Letters to Regulators: Letter to the SEC and CFTC on Proposed Amendments to Form PF

View or download a PDF of the letter here.

October 11, 2022 

Vanessa A. Countryman
Securities and Exchange Commission
100 F St NE
Washington, DC 20549-1090 

Christopher Kirkpatrick
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st St NW
Washington, DC 20581 

Re: Amendments to Form PF to Amend Reporting Requirements for All Filers and Large Hedge  Fund Advisers (File No: S7-22-22/RIN 3038-AF31)  

Secretary Countryman & Kirkpatrick, 

The Americans for Financial Reform Education Fund appreciates this opportunity to comment  on the Securities and Exchange Commission’s (SEC) and Commodity Futures Trading  Commission’s (CFTC) joint proposal that would update private fund adviser reporting to the SEC  on Form PF as well as the CFTC’s Form CPO-PQR. The proposed changes are particularly  important given the rapid growth and risks of assets in this space. 

Visibility into large private fund advisers, and in particular the risks from highly concentrated  and leveraged positions and the extent of interconnectedness with other financial institutions is  important, and regulators currently have very little information. Despite the “private funds”  label, the public has repeatedly borne the costs of aiding large private fund advisers that  suddenly posed risks to the financial system, whether it was the implosion of hedge fund Long  Term Capital Management in 1998, the Financial Crisis of 2008, or several hedge funds caught  off-guard by highly leveraged relative value trades on U.S. Treasuries in March 2020.  

We support the SEC and CFTC proposals to collect additional information. Having and sharing  this information and with the Financial Stability Oversight Council (FSOC) will help financial  regulators fully understand the risks across the financial system so that they can better address  issues that may arise from future economic downturns or sudden disruptions to the financial  system. 

Reporting of digital assets is long overdue 

We strongly support the SEC and CFTC’s proposal to require private fund advisers to report an  additional field detailing their holdings of digital assets. We also suggest that the SEC and CFTC  make a distinction in reporting between “stablecoins” and other cryptocurrencies. The size of the digital asset market has grown exponentially in the past few years from practically non existent over a decade ago when Form PF was first adopted to about $920 billion today.1 

Although digital assets are frequently marketed as an alternative to the traditional finance  system, hedge funds, private equity firms, and banks have been getting more involved in  investing and lending those assets. Examples range from the largest asset manager BlackRock  investing in2 and offering several Bitcoin related products to its clients3to investment bank  Goldman Sachs offering cryptocurrency derivatives to hedge fund clients.4 

Some hedge funds especially focused on digital assets have already caused sizeable losses. For  example, the mismanagement of Three Arrows Capital (“3AC”) has been estimated to be  responsible for about $1 trillion in losses across the entire cryptocurrency market.5 3AC’s  bankruptcy has in turn led to other creditors filing $3.5 billion in claims such as other crypto  focused hedge funds such as Genesis Global Trading who lent 3AC $2.3 billion, crypto exchange  Voyager Digital who is owed $650 million, and crypto company Blockchain.com $270 million. 

As more private funds continue to invest and lend a variety of cryptocurrencies it is imperative  that the SEC, CFTC, and FSOC understand how much exposure private funds have to this asset  class, and the ways in which other funds and Global Systemically Important Banks (G-SIBs) are exposed to funds that have especially concentrated holdings of various cryptocurrencies and  loans.  

We believe both the SEC and CFTC should go further to differentiate between stablecoins and  other digital assets. Unlike digital assets such as Bitcoin or Ethereum, stablecoins such as Tether  and Circle Financial’s USDCoin invest in a portfolio of short-term assets such as commercial  paper, U.S. Treasury bills, and repurchase agreements. Stablecoins therefore may be more  similar to money market mutual funds than other digital assets and therefore should be a  distinctly different reporting category.  

Both long and short positions, whether physical or synthetic, need to be reported to provide  an accurate picture of holdings 

We also strongly support the proposal to require private fund advisers to report both the long  and short positions across U.S. Treasury bonds, corporate debt, as well as the swaps and  derivatives that reference them to ensure that FSOC has a complete picture of the risk exposure  across private funds.  

