Hedge Funds - Lessons from the recent market turmoil, a supervisor's perspective
Speech by Hector Sants, Chief Executive, FSA
EDHEC/International Herald Tribune/CNBC Alternative investments day
20 November 2007
Thank you for the invitation to deliver this keynote address. I am grateful for the opportunity to present to such a distinguished panel. My remarks will address the issue of whether recent market events tell us anything new that should lead us to alter our supervisory approach to hedge funds.
Before making some observations to this question, may I make the usual caveat that 'Hedge Funds' are a loose term covering a variety of innovative techniques, many of which are also employed by investment banks. However, I think we all recognise the underlying investment techniques we are referring to, such as use of leverage, use of derivatives, a focus on absolute return and performance linked compensation. These characteristics cover a universe of some 450 managers in the UK, managing 80% of Europe's $450bn of hedge fund assets.
Returning, therefore, to the central question as to lessons learned and the theme of "Striking the right balance between financial innovation and supervision", I would start on an optimistic note. FSA's view, which may be contrary to the expectations of some commentators, is that hedge funds were not the catalyst or the drivers of the summer's events and their subsequent behaviour was broadly in line with the assumptions which underpin our regulatory approach. I would therefore say my central message for today is that the FSA remains broadly content with its approach to the regulation of hedge funds and that recent events, in our view, support rather than detract from the overall philosophy of principles and outcome focussed regulation, which seeks to foster innovation and competition.
In particular I believe from the supervisory perspective, the recent events surrounding Northern Rock reinforce rather than contradict the need to focus on the outcomes and consequences of management actions rather than just on the compliance of the actions with a set of rules. We are not operating a 'no fail regulatory regime'. We recognise that a successful financial market place requires innovation and competition. In turn, that means there will be failures. But a principles based regime, in our view, provides the best chance of achieving the requisite balance between the benefits and risks of innovation.
So against that background, for the purposes of facilitating a discussion, let me briefly remind you of our approach to hedge fund regulation. May I start by addressing a common misconception that the industry is unregulated by the FSA. This is incorrect as we do regulate the managers within the UK.
It is, of course, the case that the funds themselves are overwhelmingly located in offshore jurisdictions, where the tax systems are most advantageous. However, given the individuals running the funds are based in the regulated entities in the UK, we believe we do have sufficient regulatory powers to have an effective regime. This regime is the same for these managers as it is for the rest of the financial services community.
Hedge Funds and regulation
As an aside, can I point out that we do not agree with the assertion that our regime is 'light touch', it is risk based and proportionate. We align our resources and regulatory interventions with the perceived risk. As I have said, however, we are not a 'no fail regime'. Our role is not to prevent sophisticated investors from losing money. We do seek to ensure the funds are well managed in terms of systems and controls. We do seek to deter and enforce against poor market behaviour. We do seek to ensure that the actions of funds do not adversely impact financial stability.
Financial Stability
Turning first to financial stability. As I imagine you know, our regulatory philosophy is to ensure that the hedge funds' interaction with the large banks, which are the central transmission mechanism for financial stability, is orderly and controlled. Hedge funds relationships with the banks are principally in this context via the prime brokerage relationship. Thus, in addition to our normal supervisory relationship with the banks, we have, as you may know, introduced a six monthly survey of prime brokers' hedge fund exposures.
This survey examines the prime brokerage exposures and counterparty credit exposures of the 15 institutions which have the largest exposure to hedge funds. We look at balance sheet leverage, which we are aware does not reflect OTC derivatives, and embedded product leverage, which will also differ according to the strategy pursued by the hedge fund. In addition to this, the survey covers potential exposure measure, excess collateral and unsecured exposures.
This helps us to gauge the risk appetite of both the hedge fund and prime brokers covered by the survey, to target any outliers for further supervisory work, to identify hedge funds of growing importance, and to assess the ability of the dealers to manage their counterparty exposures.
We recognise that a six monthly survey has limits as a regulatory tool and indeed some moral hazard. However, overall, our experience suggests it is a useful addition to our tool kit. It has both increased our information and encouraged the participants to focus on the risks inherent in the prime brokerage relationship. Notwithstanding my observation about the central issue being whether or not the failure of a hedge fund would destabilise the core transmission mechanism and create a shock to the financial system, rather than concerns about single firm failure, we nevertheless recognise that larger hedge funds may introduce risks that smaller firms do not. We therefore have a relationship management team for the 35 largest hedge fund managers. This team considers issues such as transaction volumes, frequency of turnover and potential for concentration in less liquid products as part of our specific risk assessment for the managers of such funds.
