Results of the initial consultation on 'Hedge funds: A discussion of risk and regulatory engagement'
Speech by Rebecca Jones, Capital Markets Sector Manager, FSA
GAIM Invest & Fund of Funds 2005
15 November 2005
Good morning everyone. A fortnight ago we passed the deadline for responses to the FSA's Hedge Funds Discussion Paper. I plan on spending the next ten minutes giving you a brief factual overview of some of the key messages we have taken from the responses although, given the limited time we have had to review them - some trickled in a little late - we are obviously still in the early stages of analysis.
I do not propose to go as far as giving you any categorical indications of how we propose to react to those messages. That is something we will do in our feedback statement, and any related consultation papers, due in the New Year – it is important that we take our time to carefully analyse each set of comments and develop an informed, coherent and proportionate response.
So what messages have we heard? Firstly, I can commend the Discussion Paper to you, not because I co-wrote it and therefore think that it is an interesting document, but rather because the responses to it tell us that it provides an accurate assessment of the risks inherent in the hedge fund sector. There were really only two caveats to that view. Firstly, some respondents noted that the identified risks are not specific to the hedge fund sector, but rather, as we have frequently noted, that they also materialise in other forms of asset management. Secondly, a handful of commentators suggested that there may be different views as to the probability of those risks actually crystallising.
One area of absolute unanimity from our respondents was their warm welcome for our acknowledgment that hedge funds are an increasingly important element of a modern and dynamic financial market place and that, as such, it would not be beneficial if regulatory action drove hedge fund managers to move to more lightly regulated jurisdictions. We stated that hedge funds are a major source of market liquidity and can significantly enhance market efficiency. They are increasingly fundamental to the efficient reallocation of capital and risk. Hedge funds are a significant generator of revenue for their counterparties and can be a significant generator of return for their investors. They can also provide a mechanism for increasing investment portfolio diversification. We believe that hedge fund managers can be useful, upstanding members of the financial community and we will continue to say so. It is important that we have an informed discussion about hedge funds, acknowledging both the risks and the benefits that they create.
We stated in the Discussion Paper our belief that hedge fund managers have a different risk profile to other discretionary investment managers and suggested two possible practical means by which it could be possible to more clearly distinguish hedge fund managers for the purposes of regulatory oversight. The majority of respondents did not support the first of these options, namely obliging firms to seek a separate permission before being able to carry on a regulated activity. Most commented that seeking an amendment to the relevant legislation would be a burdensome approach, although a few believed that the advantages of clarity and certainty it offers make it the most attractive option. If they had to choose one of the options, almost three quarters of respondents favoured making 'undertaking hedge fund management' a notifiable event. However, a large number of responses highlighted the difficulty in creating a definition of 'hedge fund management'. A meaningful definition is generally seen as a necessary precursor to following either the 'permission' or 'notifiable event' routes.
A fair number of respondents stated that neither requiring a specific permission nor creating a notification requirement with respect to prime brokerage was necessary, especially given the FSA's close and continuous supervision of such firms. Other respondents commented that the FSA should consider stepping up the intensity of supervision and data gathering with respect to such firms given their position of influence in the hedge fund sector.
We asked in the DP for views on the optimal scope of enhanced supervision of the hedge fund sector. To remind you of our planned approach, we decided to set up a centre of hedge fund expertise in the FSA, which was launched on Monday 31 October 2005 and is being run by my co-author on the DP Andrew Shrimpton. This team will initially relationship manage 25 groups containing 35 regulated firms that were already relationship managed in the FSA, but in a variety of different teams. The team will take responsibility for assessing the risks posed individually by these firms and developing the individual risk mitigation plans for them to follow. In addition the team will deal with complex cases where an alert is generated with respect to any other hedge fund manager. Furthermore the team will undertake thematic supervision, covering a wide range of entities that have hedge fund mandates irrespective of where within the FSA that group or firm is supervised – the approach is designed to address the risks posed by the industry as a whole.
Most respondents welcomed the creation of a specific team to supervise hedge fund managers given the degree of specialisation that this would provide. They also generally welcomed the concepts of thematic and case work. In our conversations with higher impact hedge fund managers we have actually encountered considerable enthusiasm for enhanced supervisory engagement, with a number of firms even asking if they can opt up where they are not currently relationship managed.
