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Speech by Dan Waters, Asset Management Sector Leader, FSA
Hedge Funds Blueprint Europe Conference
8 February 2005

I am delighted to have the opportunity to address the rapidly growing community of people involved and interested in hedge funds. Among the people increasingly interested in hedge funds, you may or may not be pleased to know, are regulators like me. Hedge funds and regulation were, until relatively recently, often seen as occupying the opposite ends of the spectrum. The explosive growth of the hedge funds sector, if I may roughly characterise it as such, has led to more attention from us. But the FSA is a not regulator that is interested in regulation for the sake of it. I want to explain to you the approach that we are taking in looking at the booming hedge fund sector, and to explore the many challenging and interesting issues that are beginning to arise.

To provide a bit of context, I will first touch briefly on the goals that we have set for the FSA in dealing with the hedge fund sector. Then, I will move on to the current regulatory arrangements in the UK and EU in respect of managers, administrators and the funds. I will then turn to the myriad changes occurring to the European regulatory arena, driven by the Financial Services Action Plan (FSAP). Other changes include the new Qualified Investor Schemes (QIS) which have just been permitted under UK law, a change allowing vehicles with some hedge fund characteristics on shore and into our regulatory regime.

I’ll spend some time talking about access of retail investors to alternative investments, which as you know the FSA is looking at (again!). Finally, I will take a quick look at changes in the US which will have implications for many of you and for the FSA in its supervisory work going forward.

• The FSA’s goals for dealing with the asset management sector and indeed the hedge fund sector are: First, to improve our partnership and dialogue with the industry – I will be giving some examples of that today;
  
• Second, to work with the sector and encourage it to implement its own solutions to problems without detailed intervention by us;
  
• Third, for the FSA to be seen as a regulator which only intervenes from necessity – that is, where there is a market failure and where a rigorous cost benefit analysis indicates our intervention will add value; and
  
• Fourth, to recognise the increasing significance of hedge funds for the UK and global financial markets.

The UK is the leading European centre for hedge fund management with an estimated 70% market share of hedge funds managed by European based managers. (Source: Eurohedge). In global terms, it is second only to the United States in the share of hedge funds managed. It is estimated that managers authorised in the UK manage 15-20% of global hedge fund assets. The US is by far the largest centre, where estimates are that hedge fund managers located there manage 70% of global hedge fund assets. (Source: TASS). Let me illustrate further with the typical set up for a UK managed hedge fund. The FSA authorises and regulates hedge fund managers who are located here in the UK . But the hedge funds themselves are not here, they are offshore. The most popular domicile is the Cayman Islands . Other major offshore domiciles are Bermuda , the British Virgin Islands and Delaware . The hedge fund administrators too are generally offshore, most commonly in Ireland . Other locations are Cayman Islands and the Dutch Antilles. The situation could hardly be more different from the regime we have for Authorised Collective Investment Schemes (such as Unit trusts and OEICS), where the managers, the funds and the administrators are generally regulated by FSA and located here.

Other Regulators such as the Irish Financial Services Regulatory Authority are responsible for the regulation of most of the administrators of UK managed hedge funds. The administrators are appointed by the offshore funds themselves rather than the manager as is typically the case when CIS managers outsource administration. Therefore, administration is not a delegated function of the manager and the managers are not responsible in regulatory terms for the administration services (such as valuations) provided to the client. So, unlike authorised funds (CIS) most administration issues are outside the FSA's remit.

Once authorised, a hedge fund manager is required to follow our relevant rules. These include our requirements on ‘Senior Management Arrangements, Systems and Controls’. i.e. that a firm "must take reasonable care to establish and maintain such systems and controls as are appropriate to its business" (SYSC 3.1.1R). Any firm failing to meet this standard would be in breach of our rules. But as you can see, the standard is high- level, flexible and aims to cover effective systems and controls for business models that span a very wide range.

Managers are also covered by our ‘Dealing and Managing Conduct of Business’ rules; these include for example best execution, and fair and timely trade allocation. These rules apply to dealings on behalf of both private and intermediate customers.

The Code of Market Conduct/Market Abuse regime also applies to behaviour by managers in relation to qualifying investments, that is, investments which are traded on a prescribed market in, or accessible from, the UK - even if the trader is not authorised by us or is located overseas. The FSA recently took its first action against a firm for distorting the market through short selling activities, so managers should be aware of this aspect of the code if they manage funds which use aggressive trading strategies.

