Overview of DP05/3 and DP05/4
Speech by Hector Sants, Managing Director, FSA
FSA Annual Asset Management Conference
19 September 2005
As John outlined in his keynote this morning my intention is to kick off the afternoon session on "the hedge funds debate" by outlining the issues raised in the two papers the FSA published simultaneously in June. One of the papers is specifically about hedge funds – its title is "Hedge Funds: A discussion of risk and regulatory engagement". The second paper does not carry the words "hedge fund" in its title, but is related to the first paper. The second paper is called "Wider-range retail investment products: Consumer protection in a rapidly changing world".
"Hedge Funds: A discussion of risk and regulatory engagement"
I will start with the paper that does have hedge funds in the title. I will briefly describe the FSA's perception of the risks outlined in the paper, together with a number of current, planned and potential regulatory responses to those risks. It is these risks and responses that I would welcome your feedback on, either as part of our discussion today or indeed more formally in written response to our recent hedge funds discussion paper.
Firstly I wanted to re-emphasize a couple of points that John made this morning. Hedge funds are growing in importance in terms of their contribution to financial markets. They are a major source of liquidity and can significantly enhance market efficiency. They are increasingly fundamental to the efficient reallocation of capital and risk. They can also provide a mechanism for increasing investment portfolio diversification. Hedge funds no longer seem quite so 'alternative' but rather seem like a core component of a modern and dynamic market place. It is in the context of this positive contribution to markets that I set my discussion of the risks inherent in the hedge fund sector. And it is in the context of the FSA's aim to take into account the competitive position of the UK that I will frame my remarks on the options open to us in encouraging the mitigation of the identified risks. The FSA recognises that it would not be beneficial if regulatory action caused the hedge fund industry to move to more lightly regulated jurisdictions. But there are benefits to ensuring that we operate an informed, transparent and proportionate regulatory environment here in the UK.
Let me turn now to discuss the FSA's current perception of the key risks inherent in the hedge fund sector. These risks are clearly outlined in the discussion paper and include the following.
Firstly, market disruption. Given the significant role that hedge funds play in markets today, and historical market events such as the near collapse of Long Term Capital Management, it is inevitable that regulators will ask whether hedge funds pose a threat to market confidence and indeed financial stability. It is our current assessment that the failure or significant distress of a large and highly exposed hedge fund – or, with greater probability, a cluster of medium sized hedge funds with significant and concentrated exposures – could cause serious market disruption. Such an event could also erode confidence in the financial strength of other hedge funds or of firms which are counterparties to hedge funds.
However, in our view, at this point in time, the probability of an event on a scale that could significantly affect UK financial stability is relatively low. We are not aware of any UK managed hedge funds with exposures on the same scale as LTCM. There are though an increasing number of relatively large funds with the potential to create significant exposures. There is potential for the exposures of these funds to grow and change rapidly as the market starts to pick up, volatility increases, unused leverage is taken up, new strategies are pursued and new products are developed.
All hedge funds are also exposed to liquidity risk and there is potential for some of them to disrupt liquidity in a way that may lead to disorderly markets. The observed incidence of hedge funds collectively making concentrated investments (usually on a leveraged basis) in particular market segments and financial instruments is increasing. Coupled with the increasing sensitivity of their investor base to performance, this can engender a significant liquidity mismatch leading to enforced asset disposals and consequently volatile and potentially disorderly markets.
A third risk concerns transparency. The hedge fund industry has long been tarred with the brush of opacity. It is true that transparency in this sector is far from perfect but I would note that it has been improving. The real issue is that hedge fund managers are reluctant to disclose their positions and strategies to their competitors, and are therefore reluctant to make disclosures to the market in general. They are however willing to make targeted disclosure to their investors, and sometimes to their key counterparties. This means that sophisticated investors and counterparties have the opportunity to have a significant moderating influence upon hedge fund behaviour. Regulators could also play a beneficial role here. Currently regulators have insufficient information to inform regulatory action. Enhanced disclosure to regulators of reliable and comparable data could help us to take informed decisions about risk, and consequently proportionate regulatory action to mitigate that risk.
Reflecting their trading (rather than management) background and their typical ownership structures, some hedge fund managers do not have the optimal skill set or incentives to create an effective control infrastructure. Many hedge fund managers are used to having risk management and operational support provided to them, as they frequently come from investment banks and institutional asset management companies. Developing such support when they are used to focusing purely on trading and profit generation is a difficult task. It is also the case that such firms are frequently launched with a very small and concentrated staff base, which raises questions in relation to independent oversight, the 'four eyes' requirement, conflict of interest management etc.
Clearly robust risk management is essential within the hedge fund sector. We have not observed any material weaknesses in the risk management techniques being employed, although there are particular challenges in risk managing multi-strategy portfolios and there are possible improvements that could be made with respect to stress testing.
Another significant risk we have observed is the fact that weaknesses in asset valuation methodologies and processes related to skill shortages and conflicts of interest are creating considerable potential for ill-informed investment decisions and detriment to market confidence. It can be difficult to obtain a robust and truly independent valuation of the complex assets frequently utilised by hedge funds. Conflicts of interest can develop in the asset valuation process, where reliance is placed on either the hedge fund manager's own valuations and models or the valuations of counterparties to the trades.
In the context of inappropriate behaviour, I would draw your attention to our perception that some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation. Having said that, when considering market conduct issues in the hedge fund sector it may not be simply a question of considering whether hedge fund managers act inappropriately but also whether their models (including the high commissions they generate and their trading methodology) may create incentives for others to commit market abuse.
