

           One aspect of the CSE program involves how the securities firms
           manage various risk exposures, including those from hedge fund
           activities such as providing prime brokerage service and acting as
           creditors and counterparties through financing and OTC derivatives
           trade transactions. These large integrated financial institutions
           may be exposed to various risks from hedge fund activities such as
           providing prime brokerage services through a registered
           broker-dealer, acting as creditors and counterparties, or owning a
           hedge fund. For example, the recent problems at two hedge funds
           sponsored by Bear Stearns Asset Management that invested in
           financial instruments tied to subprime mortgages (where Bear
           Stearns ultimately provided some secured financing to the funds)
           highlight such risks. As part of the application process that took
           place from November 2004 through January 2006, SEC examined the
           five securities firms' risk management systems (market, credit,
           liquidity, operational, and legal and compliance), internal
           controls, and capital adequacy calculations and continues to do so
           on an ongoing basis. SEC did not target hedge fund activities
           specifically within the scope of the five application
           examinations, because hedge funds were not products or activities
           judged to pose the greatest risks to the firms. Our review of the
           five CSEs' application examinations found that examination
           findings generally were related to firms' documentation of
           compliance with rules and requirements. SEC shared the findings
           with the firms and has monitored the firms' implementation of its
           recommendations. An SEC official said that those issues have been
           resolved, but more recently, SEC's examinations of three of the
           firms identified a number of issues related to capital
           computations, operational controls, and risk management.
           Examination staff are addressing these issues with the firms.

           SEC monitors CSEs continuously for financial and operational
           weakness that might place regulated entities within the group or
           the broader financial system at risk. According to an SEC
           official, the CSE program allows SEC to conduct reviews across the
           five firms (i.e., cross-firm reviews) to gain insights into
           business areas that are material by risk or balance sheet
           measures, rapidly growing, pose particular challenges in
           implementing the Basel regulatory risk-based capital regime, or
           have some combination of these characteristics.33 For example, in
           fiscal year 2006, SEC conducted two cross-firm reviews related to
           leveraged lending and hedge fund derivatives, and in fiscal year
           2007, SEC conducted two cross-firm reviews related to
           securitization and private equity and principal investments.34
           According to the official, SEC generally found that the firms were
           in regulatory compliance, but there were areas where capital
           computation methodology and risk management practices can be
           improved. For example, four firms modified their capital
           computations as a result of feedback from the leveraged lending
           project. For each review, SEC produced a report that described the
           business model, related risk management, and capital treatment to
           each review area, and provided feedback to each firm on where it
           stood among the peer firms.
			  
			  CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance,
			  Regulatory Compliance Surveillance, and Delegated Examination Programs

           Although CFTC does not specifically target hedge funds, through
           its general market and financial supervisory activities, it can
           provide oversight of persons registered as CPOs and CTAs that
           operate or advise hedge funds that trade in the futures markets.
           As part of its market surveillance program, CFTC collects
           information on market participants, regardless of their
           registration status, to monitor their activities and trading
           practices. In particular, traders are required to report their
           futures and options positions when a CFTC-specified level is
           reached in a certain contract market and CFTC electronically
           collects these data through its Large Trader Reporting System
           (LTRS).35 CFTC also uses the futures and options positions
           information reported by traders through the LTRS as part of its
           monitoring of the potential financial exposure of traders to
           clearing firms, and of clearing firms to derivatives clearing
           organizations. CFTC collects position information from exchanges,
           clearing members, futures commission merchants (FCM), and foreign
           brokers and other traders--including hedge funds--about firm and
           customer accounts in an attempt to detect and deter
           manipulation.36 Customers, including hedge funds, are required to
           maintain margin on deposit with their FCMs to cover losses that
           might be incurred due to price changes. FCMs also are required to
           maintain CFTC-imposed minimum capital requirements in order to
           meet their financial obligations. Such financial safeguards are
           put in place to mitigate the potential spillover effect to the
           broader market resulting from the failure of a customer or of an
           FCM.
			  
33 Basel regulatory capital standards were developed by the Basel Committee
on Banking Supervision, which consists of central bank and regulatory
officials from 13 member countries. The standards aim to align minimum
capital requirements with enhanced risk measurement techniques and to
encourage internationally actively banks to develop a more disciplined
approach to risk management.

34 A cross-firm review is a coordinated supervisory review of a specific
activity, business line, or risk management practice conducted across a
group of peer institutions. All five of the CSEs were reviewed.

35 According to CFTC officials, the LTRS captures 70 to 90 percent of the
daily activity on registered futures exchanges.		

36 FCMs are individuals, associations, partnerships, corporations, or
trusts that solicit or accept orders for the purchase or sale of any
commodity for future delivery on or subject to the rules of any contract
market or derivatives transaction execution facility; and in connection
with such solicitation or acceptance of orders, accept money, securities,
or property (or extend credit in lieu thereof) to margin, guarantee, or
secure any trades or contracts that result or may result therefrom.

           According to CFTC officials, the demise (due to trading losses
           related to natural gas derivatives) in the fall of 2006 of
           Amaranth Advisors, LLC (Amaranth), a $9 billion multistrategy
           hedge fund, had no impact on the integrity of the clearing system
           for CFTC-regulated futures and option contracts. The officials
           said that at all times Amaranth's account at its clearing FCM was
           fully margined and the clearing FCM met all of its settlement
           obligations to its clearinghouse. They also said that the
           approximate $6 billion of losses suffered by Amaranth on regulated
           and unregulated exchanges did not affect its clearing FCM, the
           other customers of the clearing FCM, or the clearinghouse.37

           CFTC investigates and, as necessary, prosecutes alleged violators
           of the Commodity Exchange Act (CEA) and CFTC regulations and may
           conduct such investigations in cooperation with federal, state,
           and foreign authorities. Enforcement referrals can come from
           several sources, including CFTC's market surveillance group or
           tips. Remedies sought in enforcement actions generally 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. On the basis of CFTC enforcement
           data, from the beginning of fiscal year 2001 through May 1, 2007,
           CFTC brought 58 enforcement actions against CPOs and CTAs,
           including those affiliated with hedge funds, for various
           violations.38 A summary of the violations cited in the actions
           includes misrepresentation with respect to assets under management
           or profitability; failure to register with CFTC; failure to make
           required disclosures, statement, or reports; misappropriation of
           participants' funds; and violation of prior prohibitions (i.e.,
           prior civil injunction or CFTC cease and desist order).
			  
37 In the CFTC complaint filed against Amaranth Advisors, LLC; Amaranth
Advisors (Calgary), ULC, and Brian Hunter, CFTC alleged that the
defendants attempted to manipulate the price of natural gas contracts on
the New York Mercantile Exchange, Inc., in 2006. Complaint for Injunctive
and Other Equitable Relief and Civil Monetary Penalties under the
Commodity Exchange Act, CFTC v. Amaranth Advisors, LLC, No. 07-6682
(S.D.N.Y., July 25, 2007).

38 Because "hedge fund" is not a defined term under the CEA or any other
federal statute, CFTC and NFA records do not identify whether a commodity
pool is a hedge fund. Thus, CFTC cannot report on the exact number of
examinations that involve hedge funds. In the event the CPO or CTA
self-designates itself as a hedge fund, the Division of Enforcement
typically incorporates that designation in the enforcement action, and
that designation is often used in the press release notifying the public
of the enforcement action.

           Pursuant to CFTC-delegated authority, NFA, a registered futures
           association under the CEA and a self-regulatory organization,
           oversees the activities, and conducts examinations, of registered
           CPOs and CTAs.39 As such, hedge fund advisers registered as CPOs
           or CTAs are subject to direct oversight in connection with their
           trading in futures markets.40 More specifically, to the extent
           that hedge fund operators or advisers trade futures or options on
           futures on behalf of hedge funds, the funds are commodity pools
           and the operators of, and advisers to, such funds are required to
           register as CPOs and CTAs, respectively, with CFTC and become
           members of NFA if they are not exempted from registration. Once
           registered, CPOs and CTAs become subject to detailed disclosure,
           periodic reporting and record-keeping requirements, and periodic
           on-site risk-based examinations. However, regardless of
           registration status, all CPOs and CTAs (including those affiliated
           with hedge funds) remain subject to CFTC's anti-fraud and
           anti-manipulation authority.

           Our review of NFA documentation found that 29 advisers of the
           largest 78 U.S. hedge funds (previously mentioned) are registered
           with CFTC as CPOs or CTAs. In addition, 20 of the 29 also are
           registered with SEC as investment advisers or broker-dealers.
           According to NFA officials, because there is no legal definition
           of hedge funds, it does not require CPOs or CTAs to identify
           themselves as hedge fund operators or advisers. NFA, therefore,
           considers all CPOs and CTAs as potential hedge fund operators or
           advisers. According to NFA, in fiscal year 2006 NFA examined 212
           CPOs, including 6 of the 29 largest hedge fund advisers registered
           with NFA. During the examinations, NFA staff performed tests of
           books and records and other auditing procedures to provide
           reasonable assurance that the firm was complying with NFA rules
           and all account balances of a certain date were properly stated
           and classified. Our review of four of the examinations found that
           3 of the CPOs examined generally were in compliance with NFA
           regulations and the remaining 1 was found to have certain
           employees that were not properly registered with CFTC. According
           to examination documentation, subsequent to the examination, the
           hedge fund provided a satisfactory written response to NFA noting
           that it would soon properly register the employees.

