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Speech by Dan Waters, Director,
Asset Management Sector Leader and Director of Retail Policy, FSA
AsiaHedge Conference, Hong Kong
19 October 2006

Good afternoon Ladies and Gentlemen and thanks to AsiaHedge for inviting me to speak here today. The spectacular growth of hedge funds in the past decade and their burgeoning impact upon the global capital markets present issues of increasing importance in the international financial community. Speaking as a regulator, it is essential that we develop a regulatory approach that is proportionate, internationally literate and effective in addressing the challenges that this market sector presents.

The FSA takes the view that properly run, hedge funds contribute significantly to the efficiency and liquidity of global capital markets. They allow investors to diversify their portfolios and to enhance returns. They are particularly well suited to institutional investors, who can perform proper due diligence on the fund and its managers and who can evaluate the fund's investment strategy and the fund manager's capabilities, including his administrative competence. So the FSA's starting point – possibly unlike the starting point of some regulators or finance ministries – is not one that regards hedge funds first of all as a threat.

Hedge funds have been a significant item on the FSA agenda for some time now. Hedge fund managers authorised by the FSA manage investment portfolios worth about $300 billion (source EuroHedge March 2006 and other market data), representing over three quarters of hedge fund assets managed by European-based firms, and around 20% of global hedge fund assets. We are conscious that the international hedge fund community has the resources and the technology to be portable. We are committed to playing our part in ensuring the UK remains an attractive and well-regulated jurisdiction for hedge fund managers.

I see from AsiaHedge's own estimates that the industry is developing rapidly in Asia, and recent estimates put the figure of Assets Under Management in the neighbourhood of $126 billion. Some $30bn of this is managed in Australia, $22bn in Japan and $20bn in Hong Kong. Some $20bn is managed by UK managers and $28bn from the US, so Asia is in some respects the most diverse and global hedge fund sector. These numbers need updating, however. The SFC just yesterday published its very interesting report on hedge funds in Hong Kong. This shows a total of $33.5billion hedge funds under management in Hong Kong, a whopping 268% increase in just two years. Further evidence of the potential for the Asian market to grow significantly.

I want to cover three main issues with you today:

1. First, from a regulatory point of view, what are the key risks posed by hedge funds?
2. Second, what is the appropriate regulatory response to these risks?
3. And third, what is the approach being taken by the International Organisation of Securities Commissions to hedge funds, focusing in particular on its work on valuation policies and pricing procedures for hedge fund portfolios.

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From a regulatory perspective, what are the key risks posed by hedge funds?

Before turning to the risks that are particular to hedge funds and hedge fund managers, it is worth stressing that the FSA believes firmly that a regulator should only intervene in markets where the market is failing to deliver acceptable outcomes, and where the costs of intervention are justified by the benefits to be delivered by regulation. Moreover, we are not a regulator who considers it sensible or desirable to deliver a regulatory regime that guarantees that failures will never occur. A non-zero failure regime of the sort we operate accepts that firms will from time to time fail. While we aim to minimise the impact of failures which arise from regulatory breaches, we must accept that firms will make errors of business judgement, timing, or strategy or simply fail to measure up to the competition. In any vibrant and successful marketplace some businesses must fail, and this reality helps drive standards higher for those who succeed.

The Amaranth case is in some respects an interesting example of what I mean, and I digress for just a moment longer. There are inquiries underway and it is not possible to comment definitively, but there are aspects of this collapse that suggest that the overall regulatory framework did operate in an effective manner. The losses were catastrophic for the firm and sudden, but the overall impact on the market relatively insignificant. The prime brokers involved appear all to have had more than adequate collateral, and the positions of Amarath appear to have been liquidated or transferred without undue disruption to trading in the sector or its underlying physical markets. Judging from the information available to investors before the collapse, there may be interesting questions for fund of hedge fund managers and other investors in the fund to ask themselves about whether the collapse could have been foreseen, so there may be lessons to be learned about due diligence performed by hedge fund investors.

But no one should expect that hedge funds will never lose money or forget that they indeed may from time to time disappear. This is part of the risk/reward framework that underlies all financial markets.

