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The new head of the US Treasury has revived a dedicated committee to scrutinise the role hedge funds play in amplifying market stresses.
Last week, Janet Yellen, President Biden’s new pick to head up the US Treasury, the first woman in the role, highlighted three new areas of vulnerability that she says the Treasury Department must focus on in the post-COVID-19 era.
The revived Hedge Fund Working Group — put on hiatus under the Trump administration — forms part of the Treasury Department’s first priority and will look into vulnerabilities in nonbank financial intermediation.
The working group will look at the way that leverage strategies of some hedge funds can amplify the sort of market stresses the economy faced during the pandemic.
Addressing her first Financial Stability Oversight Council (FSOC) meeting as chair, Yellen said the re-establishment of the working group means “that we can better share data, identify risks, and work to strengthen our financial system”.
The move will be a signal to many that Biden, much like Obama after 2008’s global financial crisis, wants to take the opportunity post-COVID-19 to tighten up market regulations relaxed under the previous administration and attempt to curb market excesses. “Last year’s disruption of the treasury market warrants a broad, interagency effort,” Yellen said.
“Investors sought safety in the form of cash and short-term government securities,” she told the committee. “Bond markets became illiquid.”
“The fact that extreme policy interventions were still required to support market functioning should serve as a clear reminder: we have to do more to address vulnerabilities in the financial system,” Yellen continued.
If not for the extreme measures to shore up the US’ financial system at the peak of the pandemic, “the hole could easily have been even deeper,” Yellen said. The increased capital and liquidity requirements imposed after the 2008 financial crisis helped banks weather the pandemic-induced crisis, she added.
The second priority, Yellen explained, was a need to address vulnerabilities in the US treasury securities market. “We have to better understand the factors that contributed to an increase in the demand for liquidity by all types of investors — and a reduction in the supply of liquidity by dealers and principal trading firms,” Yellen said.
Climate change — “the big one”, Yellen described — rounded out the three, calling it an “existential threat” to the environment and a “tremendous risk” to the country’s financial stability.
Yellen also took the opportunity to draw attention to other factors that will affect domestic and international financial security, including cybersecurity, the growth of nonfinancial corporate credit, the importance of large banks and central counterparties and the evolving role of digital assets. Established under Dodd-Frank, the FSOC brings together federal and state financial regulators and an independent insurance expert.
The preliminary hearing did not produce any concrete proposals for how to address concerns around the use of leverage by hedge funds.
Calls to create enhanced oversight of and transparency in the US hedge fund space have been made repeatedly over the years, often immediately following a market downturn or period of volatility.
Such demands rarely offer details on what specifically should be done and, in a post-COVID and post-GameStop world, Yellen may find significant support for any proposal seen to be cracking down on what is perceived to be an under-regulated market demographic.