           According to an NFA official, since 2003 NFA has taken 23
           enforcement actions against CPOs and CTAs, many of which involved
           hedge funds. Some of the violations found included filing
           fraudulent financial statements with NFA, not providing timely
           financial statements to investors, failure to register with CFTC
           as a CPO, failure to maintain required books and records, use of
           misleading promotional materials, and failure to supervise staff.
           The penalties included barring CPOs and CTAs from NFA membership
           temporarily or permanently or imposing monetary fines ranging from
           $5,000 to $45,000.

39 A registered CPO or CTA seeking to engage in futures business with the
public or with any member of NFA must itself be a member of NFA.

40 For the purpose of this report the term "hedge fund advisers" includes,
as the context requires, CPOs, CTAs, or securities investment advisers.

           Bank Regulators Have Conducted Some Examinations Relating to Hedge
			  Fund Business at Banks

           Bank regulators (the Federal Reserve, OCC, and FDIC) monitor the
           risk management practices of their regulated institutions'
           interactions with hedge funds as creditors and counterparties.
           They are responsible for ensuring that the organizations under
           their jurisdiction are complying with supervisory guidance and
           industry sound practices regarding prudent risk management
           throughout their business, including the guidance and practices
           applicable to their activities with hedge funds. The 1999 PWG
           report recommended that bank regulators encourage improvements in
           the risk management systems of the regulated entities and promote
           the development of a more risk-based approach to capital adequacy.

           In overseeing banks' hedge fund-related activities, the bank
           regulators examine the extent to which banks are following sound
           practices as part of their reviews of banks' capital market
           activities. Bank regulators conduct routine supervisory
           examinations of risk management practices relating to hedge funds
           and other highly leveraged counterparties to ensure that the
           supervised entities (1) perform appropriate due diligence in
           assessing the business, risk exposures, and credit standing of
           their counterparties; (2) establish, monitor, and enforce
           appropriate quantitative risk exposure limits for each of their
           counterparties; (3) use appropriate systems to identify, measure,
           and manage counterparty credit risk; and (4) deploy appropriate
           internal controls to ensure the integrity of their processes for
           managing counterparty credit risk.

           The Federal Reserve's supervision of banks' hedge fund-related
           activities is part of a broader, more comprehensive set of
           supervisory initiatives to assess whether banks' risk management
           practices and financial market infrastructures are sufficiently
           robust to cope with stresses that could accompany deteriorating
           market conditions. Specifically, the Federal Reserve has been
           focusing on five key supervisory initiatives: (1) comprehensive
           reviews of firms' corporate-level stress testing practices, (2) a
           multilateral supervisory assessment of the leading global banks'
           current practices for managing their exposures to hedge funds, (3)
           a review of the risks associated with the rapid growth of
           leveraged lending, (4) a new assessment of practices to manage
           liquidity risk, and (5) continued efforts to reduce risks
           associated with weaknesses in the clearing and settlement of
           credit derivatives and other OTC derivatives.

           The bank regulators also have performed targeted examinations of
           the credit risk management practices of regulated entities that
           are major hedge fund creditors or counterparties. From 2004
           through 2007, FRBNY conducted various reviews that addressed
           aspects of certain banks' counterparty credit risk management
           practices that involved hedge fund activities. These reviews were
           motivated by the rapid growth of the hedge fund industry and also
           done to gauge progress made in improving risk management practices
           pursuant to supervisory guidance and industry recommendations.
           Examiners conducted meetings with management and reviewed policies
           and procedures primarily by performing transactional testing,
           relying on internal audits, and studying other functional
           regulators' reviews.

           According to a Federal Reserve official, while global banks have
           significantly strengthened their risk management practices and
           procedures for managing risk exposures to hedge funds, further
           progress is needed. For example, in a 2006 firmwide examination of
           stress-testing practices at certain U.S. banks, FRBNY indicated a
           need for the banks "to enhance their capacity to aggregate credit
           exposures at the firm wide level, including across counterparties;
           to assess the potential for counterparty credit losses to be
           compounded by losses on the banks' proprietary trading positions;
           and to assess the potential effects of a rapid and possibly a
           protracted decline in asset market liquidity."41 According to this
           official, the Federal Reserve has begun a review of liquidity risk
           management practices at the largest U.S. bank holding companies,
           focusing on the firms' efforts to ensure adequate funding in more
           adverse market conditions.42

           Federal Reserve examiners made a variety of other recommendations
           as a result of the various reviews. Many of their recommendations
           were developed as ways that banks could continue to enhance their
           risk management processes associated with hedge fund
           counterparties. The examiners found a range of practices for
           counterparty stress testing for hedge funds and noted that there
           was room for improvement even at the banks with the most advanced
           practices. Where examiners identified deficiencies, specific
           recommendations were made. Although credit officers often adjusted
           credit terms for degree of transparency, examiners recommended
           that banks' policies explicitly link transparency to credit terms
           and that banks monitor evolving credit terms for hedge fund
           counterparties. Moreover, examiners found that the banks that were
           part of the reviews needed to enhance their policies to more
           specifically address due diligence requirements or standards to
           provide clearer standards and guidance for reviewing hedge fund
           valuation processes.

           In 2005 and 2006, OCC conducted an examination of hedge
           fund-related activities--mainly counterparty credit risk
           management practices (such as due diligence of their hedge fund
           customer's business), and margining and collateral monitoring
           processes--at the three large U.S. banks. OCC generally found the
           overall risk management practices of these banks to be
           satisfactory. However, examiners identified concerns in the lack
           of transparency in the banks' hedge fund review processes and
           issued recommendations accordingly. For example, examiners found
           in certain banks a lack of adequate credit review policies that
           clearly outline risk assessment criteria for levels of leverage,
           risk strategies and concentrations, and other key parameters and
           documentation to support accuracy of a bank's credit analysis and
           risk rating system. Examiners also found that financial
           information provided by some hedge fund borrowers has been
           incomplete and that banks should document the lack of such
           information in their credit review process. OCC noted that the
           banks have taken satisfactory steps in response to examination
           issues raised.
			  
41 Testimony of Kevin Warsh, Governor, Board of Governors of the Federal
Reserve Board System, before the House Committee on Financial Services,
110th Congress, 1st Sess., July 11, 2007.

42 Liquidity risk is the potential that a firm will be unable to meet its
obligations as they come due because of an inability to liquidate assets
or obtain adequate funding or that it cannot easily unwind or offset
specific exposures without significantly lowering market prices because of
inadequate market depth or market disruptions.

           In addition, in 2005 and 2006, FDIC conducted an examination of
           hedge fund lending at one of its banks. FDIC noted that the bank
           was not in compliance with the bank's lending policy to diversify
           its hedge fund loans and that certain policies should be updated,
           but generally found the risk management practices of the bank's
           hedge fund lending program to be satisfactory.

           Bank regulators largely rely on their oversight of hedge
           fund-related activities at those regulated entities that transact
           with hedge funds in their efforts to mitigate the potential for
           hedge funds to contribute to systemic risk. Since 2004, regulators
           have increased their attention to these activities. In particular,
           bank regulators are reviewing the entities' ability to identify
           and manage their counterparty credit risk exposures, including
           those that involve hedge funds. Regulated entities have the
           responsibility to practice prudent risk management standards, but
           prudent standards do not guarantee prudent practices. As such, it
           will be important for regulators to show continued vigilance in
           overseeing banks' hedge fund-related activities.
			  
			  Investors, Creditors, and Counterparties Have Increased Efforts to
			  Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain

           Investors, creditors, and counterparties impose market
           discipline--by rewarding well-managed hedge funds and reducing
           their exposure to risky, poorly managed hedge funds--during due
           diligence exercises and through ongoing monitoring. During due
           diligence, hedge funds should be asked to provide credible
           information about risks and prospective returns. Market
           participants told us that growing investments by institutional
           investors with fiduciary responsibilities and guidance from
           regulators and industry groups led hedge fund advisers to improve
           disclosure and transparency in recent years. Creditors and
           counterparties also can impose market discipline through ongoing
           management of credit terms (such as collateral requirements).
           However, some market participants and regulators identified
           limitations to market discipline or failures to exercise it
           properly. For instance, large hedge funds use multiple prime
           brokers, making it unlikely that any single broker would have all
           the data needed to assess a client's total leverage. Others were
           concerned that some creditors and counterparties may lack the
           capacity to assess risk exposures because of the complex financial
           instruments and investment strategies that some hedge funds use,
           which could illustrate a failure to exercise market discipline
           properly if the creditor or counterparty continued to do business
           with the fund. Further, regulators have raised concerns that
           creditors may have relaxed credit standards to attract and retain
           hedge fund clients, another potential failure of market
           discipline.
			  