The FSA has authorised around 160 managers who are specialist hedge funds managers and the number has been growing rapidly. We estimate there are another 90 authorised managers who have added hedge fund mandates to an established fund management business. The FSA’s supervisory approach applies resources to firms on the basis of a risk assessment. We look at the impact of the firm if something serious were to go wrong, and the likelihood of that happening. The higher the impact and the greater the probability of problems, the more resources we apply.

Our current impact metrics are such that the vast majority of hedge fund managers are viewed as low impact and low risk. This means that they do not have their own supervisory relationship manager. At the moment, only 15 managers of the 160 FSA authorised specialist hedge fund mangers are relationship managed. This does NOT mean however that the rest are not subject to supervision. Our central research and risk area monitors industry trends and developments. This informs areas and issues that we may wish to consider in more detail. Similarly, the Asset Management sector team conducts intelligence gathering and cross-sector risk assessment work. These analytical activities may lead to us commissioning so-called thematic (or project) work, that is, supervisory work not focused on one individual firm, but rather on a group of them. Thematic work often does involve us contacting and visiting hedge fund managers, and requesting information from them or the providers of services to them.

Let me demonstrate with an example. We have been keen to work with the industry to understand the risks in hedge fund financing activities. Why is the FSA interested in this? The post-LTCM official reports – including US President’s Working Group (1999), Basel/IOSCO review (2000/1), Financial Stability Forum (FSF)(2000) made a number of recommendations including:

1. enhanced regulatory oversight of credit providers to the hedge fund sector and;
   
2. the encouragement of stronger counterparty risk management at credit providers.

The FSA has fully contributed to international assessments of progress against these recommendations in recent years (including many of the reports already noted, and the FSF review in 2002).

But we also launched a project, recently completed, to obtain data on a voluntary basis from prime brokers on their exposure to hedge fund counterparties, exposure both in aggregate and by strategy type. What prompted this additional work? Surveillance showed that hedge funds were attracting record net inflows, and there was mounting evidence that competition for prime broker mandates was becoming more intense. We needed a better handle on these overall flows and the levels of leverage implied. We also thought that there was a growing risk that competition for this business could lead to weaknesses emerging in counterparty risk management standards.

We are very grateful to the firms that participated in this project for the time and effort they have put into providing us the information we requested. The main objectives of this data collection exercise were:

• to enhance our understanding of the hedge fund sector;
  
• to identify outliers in the peer group of respondents, for the purposes of follow-up through individual firm supervision;
  
• to gauge risk appetite (at both funds and prime brokers); and
  
• to assess prime brokers' ability to aggregate data across business lines.

What are some of the outputs of this project? We are building a database of prime brokers' exposures to hedge funds, including information on market size, shares, concentration and risk metrics. This gives us a view, albeit a rather impressionistic one, on the distribution of leverage and risk, by strategy and by firm. There are, of course, some important limitations, as participants in some areas have taken different approaches in their responses – aggregating the data can be difficult as a result. We should also stress that the survey has limited benefits in addressing systemic risk concerns in the absence of global exposure data. But we have been encouraged by some firms telling us that they should be conducting a similar exercise in any case for internal risk management purposes, given the need to aggregate exposures to hedge fund clients across business lines.

Feedback on the results of the survey necessarily has to be kept at a high, general level, given the commercial sensitivity of the data firms have provided. In aggregate, around $250bn of hedge fund equity appeared to be serviced by participants in the survey, as at end-July 2004. If we take a rough estimate that hedge funds globally have collective equity of around $1000bn, our survey indicates that about one-quarter of this is financed from London-based firms. Our survey also indicated that equity long / short funds are the single most popular strategy, with 37% of aggregate equity. Multi-strategy funds are next most popular, with 27%, followed by fixed income funds (15%).

On leverage, our survey indicates for hedge funds serviced by survey participants and bearing in mind the data limitations above that:

• overall, funds have long positions of around 2.1x their equity (long leverage) to produce aggregate long positions of around $520bn;
  
• fixed income funds unsurprisingly were most leveraged, with long leverage of around 4.5 x their equity;
  
• aggregate short positions of around $340bn; and
  
• hedge fund counterparties therefore had gross positions therefore of around $860bn.

These figures, admittedly not precise, give us a crude sense of the overall potential market impact of hedge funds.