Having discussed the key risks posed by hedge funds, let me turn now to risk mitigation. There are a number of current, planned and potential risk mitigation actions that merit attention, both in a domestic and an international context. In exposing these concepts I would once again remind you that it is our aim to create a first class regulatory environment that adds value by responding in an informed and proportionate manner to risks, whilst taking into account the benefits of an innovative and competitive market place.
In terms of current actions, we have frequent non-supervisory dialogue with market participants, we are applying focused risk mitigation programmes to relationship managed firms and we have increased our thematic reviews of hedge fund managers. Furthermore, we have implemented a regular 'hedge funds as counterparties' survey which seeks to enhance the FSA’s understanding of prime brokerage, gauge the risk appetite of both credit providers and hedge funds, and identify any very large highly leveraged funds. We also highlighted the importance of performing stress testing in a discussion paper published in May. And finally, we participated in international regulatory dialogue in fora such as the Financial Stability Forum and the Joint Forum, setting out our assessments of risk and learning from the experience and knowledge of others.
15. We have decided to supplement these initiatives by reorganising our resources to create a centre of hedge fund expertise within the Wholesale Markets Business Unit to undertake enhanced surveillance of the hedge fund sector including relationship management of high-impact firms and increased thematic supervision based on the strategies and markets in which the firms are active. In support of this approach we will be reviewing our impact metrics to allow us to more accurately take into account market impact when assessing the risk an individual firm poses to our statutory objectives and therefore the optimal regulatory response. We also intend to increase our proactive surveillance with respect to issues of market conduct in the hedge fund sector, both in relation to hedge fund managers and their counterparties. To help with surveillance work we will also be giving consideration, as part of the implementation of the Markets in Financial Instruments Directive, to requiring firms to identify the hedge fund manager rather than the hedge fund as the counterparty to a trade for transaction reporting purposes.
What I would really like to focus on though, in terms of risk mitigation, are the potential additional risk mitigation actions on which we are formally seeking industry views.
We are considering distinguishing hedge fund managers more clearly from other types of discretionary investment managers and advisors. Currently there is no easy way for us to identify which of the many firms we supervise are actually managing a hedge fund. Given our assessment that hedge fund managers have a different risk profile from traditional investment managers and advisors we believe that it would be beneficial to identify hedge fund managers more clearly to allow us to target our supervisory resources more effectively. In the same vein, we are also looking for your opinion on whether it would be beneficial to distinguish prime brokers using similar techniques.
To support our decision to enhance our supervisory oversight of hedge fund managers we are considering collecting additional data from hedge fund managers. In designing this potential data set we have had mind to the fact that, whilst there are a number of risk metrics that are relevant to a particular strategy, there are very few metrics that are meaningful across the full range of hedge fund strategies. We have therefore aimed to keep the proposed sector wide data to the bare minimum, with the intention of requesting additional targeted data from high impact firms and firms involved in thematic reviews.
It is not just regulatory action that we are considering. There are also a number of areas where we believe the market may be well placed to raise standards itself. For example, we believe it would be beneficial to encourage industry initiatives to improve investor due diligence and hedge fund disclosure.
One area where we are particularly keen to see industry improvements is in relation to hedge fund valuations. We are considering a range of possible actions here including promoting the development of an international code of practice that all parties involved in hedge fund valuation could adhere to.
"Wider-range retail investment products: Consumer protection in a rapidly changing world".
Now let me turn to the paper that does not have hedge funds in its title i.e. our paper on "Wider range retail investment products". The "wider range" paper certainly includes hedge funds in its scope. I will cover the three risks outlined in the paper and potential mitigation for each one in turn.
The first risk outlined is that retail consumers do not understand and regulated firms do not adequately manage the significantly changed risk characteristics of UCITS III as compared to UCITS I funds. To mitigate this risk we will scrutinise proposals for new UCITS III funds and conversions of existing funds and will engage in a thematic review of the risk-management systems of firms that are proposing to operate or are operating UCITS III funds. Disclosure of risk information is a component of mitigating this risk, and we will take a close look at UCITS III promotions to ensure that the risks are explained to consumers in a fair, clear and not misleading manner
The second risk outlined is that retail consumers may be confused by the different forms and distribution channels of wider range products, resulting in mis-buying or mis-selling. We acknowledge that mitigating this risk is extremely difficult to achieve nationally, given the impact of EU legislation. In this paper, we discuss tentatively the possibility of both improved disclosure and more structured product segmentation for distinguishing between products to act as a signposting for consumers. However, it is clear that such a distinction will be difficult to draw and may result in moral hazard if consumers somehow perceive some products as inherently safe.
The third risk outlined is somewhat contradictory to the first two i.e. the different regulatory approaches applying to the marketability of different investment products means that some retail consumers may not, under the present regime, have sufficient access to investment products that have comparable economic characteristics, and may thereby suffer detriment. In the paper we discuss whether we can move from a regulatory approach based on product structure to one based on the nature (principally the riskiness) of the strategy being operated within the various possible structures. There is a balance to draw between the marketability of a product and the regulation applied to it. If we were, for example, to lift the marketing restrictions from unregulated schemes, or some of them, we would need to apply safeguards to protect consumers. These protections could be disclosure based or could include the use of other safeguards. In addition, we must also recognise that measures to liberalise the marketability of such products will increase the risk of mis-selling or mis-buying of those products for other consumers for whom they are not suitable. The key here is to ensure that consumers are properly equipped to be able to make sensible choices in a world of greater choice.
Thank you for your attention today. I would now welcome any feedback you may have on our approach to hedge funds and wider range retail investment products. In particular, do you believe we have identified the correct risks and corresponding mitigating actions? Is there anything we haven't thought about?