			  Better Due Diligence and Greater Demand for Transparency from
			  Investors Have Resulted in Increased Hedge Fund Disclosure, but
			  Some Investors May Lack the Capacity to Assess Risk Exposures

           By evaluating hedge fund management, the fund's business
           activities, and its internal controls, investors are imposing
           discipline on hedge fund advisers. Market participants who
           generally transact with large hedge funds and institutional
           investors told us that before investing in a hedge fund, potential
           investors usually conduct a due diligence exercise of the
           business, management, legal, and operational aspects of the hedge
           fund under consideration for investment. Market participants
           further noted that the exercise moves from an initial screening to
           quickly identify the funds that do meet the potential investor's
           investment criteria to a detailed evaluation that involves
           addressing a series of questions about the business, management,
           legal, and operational aspects of the hedge fund. Among other
           things, investors may take into account investment strategies
           hedge funds use to produce their returns, the types of investments
           traded, and the fund's risk management practices and risk
           profiles. Investors analyze this information to determine whether
           the investment's risks and reward warrant further consideration.

           Typically, prospective investors receive written information from
           the hedge fund manager in the form of a private offering
           memorandum or private placement memorandum (PPM).43 We could not
           obtain hedge fund offering documents, but market participants who
           have reviewed PPMs told us that there are no standard disclosure
           requirements for PPMs and the information disclosed is often
           general in scope. Consequently, investors may seek information
           beyond that provided in PPMs and sometimes beyond what hedge funds
           are willing to provide. For instance, they may request from hedge
           fund managers a list of hedge fund securities positions and
           holdings (position transparency) or information about the risks
           associated with the hedge fund's market positions (risk
           transparency). However, according to market participants we
           interviewed, although most hedge funds may be willing to provide
           information on aggregate position and holdings, many hedge funds
           decline to share specific position transparency, citing the need
           to keep such information confidential for fear that disclosure
           might permit other market participants to take advantage of their
           trading positions to the detriment of the fund and its investors.
           Additionally, some prospective investors also may obtain from
           hedge fund managers access to the hedge funds' prime brokers and
           other service providers such as auditors, lawyers, fund
           administrators, and accountants for background checks. A
           representative of a group that represents institutional investors
           we met with told us that after making an investment, investors
           typically will monitor their investment on an ongoing basis to
           evaluate portfolio performance and track how well investments are
           moving toward investment goals and benchmarks.
			  
43According to an SEC report and some market participants we interviewed,
PPMs discuss in broad terms the fund's investment strategies and
practices; risk factors; information on the general partner or investment
manager; management fees and incentive compensation; key personnel of the
fund manager; synopsis of the limited partnership agreement or other
organizational documents; conflicts of interest; side letters
(preferential redemption terms that may be granted to one class of
investors) and side pockets (illiquid investments held separately from the
primary fund); investment, withdrawal, and transfer procedures; and
valuation.

           Recently, hedge fund advisers have increased their level of
           disclosure in response to demands from institutional investors.
           Institutional investments in hedge funds have grown substantially
           in recent years. Over the last 3 years, institutional investors in
           search of higher returns and risk diversification, such as pension
           funds, endowments, and funds of hedge funds, have accounted for a
           significant portion of the inflows to hedge funds assets under
           management. (See app. II for information on pension plan
           investments in hedge funds). According to market participants and
           industry literature, the increasing popularity of hedge funds
           among these institutional investors has led to changes in the
           industry. That is, hedge fund advisers have responded to the
           requirements of these clients by providing disclosure that allows
           them to meet fiduciary responsibilities. For example, one market
           participant we met with stated that a trustee to a pension plan
           that is subject to the "prudent person" standard of the Employee
           Retirement Income Security Act of 1974 (ERISA) is required to make
           investment decisions for the plan in accordance with a "prudent
           person" standard of care that may require plan trustees to demand
           greater quality oversight of their capital; in consequence, they
           may demand greater transparency, risk information, and valuation
           techniques than individual investors.44 Market participants with
           whom we met also told us that the trend toward permanent capital
           also has been driving hedge fund transparency. Markets
           participants further noted that as hedge funds reach a certain
           size, they tend to seek more permanent capital through the public
           markets to avoid the liquidity risks inherent with sudden investor
           redemptions.
			  
44ERISA S 404(a)(1)(B) [ 29 U.S.C. 1104(a)(1)(B)] requires a fiduciary to
act with the care, skill, prudence, and diligence under the prevailing
circumstances that a prudent person acting in a like capacity and familiar
with such matters would use.

           The ability of market discipline to control hedge funds' risk
           taking is limited by some investors' inability to fully understand
           and evaluate the information they receive on hedge fund activities
           or these investors' willingness to hire others to evaluate that
           information for them. An example can be found in the Amaranth
           case. According to market participants we interviewed and industry
           coverage that documented the event, Amaranth noted in its periodic
           letters to investors that it had a large concentration in the
           natural gas sector. The market participants and the documents
           noted that some investors became concerned about the potential
           risks associated with concentrated positions and withdrew their
           money from Amaranth several months before Amaranth failed. They
           also said that other investors did not heed potential warning
           signs included in the investor letter and kept their money in
           Amaranth either in pursuit of higher investment returns or because
           they did not fully comprehend the changing risk profile of the
           hedge fund.

           Regulators, market participants, and academics generally agree
           that hedge funds have improved disclosure and risk management
           practices since the LTCM crisis and have largely adopted the
           guidance from various industry groups and the PWG. Regulators told
           us that from their examinations of regulated entities that
           transact business with hedge funds as creditors and
           counterparties, they have observed that hedge fund disclosure and
           risk management practices have improved since LTCM. For example,
           in response to the 1999 PWG report recommendation that hedge funds
           establish a set of sound practices for risk management and
           internal controls, private sector entities such as the Managed
           Funds Association (MFA), and the Counterparty Risk Management
           Policy Group (CRMPG), as well as the public sector International
           Organization of Securities Commissions (IOSCO) published guidance
           for hedge funds and their advisers.45 Market participants told us
           that many hedge fund advisers with which they conduct business
           have adopted these best practices, including risk management
           models that go beyond measuring "value at risk," and now regularly
           stress-test portfolios under a wide range of adverse conditions.46
           Representatives from a risk management firm told us that in the
           past, hedge fund advisers viewed risk management practices as
           proprietary. However, as the trading environment evolved, advisers
           realized they needed to provide results of risk assessments to
           investors to attract investments.
			  
45 MFA is a hedge fund trade group.	

CRMPG is an industry policy group that formed in 1999 after the near
collapse of LTCM and comprises the 12 largest internationally active
commercial and investment banks.

IOSCO is an international organization that brings together the regulators
of the world's securities and futures markets. IOSCO and its sister
organizations, the Basel Committee on Banking Supervision and the
International Association of Insurance Supervisors, make up the Joint
Forum of international financial regulators.

           Creditors and Counterparties Can Impose Some Market Discipline
			  on Hedge Fund Advisers as Part of Credit Extension, but the
			  Complexity of Counterparty Credit Risk Management Poses Ongoing
			  Challenges for Financial Institutions

           By evaluating hedge fund management, the fund's business
           activities, and its internal and risk management controls,
           creditors and counterparties exert discipline on hedge fund
           advisers. According to market participants, entering into
           contracts with hedge funds as creditors or counterparties is the
           primary mechanism by which financial institutions' credit
           exposures to hedge funds arise, and exercising counterparty risk
           management is the primary mechanism by which financial
           institutions impose market discipline on hedge funds. According to
           the staff of the member agencies of the PWG, the credit risk
           exposures between hedge funds and their creditors and
           counterparties arise primarily from trading and lending
           relationships, including various types of derivatives and
           securities transactions.47 As part of the credit extension
           process, creditors and counterparties typically require hedge
           funds to post collateral that can be sold in the event of default.
           According to market participants we interviewed, collateral most
           often takes the form of cash or high-quality, highly liquid
           securities (e.g., government securities), but it can also include
           lower-rated securities (e.g., BBB rated bonds) and less liquid
           assets (e.g., CDOs). They told us they take steps to ensure that
           they have clear control over collateral that is pledged, which
           according to some creditors and counterparties we interviewed,
           that was not the case with LTCM. Creditors and counterparties
           generally require hedge funds to post collateral to cover current
           credit exposures (this generally occurs daily) and, with some
           exceptions, require additional collateral, or initial margin, to
           cover potential exposures that could arise if markets moved
           sharply.48 Creditors to hedge funds said that they measure a
           fund's current and potential risk exposure on a daily basis to
           evaluate counterparty positions and collateral.
			  