Let me return then to the question of what the FSA considers are the key regulatory risks arising in respect of hedge funds and those who manage and provide services to them. I am speaking therefore of risks that arise to our regulatory objectives of proportionate investor protection and maintenance of market confidence. Once we have identified the key risks, we must determine the likelihood of them crystallising, in order to decide whether there are any proportionate mitigating actions that we or indeed others might be best placed to take.

So, what are the key risks? We see six:

1. Serious market disruption and erosion of confidence - The failure or significant distress of a large and highly exposed hedge fund – or, with greater probability, of a cluster of medium sized hedge funds with significant and concentrated exposures – could cause serious market disruption. It could also erode confidence in the financial strength of other hedge funds or of firms that are counterparties to hedge funds.
2. Market abuse / insider trading and manipulation – As we have said, we believe some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation. In addition, given their payment of significant commissions and their close relations with counterparties, they may create incentives for others to commit market abuse. We are supporting and testing these assertions by devising metrics to measure the incidence of unusual price movements.
3. Control and Operational issues - The recent rapid growth of the sector has been challenging for some hedge fund managers, with problems such as late trade confirmations, non-notified trade assignments and novations adding significantly to market-wide operational and credit risk levels.
4. Preferential treatment of investors – Some hedge funds are issuing undisclosed side letters which offer enhanced liquidity and other preferential benefits to selected investors, to the potential detriment of other investors in the fund.
5. Retailisation – The increasing penetration of the retail market by hedge fund investment techniques (referred to here as ‘retailisation’) poses the risk that unsophisticated retail consumers may not understand, and firms may not adequately manage the different risk characteristics of these funds and products. The examples of these new products in the UK and elsewhere are myriad - structured products linked to the performance of hedge fund indices, listed funds of hedge funds, funds of hedge funds with low investment minimums being offered from other European jurisdictions over the internet, and even the new UCITS III funds, which have many of the investment characteristics of hedge funds. I recall the surprise expressed by my colleagues at the SFC in Hong Kong when the first UCITS III funds began to appear in Hong Kong – they immediately recognised that these were quite different in character from the old UCITS funds.
6. Mis-valuation of complex illiquid instruments/fraud - Conflicts of interest arise when managers provide valuations of complex, illiquid instruments to administrators or indeed do so in the context as is often the case in the US, of a self-administered fund. Where performance has been poor, the pressure on managers to provide overstated valuations is greatest.

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If these are the principal risks, what then is the appropriate response for a regulator to them?

Firstly, I must emphasise the FSA is not seeking to authorise and regulate the funds themselves, which at present are located outside our jurisdiction. Our approach is to mitigate the risks through our existing authority over hedge fund managers and the broker/dealers who provide prime brokerage services to the funds. We do not consider that the assertion of extra-territorial jurisdiction is a necessary or desirable regulatory intervention in this market.

With this in mind, the FSA set up a centre of hedge fund expertise in October 2005. A priority of this team has been to enhance our oversight of 31 of the largest hedge fund managers in the UK (accounting for 50% of assets managed). These managers have a dedicated supervisor in regular contact with the firms and undertaking periodic risk assessments to develop individual risk mitigation plans with them. Lower impact firms are subject to baseline monitoring through regulatory returns and other types of alerts and market intelligence. The centre of expertise advises and where relevant takes the lead on the FSA response to any hedge fund cases. Furthermore, it undertakes thematic supervision, covering a wide range of entities that have hedge fund mandates irrespective of where within the FSA that group or firm is primarily supervised – the approach is designed to address the risks posed to our objectives by the industry as a whole.

That's how we have organised our resources, but now let me deal with our response to the specific risks to our objectives I outlined earlier.

1) Market disruption/systemic issues

In 2004, we established a regular six monthly survey on the exposures to hedge funds of the main London based banks that provide prime brokerage services. The aim of this survey is to enhance our understanding of prime brokerage and to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives. The survey targets the largest Prime Brokers (currently 15 firms) with 2 main data requests; the first looks at their credit exposures to hedge funds, the second focuses on the prime broker business. The quantitative benefits of the survey have worked in tandem with qualitative support; it has advanced supervisory discourse with firms, particularly those with large risk exposures, and encouraged the improvement of risk management systems in the prime brokers themselves.