There is also more detailed supervision of controls, including arrangements for managing conflicts of interest and compliance. Each manager has a specific supervisory contact in our Alternative Investments Team with whom an open and constant dialogue is available. These firms manage around 50% of the funds under management in the UK, and it is entirely consistent with our risk based approach that we devote more intensive regulatory attention to them. I consider the success of these relationships to be a real strength of the FSA, and an embodiment of the principles based agenda.
The remainder of the hedge fund managers in the UK are supervised like any other small wholesale firm, through a series of reactive and proactive thematic projects, firm visits and through reviews of regulatory and other data. As I recently announced, the FSA is increasing its resources devoted to the smaller firms that we supervise to provide a better service, and this applies equally to hedge fund managers. We believe that these firms, with lower volumes of assets under management, are generally not large enough to have a significant systemic impact, although there may be issues to manage where they hold concentrated positions in specific thinly traded securities.
In summary I believe that this two-pronged approach, monitoring the activities of the fund managers themselves and also the transmission mechanism to the prime brokers, provides us with an appropriate means of discharging our systemic risk agenda.
Market abuse and market integrity
Turning now to market integrity. Market integrity and market stability are, in our view, the key issues from a regulatory perspective with regard to hedge funds. The recent market volatility and market uncertainty unfortunately creates a climate which provides the opportunity and incentive for rumours and market abuse. Hedge fund managers should, as must all major market participants, shoulder their share of responsibility in seeking to ensure orderly market behaviour in these difficult times, and I would take the opportunity to reiterate this message. More generally the reduction in market abuse remains an FSA priority which we are vigorously tackling.
There are various strands to this work. Firstly, we continue to invest in new infrastructure with regard to transaction analysis. Secondly we have increased our supervisory engagement, particularly with regard to thematic visits and we have also made clear our intention to increase our sanctions. This intention covers both increased fines and our use of criminal powers where appropriate. We want to ensure those market participants who wish to work with us to improve market quality are encouraged to do so whilst those who do not believe our deterrence to be credible.
A word here on a particular issue for market quality, namely the disclosure of contracts for difference and other derivative instruments. In general we regard CfDs as a useful market tool and do not seek to constrain their proper use. However, we recognise the concern that some of these positions are used as a way of circumventing proper disclosure obligations. We have therefore, in our recent CP, set out some proposals to increase transparency and we welcome the industry's feedback on this. The essence of the proposal is to ensure full disclosure of voting rights regardless of whether obtained through shares or CfDs and to consider a limited high threshold of disclosure for economic rights.
Systems and controls
I have touched on market stability and quality, a word now on systems and controls. Again, I believe recent market events have underpinned our approach in this area. Our emphasis has been on ensuring good risk management systems, effective stress testing and credible valuations. Undeniably, recent events strengthened the case for ensuring the industry has effective risk scenario planning and stress testing. I believe the Northern Rock experience is of direct relevance to this observation. I would also highlight in this area of controls the an initiative led by the FSA in IOSCO on valuations. IOSCO has now published their final version of "Principles for the valuation of Hedge Fund Portfolios". This piece of work will help reinforce the importance of maintaining robust valuation portfolios and pricing procedures applied in a consistent manner.
Financial Accounting Standard 157, 'Fair Value Measurement' published this month has also highlighted the importance of obtaining observable market prices from an independent source. That source is often the leading price making banks, especially for products which trade on an OTC basis.
A word at this point, if I may, about the recent industry-wide initiative. In response to the recommendations of the Financial Stability Forum, a working group of hedge fund managers was formed under the chairmanship of Sir Andrew Large. The group focussed on risk management, valuation and disclosure requirements for funds. Although the working group has no formal regulatory status, we believe it is the sort of industry-led initiative that the FSF had in mind in recommending the global hedge fund industry should review and enhance existing practices. We are pleased that UK managers have taken this initiative to demonstrate to their critics that the sector is alive to areas to where it needs to improve, and committed to constant improvement in its practices. It is, however, important that such an initiative, if it is to work, receives general industry support and is seen to be adding to the existing code of practices.
Retail
Having discussed the main regulatory concerns of the FSA with regard to hedge funds themselves, a word on consumer protection.
Hedge funds require less consideration with regard to consumer protection than many financial institutions for the simple reason that they are currently not a product for retail consumers. Hedge fund managers are prohibited from marketing their funds to UK retail consumers, and most have a minimum entry requirement, generally well over £100,000.
Sophisticated individuals and institutions should be expected to make their own decisions with far less protection than would be appropriate in most retail markets. Participants are free to negotiate their own conditions with regard to fees, lock-ins, information, strategies, and though there is a role for the FSA in encouraging greater transparency from hedge fund managers, this is largely a commercial relationship.
However, our work in the past year on the subject of side letters is one example where we felt that investors were not being given sufficient opportunity to assess the true level of risk in their investment. We have made clear that where it is essential to offer preferential treatments conferred in side letters, that the existence of these letters at the very least should be disclosed to all investors, so that all are aware of their positions. We have been encouraged by the commitment of UK hedge fund managers to address this issue, and have seen a reduction in the usage of such terms- and an increase in openness where they remain.