46 Value at risk is a calculation used to determine the amount that could
be expected to be lost from an investment or a portfolio of investments
over a specified time under certain circumstances.

47 A derivative is a financial instrument, such as an option or futures
contract, the value of which depends on the performance of an underlying
security or asset. Securities financing transactions include repurchase
agreements, securities lending transactions, and other types of borrowing
transactions that, in economic substance, utilize securities as collateral
for the extension of credit. A repurchase agreement is a financial
transaction in which a dealer borrows money by selling securities and
simultaneously agreeing to buy them back at a later date.
			  
           To control their risk exposures, creditors and counterparties to
           generally large hedge funds told us that, unlike in the late
           1990s, they now conduct more extensive due diligence and ongoing
           monitoring of a hedge fund client. According to OCC, banks also
           conduct "abbreviated" underwriting procedures for small hedge
           funds in which they do not conduct much due diligence. OCC
           officials also told us that losses due to the extension of credit
           to hedge funds were rare. Creditors and counterparties of large
           hedge funds use their own internal rating and credit or
           counterparty risk management process and may require additional
           collateral from hedge funds as a buffer against increased risk
           exposure. They said that as part of their due diligence, they
           typically request information that includes hedge fund managers'
           background and track record; risk measures; periodic net asset
           valuation calculations; side pockets and side letters; fees and
           redemption policy; liquidity, valuations, capital measures, and
           net changes to capital; and annual audited statements. According
           to industry and regulatory officials familiar with the LTCM
           episode, this was not necessarily the case in the 1990s. At that
           time, creditors and counterparties had not asked enough questions
           about the risks that were being taken to generate the high
           returns. Creditors and counterparties told us they currently
           establish credit terms partly based on the scope and depth of
           information that hedge funds are willing to provide, the
           willingness of the fund managers to answer questions during
           on-site visits, and the assessment of the hedge fund's risk
           exposure and capacity to manage risk. If approved, the hedge fund
           receives a credit rating and a line of credit. Several prime
           brokers told us that losses from hedge fund clients were extremely
           rare due to the asset-based lending they provided such funds.
           Also, one prime broker noted that during the course of its
           monitoring the risk profile of a hedge fund client, it noticed
           that the hedge fund manager was taking what the broker considered
           to be excessive risk, and requested additional information on the
           fund's activity. The client did not comply with the prime broker's
           request for additional information, and the prime broker
           terminated the relationship with the client.
			  
48 According to the literature, (1) current exposure represents the current
replacement cost of financial instrument transactions, i.e., their current
market value; (2) potential exposure is an estimate of the future
replacement cost of financial instrument transactions; and (3) an initial
margin is the good-faith deposit that protects the counterparty against a
loss from adverse market movements in the interval between periodic
marking-to-market.

           Through continuous monitoring of counterparty credit exposure to
           hedge funds, creditors and counterparties can further impose
           market discipline on hedge fund advisers. Some creditors and
           counterparties also told us that they measure counterparty credit
           exposure on an ongoing basis through a credit system that is
           updated each day to determine current and potential exposures.
           Credit officers at one bank said that they receive monthly
           investor summaries from many of their hedge fund clients. The
           summaries provide information for monitoring the activities and
           performance of hedge funds. Officials at another bank told us that
           they generally monitor their hedge fund clients on a quarterly
           basis and may alter credit terms or terminate a relationship if it
           is determined that the fund is not dealing with risk adequately or
           if it does not disclose requested information.

           Some creditors also said that they may provide better credit terms
           to hedge funds that consolidate all trade executions and
           settlements at their firm than to hedge funds that use several
           prime brokers because they would know more about the fund's
           exposure. However, large hedge funds may limit the information
           they provide to banks and prime brokers for various reasons.
           Unlike small hedge funds that generally depend on a single prime
           broker for a large number of services ranging from capital
           introductions to the generation of customized accounting reports,
           many large hedge funds are less dependent on the services of any
           single prime broker and, according to several market participants,
           use multiple prime brokers as a means to protect proprietary
           trading positions and strategies, and to diversify their credit
           and operational risks.

           Despite improvements in disclosure and counterparty credit risk
           management, regulators noted that the effectiveness of market
           discipline may be limited or market discipline may not be
           exercised properly for several reasons. First, because large hedge
           funds use several prime brokers as creditors and counterparties,
           no single prime broker may be able to assess the total amount of
           leverage used by a large hedge fund client. The stress tests and
           other tools that prime brokers use to monitor a given
           counterparty's risk profile can incorporate only those positions
           known to a trading partner. Second, the increasing complexity of
           structured financial instruments has raised concerns that
           counterparties lack the capacity (in terms of risk models and
           resources) to keep pace with and assess actual risk, illustrating
           a possible failure to exercise market discipline properly. More
           specifically, despite improvements in risk modeling and risk
           management, the Federal Reserve believes that further progress is
           needed in the procedures global banks use to manage exposures to
           highly leveraged counterparties such as hedge funds, in part
           because of the increasing complexity of products such as
           structured credit products and CDOs in which hedge funds are
           active participants. The complexity of structured credit products
           can add to the already complex task of measuring and managing
           counterparty credit risk. For example, another Federal Reserve
           official has noted that the measurement of counterparty credit
           risk requires complex computer simulations and that "the
           management of counterparty risk is also complicated further by
           hedge funds' complicated organizational structures, legal rights,
           collateral arrangements, and frequent trading. It is important
           that banks develop the systems capability to regularly gather and
           analyze data across diverse internal systems to manage their
           counterparty credit risk to hedge funds." One regulatory official
           further noted the challenges faced by institutions in finding,
           developing and retaining individuals with the expertise required
           to analyze the adequacy of these increasingly complex models. The
           lack of talented staff can affect counterparty credit risk
           monitoring and the ability to impose market discipline on hedge
           fund risk taking activities. Third, some regulators have expressed
           concerns that some creditors and counterparties may have relaxed
           their counterparty credit risk management practices for hedge
           funds, which could weaken the effectiveness of market discipline
           as a tool to limit the exposure of hedge fund managers. They noted
           that competition for hedge fund clients may have led some to
           reduce the initial margin in collateral agreements, reducing the
           amount of collateral to cover potential credit exposure.
			  
			  Regulators View Hedge Fund Activities as Potential Sources of
			  Systemic Risk and Are Taking Measures to Enhance Market Discipline
			  and Prepare for Financial Disruptions

           Financial regulators and industry observers remain concerned about
           the adequacy of counterparty credit risk management at major
           financial institutions because it is a key factor in controlling
           the potential for hedge funds to become a source of systemic risk.
           While hedge funds generally add liquidity to many markets,
           including distressed asset markets, in some circumstances hedge
           funds' activities can strain liquidity and contribute to financial
           distress. In response to their concerns regarding the adequacy of
           counterparty credit risk, a group of regulators have, over the
           past year, been collaborating to examine particular hedge
           fund-related activities across entities they regulate, mainly
           through international multilateral efforts and the domestic PWG.
           The PWG also has established two private sector committees to
           identify best practices to address systemic risk and investor
           protection issues and has formalized protocols to respond to
           financial shocks.
			  
			  Despite Intensified Market Discipline, Concerns about Hedge Funds
			  Creating Systemic Risk Remain

           Financial regulators believe that the market discipline imposed by
           investors, creditors, and counterparties is the most effective
           mechanism for limiting the systemic risk from the activities of
           hedge funds (and other private pools of capital). The most
           important providers of market discipline are the large, global
           commercial and investment banks that are hedge funds' principal
           creditors and counterparties. While regulators and others
           recognize that counterparty credit risk management has improved
           since LTCM, the ability of financial institutions to maintain the
           adequacy of these management processes in light of the dramatic
           growth in hedge fund activities remains a particular focus of
           concern. In its July 2005 report, CRMPG noted that "credit risk
           and, in particular counterparty credit risk, is probably the
           single most important variable in determining whether and with
           what speed financial disturbances become financial shocks with
           potential systemic traits."49 CRMPG further noted that no single
           hedge fund today is leveraged on a scale comparable to that of
           LTCM in 1998 and that the risk management capabilities of hedge
           funds had improved. Although CRMPG concluded that the chance of
           systemic financial shocks had declined, Treasury officials noted
           that regulators continually review whether the failure of one or
           more large market participants, including hedge funds, could
           destabilize regulated financial institutions or financial markets
           in a way that generates broader macroeconomic consequences.50

           Effective market discipline requires that the creditors and
           counterparties to hedge funds obtain sufficient information to
           reliably assess clients' risk profiles and that they have systems
           to monitor and limit exposures to levels commensurate with each
           client's risk and creditworthiness. A number of large commercial
           banks and prime brokers bear and manage the credit and
           counterparty risks that hedge fund leverage creates. According to
           a Federal Reserve official, the recent growth of hedge funds poses
           formidable challenges, including significant risk management
           challenges to these market participants. If market participants
           prove unwilling or unable to meet these challenges, losses in the
           hedge fund sector could pose significant risk to financial
           stability. Concerns remain that creditors and counterparties face
           constant challenges in measuring and managing counterparty credit
           risk exposures to hedge funds, and in maintaining qualified staff
           to implement the various elements of counterparty credit risk
           management, including stress testing.
			  