We are conscious of the importance to hedge fund managers of a small number of very large prime brokers, who provide both financial gearing and operational support to the hedge fund managers. These prime brokers are institutions with which we at the FSA already have a close regulatory relationship, and we have used this to develop a much improved understanding of the position of these banks vis-à-vis hedge funds. So what are the headline findings thus far? Our April 2006 survey showed:

• Assets under management had grown, on an equity basis, by 29% per cent to $494 billion;
• Aggregate average leverage had grown slightly from to 2.25 to 2.39;
• Two prime brokers continued to account for just over half the sector's total exposure to hedge funds;
• Average excess collateral remains unchanged at 100 per cent;
• No fund with major exposures comparable to LTCM has been identified. Generally, the funds' gearing was significantly lower than LTCM, which was leveraged at 25:1 until early 1998, and 50:1 by the time of its collapse. Present leverage on average as revealed by our survey is 2.4:1. The highest gearing of any fund was 15:1
• We found that exposures of the prime brokers to the hedge funds were both limited in absolute amount and relative to capital, and were in general fully collateralised, as was evident as noted in the Amaranth collapse.

A word about the limitations of this survey. With two exceptions, our information covers only exposures booked in London, so we do not have and do not purport to have the total global picture in respect of these prime brokers or indeed of any underlying hedge fund. Nonetheless, we consider that this information, which does cover a substantial percentage of the global market, is a good indicator of the present position. We are also discussing with the prime brokers and other regulators whether, and if so how, this voluntary survey might be extended internationally.

2) Market Integrity

Our focus on market integrity has two strands. Firstly, seeking to deter abuse. Credible deterrence has four key components – pro-active surveillance of likely 'hot spots,' a modern transaction analysis system, industry cooperation to ensure a steady flow of information, and an effective enforcement programme. It is worth mentioning that we have been devoting significant supervisory efforts to enhancing managers' systems and procedures for dealing with price sensitive information. We have been active in encouraging an improvement of the hedge fund managers’ procedures in this area. We have also not hesitated to take enforcement action where warranted and have identified market abuse as an enforcement priority for the organisation going forward.

3) A co-ordinated global approach to reducing credit derivatives backlogs

We, together with regulators in other major financial centres - notably the US Federal Reserve and the SEC - became very concerned about significant trade confirmation backlogs in the credit derivative markets last year. In assessing this risk, we became aware that the assignment of trades by hedge funds, without prior approval or even notification of their counterparty, was significantly contributing to this backlog. Our response has been to work as a group to set targets and encourage the banks to improve. This approach has proved effective, with very significant reductions in backlogs already achieved, and more still on the way.

4) Transparency/ side letters

We made clear in our policy statement on hedge fund issues that a failure by a UK based hedge fund manager to make adequate disclosures of material side letters would amount to a breach of Principle 1 of our Principles for Businesses. This is one of our core principles, and states that a firm must conduct its business with integrity. As a minimum, we would expect acceptable market practice to be for managers to ensure that all investors are informed when a material side letter is granted. AIMA has recently published industry guidance on the disclosure of side letters. We have reviewed the guidance and confirmed that we will take it into account when exercising our regulatory functions, although this cannot affect the rights of third parties. In summary, firms will be required to disclose the existence of side letters which contain “material terms”, and the nature of such terms, where the firm is a party to the side letters. Material Terms focus essentially on granting more favourable treatment than other holders of the same class of share or interest and thereby conferring an advantage in respect of redemption or the right to redeem. We will be conducting some thematic work to test the market’s response to these standards in the near future.

5) Retailisation

We published a discussion paper last year on the possibility of opening the UK retail market to a wider range of alternative investment products. We have decided to consult on the creation of an on-shore fund of hedge funds and other unauthorised funds regime. Given the increasing penetration of the UK retail market by alternative investment vehicles, it seemed anomalous that there was no similar on-shore vehicle that was more widely available to the retail market, and which would benefit from some of the structural and investment protections that characterised regulated investment funds on shore. We will be publishing our consultation paper in the first quarter of the New Year.