This 'sophisticated investor' approach has been extremely successful in protecting retail consumers from the risks introduced by hedge fund investment techniques. Retail customers have only been able to access hedge funds indirectly, through institutional investors, e.g. pension funds, or since 2003, through Non-UCITS Retail Scheme structures.
However, although retail investors have been protected by this, they have also been denied direct access to the many beneficial elements of hedge funds; their strong returns, portfolio diversification, and investment products suitable for different risk attitudes. Though there are still significant concerns that the market remains too opaque and complex for retail participants to invest directly, there is evidence to suggest that this may be improving as the market matures. Finally, there are new ways for retail customers to increase their exposures to hedge funds; through newly listed vehicles, or via the internet from a jurisdiction where domestic retail investment is permitted. We believe that these customers would be better served if they were able to invest in a scheme which had been approved by the FSA, given the protections these offer.
Consequently, in Consultation Paper 07/06, we proposed permitting retail access to Funds of Alternative Investment Funds, which would bring the UK into line with several other European regimes. The proposed products would ensure an appropriate level of consumer protection by introducing a professional manager between the consumer and the underlying funds. The manager would be expected to exercise professional care in selecting and monitoring his portfolio of underlying hedge funds. The fund of fund concept will also provide diversification, in the same way as a more traditional fund. We have received many useful comments to the consultation and will be issuing a feedback statement early in the New Year.
Conclusion
In summary, therefore, we believe that hedge funds have proved resilient over this challenging period and that our core regulatory approach has proved robust and shall be maintained. You may well be asking "are there no lessons to be learned" and I would respond "yes there certainly are" and to provoke some discussion I will highlight the following:
Firstly, the recent crisis, whilst its genesis was in specific credit mis-pricing and mis-selling namely US sub prime it became amplified through a collapse of investor confidence which led to a liquidity crisis. Investors stopped buying even high quality paper. This crisis of confidence and subsequent liquidity problem created an unforeseen scenario for fund managers and reinforces the view that managers must ensure their stress testing seeks to model the implausible and this is a lesson for hedge fund managers and their prime brokers as much as anyone.
Secondly, although primarily a commercial matter, clearly model based funds using algorithms are designed on a limited history of back data and many may have underestimated the likelihood of such extreme events. This meant that these funds have been forced to sell the most attractive stocks where they could still find liquidity, and subsequently made losses. While investment in quantitative modelling has been a significant growth area in recent years, some managers may now be questioning the wisdom of following such strategies.
Thirdly, there is a question whether the type of circumstances we have seen, with banks hoarding cash, calls into question the way that hedge fund managers look at counterparty risk and liquidity available from prime brokers. Managers will no doubt wish to assess their lock up regimes and the approach of their prime brokers to liquidity provision and see what lessons they should learn. In general, however, our perception is that the good funds continued to receive the support they required from their brokers. This reflects well on the improvements to contingency liquidity arrangements in recent years. Recent events, I think also support the use of transparent, sensible lock up arrangements.
And finally, I would like to note that transparency and complexity is now a wider issue for hedge funds. Some of even the most sophisticated hedge fund managers were show to be over-dependent on the Credit Rating Agencies. Thus when investors lost confidence in the ratings, a sense of paralysis of decision making occurred for many of them as they have sough alternative approaches. This demonstrates that the increasing complexity of the market place and its products creates risk even when transparency is available. This issue of how to assure investors and retain confidence in quality complex instruments at times of stress is a fundamental question for regulators and the market going forward. This, of course, takes in a wider topic of off balance sheet vehicles and the question of how fit for purpose is Basel II and the current liquidity regime.
As a final aside, can I just make clear that these lessons learned comments are the ones I have chosen to highlight for discussion today in a hedge fund panel. Given current sensitivities it is perhaps just worthwhile to clarify that these are not the full list of lessons to be learned from the FSA perspective in relation to Northern Rock. That issue is a wider topic and I have already made clear that from our regulatory perspective there are various lessons here. Firstly, we will review our specific supervisory engagement with Northern Rock prior to July. I believe, as I have said, that this will reinforce the importance of us continuing to deliver our outcome based approach to regulation but the review will, I am sure, impact the way we carry out such supervision on the ground. Secondly, we, in conjunction with the Bank of England, recognise we need to accelerate the work already in progress on modernising the liquidity regime, both domestically and internationally. Finally, and I believe most importantly, we will be working with our tripartite colleagues on depositor protection and on the wider question of how we operate together. These are critical issues for the FSA, but not I think for today's discussions.
I hope you find these remarks useful in focussing the panel discussion. Many thanks for your attention.