49 See Counterparty Risk Management Policy Group II, Toward Greater
Financial Stability: A Private Sector Perspective (July 27, 2005).

50 Reasons cited by CRMPG for a reduction in the probability of systemic
financial shock from hedge fund activity included (1) the strength of the
key financial institutions at the core of the financial system, (2)
improved risk management techniques, (3) improved official supervision,
(4) more effective disclosure and greater transparency, (5) strengthened
financial infrastructure, and (6) more effective techniques to hedge and
widely distribute financial risk.

           In addition to counterparty credit risk, Treasury officials noted
           that regulators continually review the liquidity of markets to
           determine whether the trading behavior of market participants,
           including hedge funds, could serve as a source of systemic risk.
           While hedge funds often provide liquidity to stressed markets by
           buying securities that are temporarily distressed, herding
           behavior by market participants, including hedge funds, could
           strain available market liquidity. According to a Treasury
           official, "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 to
           simultaneously unwind their positions."51 Some market participants
           noted that the consequences of these "crowded" trades were
           difficult to anticipate.

           Some Federal Reserve officials noted in a journal article that "in
           a crisis, interlocking credit exposures would be the key mechanism
           by which risks would be transmitted from one institution to
           another, potentially transforming a run-of-the-mill disturbance
           into a systematic situation."52 The forced sale of assets is
           recognized by regulators as a potential transmission mechanism for
           systemic risk. According to these officials, regulators in general
           share concerns that "in illiquid markets, hedge funds may be
           forced to sell positions to meet margin requirements, driving down
           market prices. In severe cases, the hedge fund may drive down the
           value of existing positions by more than they receive from the
           original sale, forcing further sales."53 However, this
           transmission mechanism is not unique to hedge funds but is a
           characteristic of leverage. Even when the failure of a hedge fund
           does not result in a large-scale liquidation of assets, the
           concerns raised by the failure can disrupt credit markets. For
           instance, concerns regarding the valuation of illiquid subprime
           mortgages, such as those held by Bear Stearns Asset Management's
           hedge funds, have contributed to questions about credit quality in
           this and other markets, and this broader questioning of credit
           quality may have contributed to the subsequent tightening of
           credit.54
			  
51 Testimony of Randal K. Quarles, Under Secretary for Domestic Finance,
Department of the Treasury, before the Senate Committee on Banking,
Housing, and Urban Affairs, 110th Congress, 1st Sess., July 25, 2006.

52 Roger T. Cole, Greg Feldberg, and David Lynch, "Hedge Funds, Credit Risk
Transfer and Financial Stability," Financial Stability Review, April 2007,
p. 13.

53 Cole, Feldberg, and Lynch, "Hedge Funds, Credit Risk Transfer and
Financial Stability," p. 15.

54 For example, according to press reports, the tightening of credit
markets that followed the collapse of two Bear Stearns-sponsored hedge
funds in June 2007 was partly triggered by a revaluation of the CDOs.
Merrill Lynch, one of the funds' prime brokers, seized $850 million of the
funds assets held as collateral, including CDOs, but it reportedly only
sold a fraction of the assets because the value of these securities had
fallen.

           Regulators Are Taking Steps to Strengthen Market Discipline to
			  Address Systemic Risk Concerns Stemming from Hedge Fund Activities

           To enhance market discipline and help mitigate the potential
           systemic risks that hedge fund activities could pose, financial
           regulators recently have increased collaboration with each other,
           foreign financial regulators, and industry participants. They have
           been conducting these efforts primarily through an international
           review of large financial institutions and actions initiated by
           the PWG. As discussed earlier, hedge funds are a potential source
           of systemic risk if the capacity of their creditors and
           counterparties to value positions and manage risk does not keep
           pace with developments such as the increasing complexity of
           financial instruments and of investment strategies. Because the
           use of these instruments and strategies is not exclusive to hedge
           funds, a regulator said that collecting data on hedge fund
           activities to monitor buildup of this risk would be difficult and
           not meaningful. Instead, regulators have taken a risk-focused and
           principles-based approach by monitoring counterparty risk
           management practices across regulated entities and issuing
           guidance to help strengthen market discipline. Currently,
           regulators are reviewing issues related to the valuation of
           complex, illiquid, and stressed instruments by all types of
           entities. The PWG has also formalized protocols for coordination
           among the financial regulators in the event of a financial market
           crisis.

           In late 2006, FRBNY, SEC, OCC, FSA, and bank regulators of Germany
           and Switzerland--collectively, the "multilateral effort"--jointly
           conducted a review of the largest commercial and investment banks
           that transacted business with hedge funds as counterparties and
           creditors. The agencies met with nine major U.S. and European bank
           and securities firms to discuss risk management policies and
           procedures related to interactions with hedge funds through prime
           brokerage, direct lending, and over-the-counter derivative
           transactions. According to one U.S. regulator, the reviewers found
           that the current and potential credit exposures of these banks to
           hedge funds were small relative to the banks' capital because of
           their extensive use of collateral agreements. However, the
           reviewers identified a number of issues related to the management
           of exposures to hedge funds and the measurement of potential
           exposures in adverse market conditions. The regulators
           participating in this effort have been addressing these issues by
           gathering additional data or information to help regulators learn
           more about the condition and quality of the firms' risk management
           practices. The regulators are conducting an ongoing follow-up
           review, which entails more detailed work by the principal
           regulator of each firm.

           In February 2007, the PWG issued principles-based guidance for
           approaching issues related to private pools of capital, including
           hedge funds. The principles are intended to guide market
           participants (for example, hedge fund advisers, creditors,
           counterparties, and investors), as well as U.S. financial
           regulators as they address investor protection and systemic risk
           issues associated with the rapid growth of private pools of
           capital and the complexity of financial instruments and investment
           strategies they employ. The efforts for each group of stakeholders
           enumerated in the principles and guidelines that the PWG issued
           entitled "Agreement Among PWG and U.S. Agency Principals on
           Principles and Guidelines Regarding Private Pools of Capital" are
           briefly summarized below:

           o "Private Pools of Capital: maintain and enhance information,
           valuation, and risk management systems to provide market
           participants with accurate, sufficient, and timely information.
           o Investors: consider the suitability of investments in a private
           pool in light of investment objectives, risk tolerances, and the
           principle of portfolio diversification.
           o Counterparties and Creditors: commit sufficient resources to
           maintain and enhance risk management practices.
           o Regulators and Supervisors: work together to communicate and use
           authority to ensure that supervisory expectations regarding
           counterparty risk management practices and market integrity are
           met."

           The PWG's principles and guidelines are intended to enhance market
           discipline, which the PWG stated most effectively addresses
           systemic risk posed by private pools of capital, without deterring
           the benefits such pools of capital provide to the U.S. economy.
           According to a Treasury official involved in developing the PWG
           guidance, the PWG believes that self-interested, more
           sophisticated, informed investors, creditors, and counterparties
           have their own economic incentives to take actions to reduce and
           manage their own risks, which will reduce systemic risk overall
           and enhance investor protection. Also, the PWG continues to
           believe that regulators have an important role to play in
           addressing these issues.

           Further, in September 2007, the PWG established two private sector
           committees. One committee comprised asset managers, and the other
           comprised investors, including labor organizations, endowments,
           foundations, corporate and public pension funds, investment
           consultants, and other U.S. and non-U.S. investors. The first task
           of these committees will be to develop best practices using the
           PWG's principles-based guidance released in February 2007 as a
           foundation to enhance investor protection and systemic risk
           safeguards. According to the mission statement of the asset
           managers' committee, best practices will cover asset advisers
           having information, valuation, and risk management systems that
           meet sound industry practices. In turn, these systems would enable
           them to provide accurate information to creditors, counterparties,
           and investors with appropriate frequency, breadth, and detail.
           According to the mission statement of the investors' committee,
           best practices would cover information, due diligence, risk
           management, and reporting and build on the PWG guidelines related
           to disclosure, due diligence, risk management capabilities, the
           suitability of the strategies of private pools given an investor's
           risk tolerance, and fiduciary duties. According to staff of the
           PWG member agencies, the PWG expects both committees to have
           drafts of the best practices available for public comment early in
           2008 and to issue final products in the spring.

