The Securities and Exchange Commission wants hedge funds to report within 72 hours certain “trigger” events that might indicate financial stress. Although there are two very real problems when it comes to reporting by hedge funds, the new rule does not solve either of them.
It’s hard to think of a crisis with triggering events that occurred more than 72 hours before they were obvious to the public. Recent bank and cryptocurrency collapses were overnight events. Flash crashes are over in minutes (hence the name) and events like the 2007 quant equity crisis are generally over in a few days. Larger financial crises, like in 2008 or the 2010–2013 euro sovereign debt crisis, developed over months and years. It’s equally hard to think of a crisis in which notice of a triggering event could have led to effective immediate SEC action, as the agency has neither the tools nor staff for rapid market intervention.
The SEC cited two candidate events: March 2020’s elevated market volatility and the January 2022 GameStop trading frenzy. But neither of these were caused by changes in hedge fund positions or relationships. The emergence of Covid-19 was the cause in March 2020, and retail trading was the culprit in January 2022. There was nothing the SEC could have done to calm markets in March 2020. It’s possible it could have implemented some emergency trading rules in January 2022, but not with a 72-hour reporting lag, and it’s not clear emergency trading rules would have led to a better outcome.
The one recent crisis with triggering events a few days before the story broke in public was Archegos in April 2022. However, Archegos was not a hedge fund, so not subject to the rule, and regulators knew about the triggering events from dealer reports anyway. One could imagine a future crisis caused by a hedge fund following a strategy similar to Archegos, with positions that escaped dealer notice, but that seems like scant justification for a new rule.
Although the new rule seems like the wrong solution, there is a real problem. The current regime—quarterly or annual reports, delivered months after events—is far too slow for emergency decision making. But the rule does not address the two reasons for the stale data. First is that current reports require extensive manual effort to compile complex information. Second is that the information is intensely proprietary so that early release would compromise trading strategies. Even in the stale form of current reports, it is protected by extensive security, only a few specially designated SEC staffers have access to the raw data.
The new rule does not solve either problem. One reason for the three-day delay, as opposed to the one-day in the original proposed rule, is that determining whether an event qualifies as a trigger requires significant analytic work and high-level review. The other reason is that disclosing a trigger event to the SEC could easily kill a fund, causing counterparties to exit positions, lenders to withdraw funds, investors to redeem and derivative contracts to be canceled. Funds want three days to try to resolve problems on their own before their troubles are revealed to the world.
The SEC is moving from mid-20th-century reporting to faster mid-20th-century reporting, but there is a vastly superior 21st-century methodology available. It goes by the intimidating name of “ homomorphic encryption.” It allows funds to assemble whatever automated information the SEC wants to assess and encrypt it so that no one in or out of the SEC can decode it, yet the SEC is still able to construct a daily or even real-time dashboard to track market stress and potential problems. Encryption solves the proprietary data issue, and automation solves the delays for analysis and review.
The idea of homomorphic encryption dates to 1978, and the first full implementation was in 2009. It is now a standard technique in many applications. Fast, reliable software exists to support it.
For example, the SEC would like to know about gross long or short positions of highly levered investors that are large compared to average daily trading volume. Volatility in the underlying security could cause forced trading that destabilises markets and induces more volatility in a vicious spiral. Hedge funds could supply encrypted daily position reports that would allow the SEC to identify problems in individual securities, without any firm’s individual position being known to anyone outside the firm, including the SEC.
Another concern of the SEC are margin calls that represent a significant fraction of a fund’s free cash. Here funds could provide encrypted information about margin calls and free cash that would allow the SEC to identify potential problems early, without any firm exposing its problems.
Homomorphic encryption has another huge advantage over traditional reporting. Currently there’s no way for regulators to reconcile fund reports with data from dealers, banks and other institutions. This makes it difficult to spot incorrect information or to identify reporting loopholes that make risk invisible. A dashboard based on homomorphic encryption can reconcile data from all market participants, identifying inconsistencies and providing robust information where things add up.
A lot of top-down financial innovation means (in Michael Goodkin’s famous phrase) getting the wrong answer faster. The new SEC rule does nothing to make answers less wrong. It will get them somewhat faster, but not enough faster to be meaningful. We now have proven technologies for getting the right — or at least more reliable and useful — answers much faster and the SEC should join the rest of us in the 21st-century.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. Views are personal and do not represent the stand of this publication.
Credit: Bloomberg