In addition to this project, we continue to carry on other thematic work with hedge fund managers themselves. We want to understand better the market impact issues from the point of view of the managers so we have recently begun a project looking at this. The high degree of leverage used by certain funds and strategies, and relatively frequent trading by hedge funds raise a number of other regulatory issues in terms of promoting efficient, orderly and fair financial markets. A disorderly failure of a particularly large hedge fund, or the rapid unwind by hedge funds of similar positions could cause disruptions in relevant markets, or even prudential problems at authorised market intermediaries (e.g. prime brokers). I am not saying that we think there is an imminent threat to markets because of the levels of leverage in hedge funds. Indeed the levels of leverage, in so far as we are able to discern them, do not appear excessive by historical standards at the moment. But we must be alert to the risks. We are also aware that hedge funds account for an increasingly large share of trading in many investment markets. In illiquid markets, this concentration could become problematic.

We have also just completed a series of visits to a number of managers in respect of our anti-Money Laundering requirements and are currently analysing the findings. W e want to understand better the relationships between fund, administrator and manager, and how money laundering responsibilities are dealt with in practice. We will want to assure ourselves that at the end of the day, there are adequate anti-money laundering systems and controls in the UK authorised fund manager, and that there are no gaps in the ability to identify the beneficial ownership of funds that are being managed.

But if the concerns outlined above reflect the current regulatory arrangements, it is important to note that changes are coming, and that many of these are relevant for hedge fund managers.

The Market Abuse Directive (MAD) will result in an EU-wide market abuse regime. It is envisaged that the final policy will be a joint publication by the FSA and Treasury during Q1 2005, which will go live in Q2 of 2005. The EU regime is substantially the same as the existing domestic regime, but there are some differences which will involve revisions to the FSA Code of Market Conduct and Price Stabilising Rules. The main changes for firms will be the introduction of a mandatory ‘suspicious transactions reporting regime’ for brokers and a requirement for issuers and their advisers to keep lists of their staff who have inside information.

The Markets in Financial Instruments Directive (previously Investment Service Directive) or MIFID is due to be implemented by the end of April 2007. It will imply significant changes to the FSA's Handbook, particularly in the conduct of business area for asset managers, including client classification, best execution and order handling (Dealing and Managing).

I would also note in passing that the target implementation date for the Capital Requirements Directive (CRD) is Q1 2007. We believe that capital requirements for fund managers will be lower due to use of "Fixed Overhead" rather than "Fixed Expenses" for the Expenditure Based Requirement.

There are also significant changes being made in the regulation of European retail market funds, allowing retail investors to be exposed to some of the risk and return characteristics of hedge funds. For the first time, amendments to the UCITS Directive allow leverage of up to 100% of Net Asset Value, using derivatives, in passportable retail funds. It is also possible for passportable retail funds to take short positions using cash settled derivatives under the new rules. These changes are captured in the UK ’s implementation of the directive in our recent overhaul of our CIS sourcebook.

I mentioned before the new Qualified Investor Schemes (QIS) which we have recently permitted to be launched in the UK . Our statute requires us to have regard to the differing needs of investors. We thought it therefore appropriate to introduce a more flexible funds regime for sophisticated investors. Other jurisdictions have similar products, so allowing them onshore should improve the competitive position of the UK (another FiSMA consideration). There was moreover, evidence of demand from sophisticated investors for a less regulated product. At the same time, however, the badge of authorisation still seems to be valued by some institutional investors: hence the attraction of a more liberalised but still authorised fund vehicle.

QIS may only be promoted to:

• market counterparties;
• intermediate investors; and
• 'Expert' investors including:
  • persons who already invest in similar schemes;
  • persons for whom it is judged suitable (on reasonable grounds), and
  • various others (charities, eligible employees and exempt persons).

The likely target audiences for QIS are 'expert' private investors and institutional clients such as pension funds. QISs can also of course use derivatives, but the total exposure relating to derivatives held must not exceed the fund's net asset value (NAV) and borrowing using debt can be only up to 100% of NAV of the fund. As a new regime, it will probably take a little time for QISs to settle down – we’ve seen this with other developments such as UCITS 3 funds and guaranteed funds. Indeed the launch was delayed by uncertainties on tax treatment, but there has been some clarification of the tax position by the Treasury recently and we have approved our first scheme.

Access of unsuitable private investors to QIS is something FSA will have to keep an eye out for. We will need to monitor to ensure that managers are undertaking the necessary checks to ensure that retail investors are not inappropriately investing in these funds. Fund managers will need to satisfy themselves and FSA that expert private investors really are expert.

There is no regulatory regime in respect of offshore domiciled hedge funds in the UK at the moment – they fall into the category of unregulated collective investment schemes, which cannot be marketed to private customers.

The UK does allow funds of hedge funds, which can be listed in company form, to be offered to retail investors - this would include through direct marketing channels. Thus far, only a small number of listed fund of hedge funds have been launched (around 6) but the market is showing signs of springing back to life and there is a proposal for a launch shortly.