           Finally, recognizing that financial shocks are inevitable, the PWG
           told us that it adopted more formalized protocols in fall 2006 to
           coordinate communications among the appropriate regulatory bodies
           in the event of market turmoil, including a liquidity crisis. The
           protocols include a detailed list of contact information for
           domestic and international regulatory bodies, financial
           institutions, risk managers, and traders, and procedures for
           communications. According to staff of the PWG member agencies, the
           protocols were used to handle recent events such as the fallout
           from the Amaranth losses in 2006 and the losses from subprime
           mortgage investments by two Bear Stearns hedge funds in summer
           2007.

           Addressing potential systemic risk posed by hedge fund activities
           involves actions by investors, creditors and counterparties, hedge
           fund advisers, and regulators. The regulators and the PWG's recent
           initiatives are intended to bring together these various groups to
           improve current practices related to hedge fund-related activities
           and to better prepare for a potential financial crisis. We view
           these initiatives as positive steps taken to address systemic
           risk. However, it is too soon to evaluate their effectiveness.
			  
			  Agency Comments

           We provided a draft of this report to CFTC, DOL, Federal Reserve,
           FDIC, OCC, OTS, SEC, and Treasury for their review and comment.
           None of the agencies provided written comments. All except for
           FDIC and OTS provided technical comments, which we have
           incorporated into the report as appropriate.

           As agreed with your offices, unless you publicly announce its
           contents earlier, we plan no further distribution of this report
           until 30 days after the date of this report. At that time, we will
           send copies of this report to the Ranking Member of the Committee
           on Financial Services, House of Representatives; the Chairman and
           Ranking Member of the Committee on Banking, Housing, and Urban
           Affairs, U.S. Senate; Ranking Member of the Subcommittee on
           Capital Markets, Insurance and Government Sponsored Enterprises,
           House of Representatives; and other interested congressional
           committees. We are also sending copies to the Chairman, Board of
           Governors of the Federal Reserve System; Chairman, Commodity
           Futures Trading Commission; Chairman, Federal Deposit Insurance
           Corporation; Secretary of Labor; Comptroller of the Currency,
           Office of the Comptroller of the Currency; Director, Office of
           Thrift Supervision; Chairman, Securities and Exchange Commission;
           Secretary of the Treasury; and other interested parties. We will
           make copies available to others upon request. The report will also
           be available at no charge on our Web site at
           [23]http://www.gao.gov .

           If you or your staff have any questions regarding this report,
           please contact me at (202) 512-8678 or [email protected]. Contact
           points for our Office of Congressional Relations and Public
           Affairs may be found on the last page of this report. GAO staff
           who made major contributions to this report are listed in appendix
           IV.

           Orice M. Williams
			  Director, Financial Markets and Community Investment

           Appendix I: Scope and Methodology
			  
           To address the first objective (regulatory oversight of hedge
           fund-related activities), we reviewed regulatory examination
           documents (for example, examination modules, scoping, examination
           reports and findings, corrective actions taken or proposed by
           firms, and regulatory follow-ups). We selected for review some of
           the recent examinations--conducted by the Office of the
           Comptroller of the Currency (OCC), Federal Reserve Bank of New
           York (FRBNY), Federal Deposit Insurance Corporation (FDIC),
           Securities and Exchange Commission (SEC), and National Futures
           Association (NFA)--of regulated entities engaged in transactions
           with hedge funds as creditors or counterparties. We reviewed
           examinations of financial institutions that are creditors or
           counterparties to hedge funds conducted from fiscal years 2004
           through 2006 and other supervisory materials. We reviewed 3 OCC
           examinations, 7 FRBNY examinations, 1 FDIC examination, 14 (9 for
           hedge fund advisers and 5 for Consolidated Supervised Entities)
           SEC examinations, and 4 NFA examinations. We reviewed information
           that the federal financial regulators provided on enforcement
           cases brought for hedge fund-related activities. In addition, we
           interviewed U.S. federal financial regulatory officials to gain an
           understanding of how they oversee hedge fund-related activities at
           the financial institutions over which they have regulatory
           authority. More specifically, we spoke with officials from the
           banking regulators--OCC, Board of Governors of the Federal Reserve
           System, FRBNY, FDIC, and Office of Thrift Supervision; a
           securities regulator--SEC; and commodities regulators--Commodity
           Futures Trading Commission and NFA. We interviewed officials
           representing Department of Treasury (Treasury), the United
           Kingdom's Financial Services Authority, and the President's
           Working Group (PWG) as well. To determine which of the
           Institutional Investor's Alpha Magazine 2007 Annual Hedge Fund 100
           listing of global hedge fund advisers were U.S.-based and
           registered with SEC as a hedge fund investment adviser or with
           CFTC as a commodity pool operator (CPO) or commodity trading
           advisor (CTA), we asked the compliance staff at SEC and NFA to
           compare their registrants' listing with the largest 100 listing.
           Representatives from both organizations said that they made their
           best attempt to match the names in the largest 100 listing with
           the registrants' listings, which was difficult because the names
           were not always identical in both listings. SEC estimates that of
           the 78 of the largest 100 hedge fund advisers identified by Alpha
           Magazine as U.S.-based, 49 were registered with SEC as investment
           advisers. NFA estimates that 29 of the 78 U.S.- based hedge fund
           advisers were registered with CFTC as CPOs or CTAs. We also
           reviewed prior GAO reports.1

           To address the second objective (market discipline), we
           interviewed relevant market participants (such as investors,
           creditors, and counterparties), and regulatory officials, to get
           their opinions on (1) how market participants impose market
           discipline on hedge funds' risk taking and leveraging (and whether
           they have improved since 1998); (2) the type and frequency of
           information such participants would need from hedge fund advisers
           to gauge funds' risk profiles and internal controls to make
           informed initial and ongoing investment decisions; and (3) the
           extent to which hedge fund disclosures to market participants have
           improved since the 1998 near failure of the large hedge fund,
           Long-Term Capital Management. We also interviewed large hedge
           funds and the Managed Funds Association--a membership organization
           representing the hedge fund industry. In addition, we conducted a
           literature search to identify research on hedge funds and reviewed
           a selection of relevant regulatory and industry studies, speeches,
           and testimonies on the matter.

           To address the third objective (systemic risk), we reviewed
           relevant speeches, testimonies, studies, principles and guidelines
           that the PWG issued about private pools of capital in 2007
           entitled "Agreement Among PWG and U.S. Agency Principals on
           Principles and Guidelines Regarding Private Pools of Capital,"
           regulatory examination documents and relevant industry best
           practices for investors, hedge fund advisers, creditors, and
           counterparties. We also reviewed PWG protocols ("PWG Crisis
           Management Protocols") for dealing with a financial market crisis.
           And we interviewed officials representing U.S. federal financial
           regulators, Treasury, and the PWG to get their views on systemic
           risk issues.

           To address pension plan investments in hedge funds discussed in
           appendix II, we reviewed and analyzed annual survey data from 2001
           through 2006 from Pensions & Investments. Also, we reviewed
           Greenwich Associates data from 2004 through 2006 that focused on
           pensions' hedge fund investments.2 We conducted data reliability
           assessments on the data from Pensions & Investments and Greenwich
           Associates that we used, and determined that the data were
           sufficiently reliable for our purposes. We also reviewed
           provisions of the Pension Protection Act of 2006 (PPA) that
           changed requirements for how hedge funds hold pension plan assets.
           We interviewed pension industry officials (such as pension plan
           sponsors of public and private funds, trade groups, pension
           consultants, pension plan and hedge fund database providers, a
           hedge fund law firm, and hedge funds), an academic and regulatory
           officials from the Department of Labor, SEC, and Treasury to get
           their opinions on the matter, including trends in such investments
           over the last few years and the impact of PPA on pension plan
           hedge fund investments. We also reviewed other relevant documents.
			  
1 See GAO, Commodity Futures Trading Commission: Trends in Energy
Derivatives Markets Raise Questions about CFTC's Oversight, [25]GAO-08-25
(Washington, D.C.: Oct. 19, 2007); Credit Derivatives: Confirmation
Backlogs Increased Dealers' Operational Risks, but Were Successfully
Addressed after Joint Regulatory Action, [26]GAO-07-716 (Washington, D.C.:
June 13, 2007); Financial Market Regulation: Agencies Engaged in
Consolidated Supervision Can Strengthen Performance Measurement and
Collaboration, [27]GAO-07-154 (Washington, D.C.: Mar. 15, 2007); and
Long-Term Capital Management: Regulators Need to Focus Greater Attention
on Systemic Risk, [28]GAO/GGD-00-3 (Washington, D.C.: Oct. 29, 1999).

2 Pensions & Investments is an industry publication that has conducted the
annual survey for the last 33 years. Greenwich and Associates is an
institutional financial services consulting and research firm.

           We conducted this performance audit from September 2006 to January
           2008 in accordance with generally accepted government auditing
           standards. Those standards require that we plan and perform the
           audit to obtain sufficient, appropriate evidence to provide a
           reasonable basis for our findings and conclusions based on our
           audit objectives. We believe that the evidence obtained provides a
           reasonable basis for our findings and conclusions based on our
           audit objectives.
			  