As the SEC has found, including when looking back to the turmoil in the U.S. Treasury bond  market in March 2020, the current aggregated reporting of U.S. Treasuries failed to provide  regulators with insight into a relative value trade several hedge funds were using that soon  required a bailout from the Federal Reserve.6 

In this notable instance, involving arguably the most systemically important market in the  world, several private funds attempted to profit from the difference between the prices of U.S.  Treasury bonds versus their corresponding futures contracts to the tune of 400 to 500 billion dollars.7 The trade is typically conducted by a hedge fund selling a Treasury futures contract  short, while purchasing the underlying U.S. Treasury bond that could later be delivered to fulfill  that short obligation. The small differences in price between the U.S. Treasury bond and its  corresponding futures contract is captured by the hedge fund and often magnified by additional  leverage to provide a greater return.8 

Under the current Form PF reporting, a hedge fund conducting such a trade would report its  U.S. Treasury bond holdings, (and in some cases has done so as “cash and cash equivalents”)  while the short U.S. Treasury bond futures are lumped in with other unrelated derivatives and  reported in a broad aggregate, providing little usable information to the SEC and FSOC.  

The need to disaggregate derivatives holdings is also apparent in corporate debt where  investment strategies involving a combination of securities and derivatives such as credit  default swap basis trades and “net-short debt activism” occur and where a look at only the  aggregated data, or a look at the underlying security and not the corresponding derivatives  seriously obscures the full picture.  

Private funds have also tried to profit from credit default swaps that are trading at a lower level  of risk (measured in basis points) to their underlying corporate bonds they reference. The  hedge fund may purchase the underlying corporate bond and buy protection (basically   purchasing insurance against a default) through the credit default swap.9In isolation, under the  current Form PF, the SEC and FSOC would see the corporate bond holdings without also seeing  the offsetting credit default swap position. Just as in the prior example of the U.S. Treasury  bond cash-futures relative value trade these trades may result in large and sudden losses, in  this case if market volatility forces market participants to close any side of the trade early.10 

Similarly, in recent years, corporate debt investors have seen the rise of “net-short debt  activism” where a bondholder holding a long position will have a larger short position using a  derivative such as a credit default swap. The net-short debt activist can then improperly utilize  its rights as a creditor on its long bond position in a way that flies against the interests of other  bondholders in order to profit on its short position.11 This greater granularity of information  collected on Form PF can also help the SEC enforce fraud and manipulation of security-based  swaps under Rule 9j-1.12 

Both the SEC and CFTC should require private funds to report in a more granular manner all  long and short positions regardless of whether they are the actual security or synthetic through  derivatives. Private funds continue to use a combination of securities and derivatives and as it  stands the SEC and FSOC are not seeing a clear picture of which derivatives also match up  against the underlying securities they reference.  

The SEC should require private funds to report holdings in their base currencies rather than  converted to U.S. dollars  

The recent sharp movements between the currency pairs of several G-10 countries clearly  makes the case for the SEC requiring private funds to report holdings in the base currency in  order for the information collected by FSOC to properly assess how much currency risk private  fund advisers are exposed to. The British Pound (GBP) for example has lost 18% of its value  against the U.S. Dollar so far in 2022 bringing the difference between the currency pair to its all time lowest levels.13  

A number of hedge funds lost sizeable sums of money on their currency positions even before  the volatility across several currency pairs picked up this year. In 2018 for example, a hedge  fund unit of Hong Kong’s GF Holdings Corp. lost a sizeable amount of money on its currency  trades which in turn lead to investment bank Citigroup incurring $180 million in losses.14 

We therefore strongly support the proposal to require private funds to report their holdings in  their base currencies rather than convert them to U.S. dollars.  

Conclusion 

We strongly support these proposals from both the SEC and CFTC that would provide both the  SEC and FSOC with much more granular data that would provide a more nuanced and complete  understanding of the distribution and urgency of risks in the $18 trillion of private fund assets.  

Such additional reporting requirements would not be unduly burdensome to private fund  advisers as all of them by the nature of their business already conduct extensive analyses on  their holdings and risk exposures.15 

We thank you for your consideration of this important matter. For additional questions please  contact Andrew Park at andrew@ourfinancialsecurity.org.  

Sincerely, 

Americans for Financial Reform Education Fund