One area where there was still a lack of clear understanding was about the precise scope of the FSA's supervisory activity. For the record I would make it clear now that the modest changes to the regime we are considering do not involve significantly increasing the burden on firms, including low impact firms, neither do they imply that we will be supervising funds – just the fund managers who are conducting investment business under the terms of the Financial Services and Markets Act.
There were many different comments on our approach to impact assessment and precisely how we should identify, on an ongoing basis, which firms should be relationship managed. In the time allowed since we received the responses we have not yet been able to form a clear picture of these, but clearly our consideration of these issues will need to be carried out in the context of our revision of the FSA's overall impact assessment methodology. This issue is also very closely linked to what data we collect on an ongoing basis.
Data collection is another area where the comments and suggestions vary considerably. The only common themes I have been able to pick out so far are that firms are willing to supply more data if it is clear that the data will be utilised and that, in considering the appropriate data set, regard must be had to the international nature of this market. I would just remind you that our rationale for gathering data from hedge fund managers is twofold. Firstly, we want to improve our ability to identify those managers that pose more of a risk to our statutory objectives, i.e. they are higher impact according to our firm assessment methodology. This will help us decide with more accuracy and confidence whether a firm should be relationship managed or not. The second aim of data collection from hedge fund managers is to allow us to target thematic supervision effectively. Such thematic work could be applied to hedge fund managers whether or not they are relationship managed and whether or not they form part of a wider financial group.
The review of data requirements imposed on hedge fund managers is also in part necessary because they are currently submitting different returns with different data depending upon when the firm was authorised and by which regulatory organisation, the FSA or one of its predecessors such as the SFA or IMRO. Clearly a logical, consistent approach would be sensible. We are also willing to work as closely as possible with regulators in other jurisdictions, being transparent about the rationale for potential decisions about what data we might collect and what data we might not collect. In any event any decision here will have to meet full cost benefit analysis requirements so you may be confident that any requirements will not be disproportionate.
In the Discussion Paper we asked for views about the use of stress testing in the hedge fund sector. On this question, respondents were supportive of the usefulness of stress testing as a risk management tool and were mainly in favour of the FSA encouraging the industry to develop its approach to stress testing. Clearly our approach on this issue will have to be determined in the context of the Capital Requirements Directive and feedback to DP 05/2, entitled "Stress Testing", which set out a principles based approach.
Even though we did not ask a question on this topic, it would be remiss of me not to mention the operational risks run by hedge funds and in particular the risks arising from the role some hedge funds are playing in the credit derivative markets. You will be aware from reading the press that we, together with regulators in other major financial centres, are very concerned about the development of significant trade confirmation backlogs in the credit derivative markets. In assessing this risk we became aware that the assignment of trades by hedge funds, without prior approval or even notification of their counterparty, is significantly contributing to this backlog. We will be closely monitoring the impact of various industry initiatives in this area, including the ISDA novation protocol, before deciding whether or not any further regulatory intervention is necessary.
I should also mention that, with respect to market conduct, I can continue to 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, in agreement with some commentators on the DP, I would reiterate the view 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 methodologies, create incentives for others to commit market abuse.
On valuations over three quarters of respondents expressed support for the opinion set out in the discussion paper that additional measures may be justified to stimulate improvements in valuation arrangements, particularly in relation to illiquid and complex assets. Many respondents suggested that fund valuation was an activity with inherent conflicts of interest. Valuation issues were seen as significantly affecting every part of the industry. The majority of respondents drew attention to the cross border aspects of this issue and the different approaches taken in different jurisdictions. Many commented on the advantages of a global industry-led initiative, perhaps facilitated by IOSCO. It was also frequently noted that existing industry standards could be built upon.
On disclosure and due diligence, few respondents who expressed a view supported the concept of the FSA providing guidance on these topics. Some suggested that the FSA was well placed to facilitate industry initiatives to enhance standards, although many noted that institutional investors already conduct extensive due diligence and that standards are improving.
Finally on the issue of an industry code of practice, the majority of respondents were supportive of the concept whilst stating that this would best be developed by the industry.
Many of the responses on which this presentation is based are already publicly available so you might wish to read them in their entirety. I would recommend that you take a look – they make interesting reading.