			  Appendix II: Pension Plan Investments in Hedge Funds Have Increased
			  but Are Still a Small Percentage of Plans' Total Assets

           This appendix presents summary information about the potential
           impact that pension law reform may have on the ability of hedge
           funds to attract pension plan investments and statistics on the
           extent of pension plan investments in hedge funds in recent
           years.1

           Section 611(f) of the Pension Protection Act of 2006 (PPA) amended
           the Employee Retirement Income Security Act (ERISA) to, among
           other things, provide a statutory definition for "plan assets,"
           which essentially codified, with some modification, the Department
           of Labor's (DOL)--the primary regulator of pension plans--existing
           plan asset regulation (sometimes referred to as the 25 percent
           benefit plan investor test).2 By modifying the 25 percent benefit
           plan investor test, the PPA amendment has the effect of permitting
           hedge funds to accept unlimited investments from certain
           "non-ERISA benefit plans" (governmental plans, foreign plans, and
           most church plans) while still accepting investments from plans
           that are subject to ERISA (ERISA benefit plans) without becoming
           subject to ERISA's fiduciary duty requirements. What constitutes
           "plan assets" is significant because a person who exercises
           discretionary authority or control over the assets of an ERISA
           benefit plan or who provides investment advice for a fee with
           respect to plan assets is a "fiduciary" subject to the fiduciary
           responsibility provisions of ERISA.3

           As ERISA did not provide a definition for "plan assets" prior to
           the enactment of PPA, DOL, in 1986, adopted Rule 2510.3-101 to
           describe the circumstances under which the assets of an entity in
           which an ERISA benefit plan invests (for example, a hedge fund)
           would be deemed to include "plan assets" so that the manager of
           the entity (for example, a hedge fund manager) would be subject to
           the fiduciary responsibility rules of ERISA.4 Rule 2510.3-101
           excludes from the definition of plan assets, the assets of an
           entity in which there is no significant aggregate investment by
           "benefit plan investors," which is defined to include both ERISA
           and non-ERISA benefit plans. Participation in an entity would be
           significant if 25 percent or more of the value of any class of
           equity securities of the entity were held by the benefit plan
           investors collectively (i.e., the 25 percent benefit plan investor
           rule). By now excluding from the 25 percent calculation those
           equity securities held by non-ERISA benefit plans, the allowable
           proportionate share of investments by ERISA benefit plans has
           increased.
			  
1 A forthcoming GAO report (to be issued in the summer of 2008) will
provide more detailed information about various aspects of pension plan
investments in hedge funds.

2 Pub. L. No. 109-280, S 611(f), 120 Stat. 952, 972 (2006) (codified at 29
U.S.C. S 1002(42)).

3 Section 3(21) of ERISA defines "fiduciary." 29 U.S.C. S 1002(21).

4 See Final Regulation Relating to the Definition of Plan Assets, 51 Fed.
Reg. 41262 (Nov. 13, 1986) (final rule codified at 29 C.F.R. 2510.3-101).
Rule 2510.3-101 describes what constitutes "plan assets" with respect to a
plan's investment in another entity for purposes of Subtitle A
(definitional and coverage provisions) and Parts 1 and 4 (reporting and
disclosure and fiduciary provisions) of Subtitle B of ERISA and for
purposes of section 4975 of the Internal Revenue Code (excise tax
provisions relating to prohibited transactions).

           We asked several large hedge funds as well as some regulators
           whether hedge fund advisers were actively soliciting investments
           from pension plans due to the reform. They were unable to comment
           on whether hedge fund advisers were taking steps to attract these
           institutional investments. However, according to one regulator and
           two large hedge funds, some hedge fund advisers do not seek
           pension investments, and others do seek out pension investments
           but are careful not to reach the 25 percent threshold that would
           require hedge fund advisers to assume fiduciary responsibilities.
           According to one regulator and an industry source, pension plans
           are attracted to various hedge fund investment strategies,
           depending on their portfolio composition. They also suggested that
           pension plans tend to invest in hedge funds through funds of hedge
           funds.

           From 2001 through 2006, investments by defined benefit (DB) plans
           in hedge funds increased, but the share of total pension plan
           assets invested in hedge funds remained small.5 Two key reasons
           pension plans invest in hedge funds are to diversify their
           investment risks and increase investment returns. Much of the
           recent growth (and expected continued growth) in hedge fund
           investments is attributable to investments by institutions such as
           pension funds, endowments, insurance companies, and foundations.

           Two recent surveys of DB plan sponsors describe the prevalence of
           hedge fund investments.6
		
5 Defined benefit plans commonly provide a guaranteed monthly benefit based
on a formula that considers salary and years of service to a company.
Defined contribution plan benefits are based on contributions and
investment returns (gains and losses).

6 If pension plan sponsors have more than one DB plan, they may
collectively manage assets for these plans and thus may provide survey
answers for the combined fund, rather than for each individual pension
plan.			  

           o According to a Greenwich Associates survey of pensions plans
           with $250 million or more in assets, the share of private and
           public DB plans (not including union plans) invested in hedge
           funds was 27 percent and 24 percent, respectively, in 2006.7 Among
           DB plans with $250 million to $500 million in assets, 16 percent
           were invested in hedge funds. About 29 percent of DB plans with $1
           billion or more in assets were invested in hedge funds.
           o The number of DB plans investing in hedge funds has increased
           over time. According to a survey of the largest pension plans by
           Pensions & Investments, the share of DB plans reporting
           investments in hedge funds increased from 11 percent in 2001 to 36
           percent in 2006.8

           Evidence from surveys of DB plans shows that between about 1 to 2
           percent of total assets were invested in hedge funds.9 Among only
           those plans that invested in hedge funds, average allocations to
           hedge funds ranged from about 3 percent to 7 percent of a plan's
           portfolio.

           o A very small number of pension plans reported substantially
           larger allocations to hedge funds. Two of the 48 largest pension
           plans that reported investments in hedge funds in the Pensions &
           Investments survey had allocations of about 30 percent (Missouri
           State Employees' Retirement System and Pennsylvania State
           Employees' Retirement System--both of these plans primarily invest
           in hedge funds through funds of funds). See table 1.
           o Survey data indicate that most pension plans invested in hedge
           funds do so, at least partially, through funds of hedge funds.
           According to the Pensions & Investments' survey, 35 of the largest
           48 DB plans that reported investments in hedge funds used funds of
           hedge funds for at least some of their hedge fund investments.
           Overall, funds of hedge funds represented 54 percent of total
           hedge fund investments for this group.

7 Greenwich Associates surveyed pension plans, endowments, and foundations,
that had a minimum of $250 million in assets and used at least two
external investment advisers. Greenwich Associates obtained asset
allocation information regarding hedge funds from 584 of the 652 DB plans
it interviewed in 2006.

8 The top 200 pension plans surveyed by Pensions & Investments are ranked
by combined assets in DB and defined contribution plans. These plans
reported almost $6 billion or more in combined DB and defined contribution
assets in 2006. Of these top 200 pension plans, 135 were DB plans that
completed the survey and provided asset allocation information, and 48 of
these plans reported investments in hedge funds in 2006.

9 Survey data were not available for DB plans with less than $200 million
in assets.

Table 1: Ten Defined Benefit Plans with the Largest Reported Hedge Fund
Investments for 2006

(Assets in millions of dollars based on September 2006 data)
Defined benefit plan: Pennsylvania State Employees' Retirement System; 
Direct investment: $1,384; 
Funds of hedge funds (indirect investment): $7,814; 
Total hedge fund investment: $9,198; 
Total DB assets: $30,372; 
Total hedge fund investment as a percentage of total DB assets: 30.3. 

Defined benefit plan: New York State Common Retirement Fund; 
Direct investment: $655; 
Funds of hedge funds (indirect investment): $3,095; 
Total hedge fund investment: $3,750; 
Total DB assets: $144,289; 
Total hedge fund investment as a percentage of total DB assets: 2.6. 

Defined benefit plan: California Public Employees' Retirement System; 
Direct investment: $3,710; 
Funds of hedge funds (indirect investment): [Empty]; 
Total hedge fund investment: $3,710; 
Total DB assets: $217,648; 
Total hedge fund investment as a percentage of total DB assets: 1.7. 

Defined benefit plan: Massachusetts Pension Reserves Investment 
Management Board; 
Direct investment: [Empty]; 
Funds of hedge funds (indirect investment): $3,032; 
Total hedge fund investment: $3,032; 
Total DB assets: $43,535; 
Total hedge fund investment as a percentage of total DB assets: 7.0. 

Defined benefit plan: General Electric Co.; 
Direct investment: $2,344; 
Funds of hedge funds (indirect investment): [Empty]; 
Total hedge fund investment: $2,344; 
Total DB assets: $51,736; 
Total hedge fund investment as a percentage of total DB assets: 4.5. 