It is clear that the line between what can and cannot be offered to private customers is becoming blurry, and that we are not in standing-still mode in Europe on the whole question of wider access to hedge fund investments. The CESR Expert Group on Investment Management will also be looking at the question of harmonisation of the treatment of unregulated collective investment schemes. This will feed into a Green Paper being prepared by the European Commission for the autumn, which will address a wide range of asset management issues, including the treatment of hedge funds. In my view this is extremely unlikely to end up in a ‘no change’ solution.

In the FSA Business Plan published in January, we explained that we will be publishing a discussion paper on the sensitive issue of wider retail access to alternative investments. The o bvious challenge is trying to square the circle between wider access, and the need to ensure adequate consumer protection in circumstances where consumer knowledge and confidence can be low, and the risks and complexity of products can be high.

A number of managers point out the difference between the single hedge funds with their high performance / high risk profile and the fund of fund products that some managers would like to offer to the retail market. These funds of hedge funds foreswear the high risk/return game, and instead seek to use derivatives and quantitative analysis to deliver more predictable, absolute returns than say a standard equity index tracking fund. These "steady Eddie" funds begin to sound like some with-profits insurance products which use actuarial judgement and reserves to smooth returns.

Our review will consider these trends, but also look at the treatment of these issues in other EU member states, and the emerging issues from the debate on the implementation of European legislation. Please do not assume that because we are reviewing the regime we have decided to seek a dramatic change in the current arrangements. We approach the analysis with an open mind. Also keep in mind that the ban that exists on the promotion of hedge funds to the retail public can only be changed by an amendment to the Financial Promotions Order, which of course is a matter for the Treasury. If our work should suggest, and if Treasury were to agree, that some liberalisation might be warranted, we would need to consider carefully appropriate consumer safeguards. These however might be difficult to design without in effect reverse-engineering into product regulation of hedge funds, which we do not find an attractive proposition. We will continue an open dialogue on difficult issues with the industry and consumers.

Before concluding, let me turn briefly to what the SEC has been up to in the hedge fund area, and its implications for you and for the FSA. The Commission voted on 26 October to introduce mandatory registration of hedge fund investment advisers under the Investment Advisers Act. SEC authorisation will be based on the number of US clients (more than 14) and an asset size threshold ($30m). This differs from the UK , where the requirement for authorisation is based on the activity of fund management and location of the manager. We expect that this change in SEC rules will capture a number of UK based hedge fund managers in US regulation for the first time.

The final rule permits an offshore adviser to treat an offshore private fund as its client (and not the investors) for many of the provisions under the Advisers Act but not all. So, the Advisers Act's substantive provisions generally would not apply to the adviser's dealings with the fund, under current SEC staff guidance. However, the offshore adviser will be subject to a number of important requirements, such as:

• complying with certain of the Advisers Act's record keeping requirements with respect to the fund and its other clients,
  
• undertaking to promptly provide such records and any records kept under foreign law to the SEC upon request, and
  
• making its personnel available for testimony before, or questioning by, the SEC or its staff.

The compliance date for the new rule is February 2006. We have been in discussion with the SEC on how to arrange sensible supervisory co-operation to minimise the impact of these changes on UK fund managers.

I have touched on the key features of the current FSA regime for hedge funds. It is a partial and relatively light-touch one. It focuses on fund managers and not the administrators or funds themselves. It relies on thematic supervision for the most part, with relatively few closely supervised hedge fund managers. BUT: The international context is changing and changing quickly, both in the US and in Europe . The UK cannot remain indifferent to these changes. We have taken steps, as have some of our European colleagues, to bring vehicles with hedge fund characteristics on shore and into our regulatory regime – Qualified Investor Schemes being the most obvious example. There are other ways in which investments with hedge-fund like features and market exposures are making their way into the wider market in the UK and elsewhere.

Many important questions arise in this rapidly shifting terrain, but I would leave you with three:

• First, is there solid ground for the retail consumer who has not as yet ventured into this unknown territory, but might do quite well if he or she did?
  
• Second, are hedge fund managers and their credit and other services providers conducting their businesses supported by sound risk management practices and underpinned by adequate systems and controls?
  
• Third, are we satisfied that the increasing importance of hedge funds is a net force for good in the overall development of robust and efficient capital markets?

The answers to these fundamental and timely questions lie, I suspect, in market developments, in your good offices, and with the FSA and other regulatory counterparts. It is extremely important that we deliver the right responses.