6) Mis-valuation of complex illiquid instruments/fraud

Internationally, we have been at the forefront of work among regulators on the issue of valuations. I am chairing a sub-committee of the International Organisation of Securities Commissions, which is looking to develop a set of good practice principles for the valuation policies and pricing procedures of hedge fund portfolios. We have been given a mandate from the IOSCO Technical Committee and expect to publish our report at the annual meeting in Mumbai in April of 2007.

This is a risk that I think deserves a fuller treatment, and I turn to that now as my third major point in today’s remarks.

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What is IOSCO's approach to hedge fund valuation risks?

Valuation of the portfolio of assets of an investment fund is not a topic of unique interest to hedge funds. Regulators around the world have long sought to ensure that the net asset value of public traded funds such as mutual funds and UCITS in Europe is rigorously controlled to ensure that fair value is achieved for the underlying investors dealing in the funds.

But IOSCO decided to focus on hedge funds in particular because of a number of factors and risks that are particularly heightened in hedge funds.

First, as widely recognised, hedge funds have grown at an astonishing rate in recent years and have emerged as a very important component of global capital markets. They make a major contribution to the innovation, liquidity and efficiency of the capital markets and as such have a central place in the health and soundness of financial markets internationally.

Second, hedge funds often deal in asset classes that can be hard to price making their strategies and portfolios difficult to value. AIMA estimated that in 2004 some 20% of Hedge Fund strategies were in hard to value securities (for example distressed debt, emerging markets, fixed income arbitrage). Moreover, an investor in a fund which focuses on just one of these strategies may have a 100% exposure to hard-to-value assets.

Third, hedge funds often utilize substantial leverage in their trading, potentially magnifying the impact of a pricing mis-mark.

Fourth, the performance based remuneration of hedge fund managers, coupled with difficult-to-value assets and in some cases self-administration of the funds, can create very substantial conflicts of interest in the pricing of assets.

Fifth, in the case of some highly illiquid assets, it is virtually impossible to find a completely objective pricing source, forcing reliance upon models or observed or implied prices based upon the judgment of market participants, none of whom may be disinterested in the transaction.

Last, but by no means least, it is estimated that in 2005, valuation-related losses in hedge funds globally totalled some $1.6 billion dollars. Poor valuation controls in combination with weak internal procedures were exploited to misrepresent hedge fund values and commit fraud. This was a wake up call to industry and the regulators to the real dangers of slipshod valuation policies and pricing practices.

So what is IOSCO doing about this?

As I mentioned, I am chairing an IOSCO sub-committee that is looking to develop good practice valuation policies and pricing procedures for hedge fund managers. Unusually for IOSCO, the sub-committee includes industry representatives as contributing members of the sub-committee, working with us hand-in-hand throughout the process. They include a small number of representatives from hedge fund managers, fund of hedge fund managers, prime brokers, auditors, administrators and third party pricing providers.

The group is mandated to develop a single set of valuation principles with a reasonable level of granularity. Without giving too much away at this stage of our work, you should expect us to be focusing on the existence of robust, written policies and procedures, the effective day-to-day operation of them, the role of the hedge fund manager, the role of independent parties in producing and/or verifying prices, and adequacy of disclosure to investors, among other key issues.

Let me stress that we are not seeking to reinvent the wheel here. There is a good deal of excellent practice out in the market already. As you would expect, many institutional investors and funds of hedge funds undertake quite demanding due diligence in respect of their investments in hedge funds. We want to encourage the spread of that good practice.

In addition, international trade associations like AIMA and the Managed Funds Association in the US have already undertaken substantial work in this area and continue to do so. Moreover, academics and industry experts have published a good deal about valuation issues for illiquid assets, and we have taken that work on board as well.
Our aim is to produce a set of principles that are practical, and can be used by investors as a guide in real-life interactions with hedge fund managers, and have the added benefit of endorsement by the international regulatory community. We hope that will make a meaningful contribution to an evolving global standard for sound valuation policies and pricing procedures in the hedge fund sector.

Conclusion

In conclusion, I hope that this overview of the FSA’s approach to regulation of hedge fund managers in the UK and to the international hedge fund sector more generally has been useful for you. I would particularly ask that you look out for the IOSCO good practice principles that will be published for consultation in April of next year. We intend to give them wide publicity and the report will be on the IOSCO website. Your contributions to the continuing debate and the development of global standards will be most welcomed.

Thank you.

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