Defined benefit plan: Virginia Retirement System; 
Direct investment: $2,209; 
Funds of hedge funds (indirect investment): [Empty]; 
Total hedge fund investment: $2,209; 
Total DB assets: $50,311; 
Total hedge fund investment as a percentage of total DB assets: 4.4. 

Defined benefit plan: Missouri State Employees' Retirement System; 
Direct investment: $752; 
Funds of hedge funds (indirect investment): $1,443; 
Total hedge fund investment: $2,195; 
Total DB assets: $7,150; 
Total hedge fund investment as a percentage of total DB assets: 30.7. 

Defined benefit plan: Pennsylvania Public School Employees' Retirement 
System; 
Direct investment: $2,098; 
Funds of hedge funds (indirect investment): [Empty]; 
Total hedge fund investment: $2,098; 
Total DB assets: $58,490; 
Total hedge fund investment as a percentage of total DB assets: 3.6. 

Defined benefit plan: General Motors Corp.; 
Direct investment: [Empty]; 
Funds of hedge funds (indirect investment): $1,975; 
Total hedge fund investment: $1,975; 
Total DB assets: $98,612; 
Total hedge fund investment as a percentage of total DB assets: 2.0. 

Defined benefit plan: Citigroup; 
Direct investment: $1,887; 
Funds of hedge funds (indirect investment): [Empty]; 
Total hedge fund investment: $1,887; 
Total DB assets: $11,549; 
Total hedge fund investment as a percentage of total DB assets: 16.3. 

Defined benefit plan: Total; 
Direct investment: $15,039; 
Funds of hedge funds (indirect investment): $17,359; 
Total hedge fund investment: $32,398; 
Total DB assets: $713,692; 
Total hedge fund investment as a percentage of total DB assets: 4.5%. 

Source: Pensions & Investments (January 2007 annual survey).

Compared with pension plans, endowments and foundations were much more
likely to invest in hedge funds. Greenwich Associates' survey found that
75 percent of endowments and foundations (with at least $250 million in
assets) were invested in hedge funds in 2006. These investments amounted
to slightly more than 12 percent of total assets for all endowments and
foundations in their sample.

According to Pensions & Investments, hedge fund investments reported among
the largest pension plans increased from about $3.2 billion in 2001 to
about $50.5 billion in 2006, approximately a 1,500 percent increase (see
fig. 1).

Figure 1: Investments in Hedge Funds Reported by Defined Benefit Plans for
the Period 2001-2006

Note: The investments are aggregated among DB plans in the top 200 pension
plans (measured by combined DB and defined contribution assets) surveyed
by Pensions & Investments. In 2006, 48 DB plans reported investments in
hedge funds.

Furthermore, for those DB plans that reported hedge fund investments in
the 2006 Pensions & Investments survey, the investments represented about
3 percent of their total DB assets under management.

Appendix III: Various Hedge Fund Investment Strategies Defined 

Hedge funds seek absolute rather than relative return--that is, look to
make a positive return whether the overall (stock or bond) market is up or
down--in a variety of market environments and use various investment
styles and strategies, and invest in a wide variety of financial
instruments, some of which follow:

Convertible arbitrage: Typically attempt to extract value by purchasing
convertible securities while hedging the equity, credit, and interest rate
exposures with short positions of the equity of the issuing firm and other
appropriate fixed-income related derivatives.

Dedicated shorts: Specialize in short-selling securities that are
perceived to be overpriced--typically equities.

Emerging market: Specialize in trading the securities of developing
economies.

Equity market neutral: Typically trade long-short portfolios of equities
with little directional exposure to the stock market.

Event driven: Specialize in trading corporate events, such as merger
transactions or corporate restructuring.

Fixed income arbitrage: Typically trade long-short portfolios of bonds.

Macro: Take bets on directional movements in stocks, bonds, foreign
exchange rates, and commodity prices.

Long/short equity: Typically exposed to a long-short portfolio of equities
with a long bias.

Managed futures: Specialize in futures trading--typically employing trend
following strategies.

Appendix IV: GAO Contacts and Staff Acknowledgments

GAO Contact

Orice Williams on (202) 512-8678 or [email protected]

Staff Acknowledgments

In addition to the contacts named above, Karen Tremba (Assistant
Director), M'Baye Diagne, Sharon Hermes, Joe Hunter, Marc Molino, Akiko
Ohnuma, Robert Pollard, Carl Ramirez, Omyra Ramsingh, Barbara Roesmann,
and Ryan Siegel made major contributions to this report.

(250313)

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Highlights of [36]GAO-08-200 , a report to congressional requesters

January 2008

HEDGE FUNDS

Regulators and Market Participants Are Taking Steps to Strengthen Market
Discipline, but Continued Attention Is Needed

Since the 1998 near collapse of Long-Term Capital Management (LTCM), a
large hedge fund--a pooled investment vehicle that is privately managed
and often engages in active trading of various types of securities and
commodity futures and options--the number of hedge funds has grown, and
they have attracted investments from institutional investors such as
pension plans. Hedge funds generally are recognized as important sources
of liquidity and as holders and managers of risks in the capital markets.
Although the market impacts of recent hedge fund near collapses were less
severe than that of LTCM, they recalled concerns about risks associated
with hedge funds and they highlighted the continuing relevance of
questions raised over LTCM. This report (1) describes how federal
financial regulators oversee hedge fund-related activities under their
existing authorities; (2) examines what measures investors, creditors, and
counterparties have taken to impose market discipline on hedge funds; and
(3) explores the potential for systemic risk from hedge fund-related
activities and describes actions regulators have taken to address this
risk. In conducting this study, GAO reviewed regulators' policy documents
and examinations and industry reports and interviewed regulatory and
industry officials, and academics.

Regulators only provided technical comments on a draft of this report,
which GAO has incorporated into the report as appropriate.

Under the existing regulatory structure, the Securities and Exchange
Commission and Commodity Futures Trading Commission can provide direct
oversight of registered hedge fund advisers, and along with federal bank
regulators, they monitor hedge fund-related activities conducted at their
regulated entities. Since LTCM's near collapse, regulators generally have
increased reviews--by such means as targeted examinations--of systems and
policies of their regulated entities to mitigate counterparty credit
risks, including those involving hedge funds. Although some examinations
found that banks generally have strengthened practices for managing risk
exposures to hedge funds, regulators recommended that they enhance
firmwide risk management systems and practices, including expanded stress
testing. Regulated entities have the responsibility to practice prudent
risk management standards, but prudent standards do not guarantee prudent
practices. As such, it will be important for regulators to show continued
vigilance in overseeing hedge fund-related activities.

According to market participants, hedge fund advisers have improved
disclosures and transparency about their operations since LTCM as a result
of industry guidance issued and pressure from investors and creditors and
counterparties (such as prime brokers). But market participants also
suggested that not all investors have the capacity to analyze the
information they receive from hedge funds. Regulators and market
participants said that creditors and counterparties have generally
conducted more due diligence and tightened their credit standards for
hedge funds. However, several factors may limit the effectiveness of
market discipline or illustrate failures to properly exercise it. For
example, because most large hedge funds use multiple prime brokers as
service providers, no one broker may have all the data necessary to assess
the total leverage of a hedge fund client. Further, if the risk controls
of creditors and counterparties are inadequate, their actions may not
prevent hedge funds from taking excessive risk. These factors can
contribute to conditions that create systemic risk if breakdowns in market
discipline and risk controls are sufficiently severe that losses by hedge
funds in turn cause significant losses at key intermediaries or in
financial markets.

Financial regulators and industry participants remain concerned about the
adequacy of counterparty credit risk management at major financial
institutions because it is a key factor in controlling the potential for
hedge funds to become a source of systemic risk. Regulators have used
risk-focused and principles-based approaches to better understand the
potential for systemic risk and respond more effectively to financial
shocks that threaten to affect the financial system. For instance,
regulators have collaborated to examine some hedge fund activities across
regulated entities. The President's Working Group has taken steps such as
issuing guidance and forming two private sector groups to develop best
practices to enhance market discipline. GAO views these as positive steps,
but it is too soon to evaluate their effectiveness.

References

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  23. http://www.gao.gov
  24. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1053
  25. http://www.gao.gov/cgi-bin/getrpt?GAO-08-25
  26. http://www.gao.gov/cgi-bin/getrpt?GAO-07-716
  27. http://www.gao.gov/cgi-bin/getrpt?GAO-07-154
  28. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-3
  29. http://www.gao.gov/
  30. http://www.gao.gov/
  31. http://www.gao.gov/fraudnet/fraudnet.htm
  32. mailto:[email protected]
  33. mailto:[email protected]
  34. mailto:[email protected]
  35. http://www.gao.gov/cgi-bin/getrpt?GAO-08-200
  36. http://www.gao.gov/cgi-bin/getrpt?GAO-08-200
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