Fed headed for a clash with hedge funds, other shadow banks

The Federal Reserve and other central banks are heading for a collision with shadow lenders — the firms with a sinister nickname that are increasingly dominating global finance.

Even as policymakers struggle to reopen their economies amid the coronavirous pandemic, they've launched a review of what went wrong with markets in March, when a worldwide dash for cash by investors nearly crashed the financial system and forced unprecedented rescue actions by central banks. Their focus is on loosely regulated money market and hedge funds, mortgage originators and other entities. Already, some watchdogs have pointed to highly leveraged trades involving U.S. Treasuries as one source of the turmoil.

"In many cases they have reached systemic importance," Bank for International Settlements General Manager Agustin Carstens said of the non-banks. He added that it's time to move toward more regulation.

There's a lot at stake should the scrutiny lead to tougher oversight. The alternative financiers are major providers of credit to households and companies, making their smooth functioning critical to the health of financial markets and the economy.

Non-banks are marshaling their lobbyists in Washington to argue that casting blame on the industry is misplaced. A point in their favor is that unlike Wall Street banks a decade ago, shadow lenders didn't cause the recent meltdown. Instead, the financial-market stress was triggered by a health crisis.

"Often you need an obvious smoking gun to make significant reforms, and it's not at that threshold for the non-banks," said Capital Alpha Partners analyst Ian Katz.

Much will depend on the results of the November U.S. election. A clean sweep by Democrats would increase the chances of far-reaching reforms, including the passage of legislation in the mode of the 2010 Dodd-Frank Act, which imposed new guardrails on banks but largely left shadow lenders unscathed.

"We need a new Dodd-Frank," said former Fed Chair Janet Yellen, who cited leveraged hedge funds, high yield and other investment vehicles that buy less liquid assets, and money market funds as areas of concern.

The Brookings Institution fellow called for strengthening the Financial Stability Oversight Council — an umbrella group of U.S. regulators led by the Treasury Secretary — so that it can ride herd on the non-banks. Private equity firms also could be in the crosshairs if the Democrats win big in November. Led by Sen. Elizabeth Warren, D-Mass., progressives argue that such firms damage workers and the economy.

Global regulators contend that it's shadow banks where the stresses showed up in March, with hedge funds dumping U.S. Treasury securities and bank loan funds and some money market funds hemorrhaging deposits. That led to wild swings in asset prices, forcing central banks to pump liquidity into markets.

In its annual economic report, the Bank for International Settlements said a rapid unwinding of so-called basis trades by hedge funds was "a key driver" of the turmoil — something the funds dispute. The transactions involved buying Treasury securities using leverage via repurchase pacts while simultaneously selling futures contracts.

The tumult highlighted the vulnerabilities of non-banks, Fed Vice Chairman for Supervision Randal Quarles wrote in a July 14 letter to central bank chiefs and finance ministers of leading nations. As head of the Financial Stability Board, he's promised to deliver a report on the mayhem to leaders of the Group of 20 nations by November.

Mr. Quarles' aim is ambitious. He wants to develop an overall framework for regulation of non-traditional lenders, rather than focusing on piecemeal reforms. And he recognizes that template can't simply be a replica of that already applied to banks.

Whereas the thrust of the reform effort coming out of the 2008 financial crisis was on building bank capital, the emphasis this time may be on liquidity, to ensure that shadow banks have sufficient cash to ride out market squalls, rather than intensify them.

Whether the scrutiny of non-banks leads to new U.S. legislation — as Ms. Yellen advises — remains an open question. Regulators typically need lawmakers' backing to stretch their oversight into new areas, but bills have been exceedingly difficult to get through a gridlocked Congress.

Dallas Fed President Robert Kaplan said Monday that the market turbulence earlier this year merited further study.

"There was a substantial amount of leverage, whether people were leveraging Treasuries as part of risk parity trades or other strategies," he said. "The Fed needs to be cognizant how financial stability concerns are sometimes hard to see."

Michael Pedroni, an executive vice president at the Managed Funds Association, which represents hedge funds, said that the unwinding of basis trades was "dwarfed" by foreign central bank selling of Treasuries. He added that evidence indicates hedge funds continued providing liquidity, even as banks pulled back.

A July 16 study by analysts at the Treasury's Office of Financial Research cast doubt on the argument that Treasury market illiquidity was amplified by the closing of basis trades, though it also said the high leverage involved in such deals remained "a cause for concern."

The shakeout has also thrown a spotlight on prime money market funds, especially those catering to institutional investors, which suffered big outflows in March. In the wake of turmoil, Fidelity Investments announced plans to drop its two prime institutional money funds.

In a May 27 presentation to a Securities and Exchange Commission's advisory committee, Investment Company Institute Chief Economist Sean Collins emphasized that many market participants were hit hard by coronavirus.

"The focus on a narrow aspect of the financial markets is not really helpful," Mr. Collins, whose group represents mutual fund companies, said in an interview.

The U.S. concerns echo long-running fears in Europe that shadow banks are a threat to financial stability. European Central Bank officials have highlighted the issue for years in speeches and in their Financial Stability Reviews. Bank of England Deputy Gov. Jon Cunliffe said in June that money market funds were a source of "vulnerability" in the financial system at the height of the coronavirus crisis that demands closer scrutiny.