The regulator's view of hedge funds and hedge fund standards
Speech by Hector Sants, Chief Executive, FSA
Hedge 2008 Conference
22 October 2008
I am delighted to be here continuing our commitment to engage with the sector. Let me start by saying that I recognise it has been a difficult year for many hedge funds. I would also like to reiterate that FSA’s view, as I have said before, contrary to the expectations of some commentators, is that hedge funds were not the catalyst or driver of last summer’s market events that we are continuing to witness.
I want to talk today about the regulator’s view of hedge funds and hedge fund standards, including the current regulatory environment for hedge funds, the ongoing international debate over direct regulation and industry initiatives; and other regulatory risks which have been highlighted by continuing turbulent market conditions.
Before I do, I would like to make some remarks about the most recent events. The measures announced over the past few weeks to support the UK financial system are a significant and comprehensive package, which we welcome. They represent decisive action taken by the FSA, Treasury and the Bank of England to maintain financial stability. All the measures are important; together they address liquidity provision, capital, and future funding needs. As the banking supervisor we are at the forefront of ensuring banks and building societies maintain strong capital and liquidity positions.
The package is an important step in dealing with the immediate issues that we all face. Clearly, we also need to do all we can to prevent the recurrence of such extreme events and to ensure that the authorities are better equipped in the event we were again to encounter such severe difficulties.
Recognising this is a global crisis with its origins in a set of global circumstances over which a national regulators influence is limited, there are however, undoubtedly lessons we can all learn. It is clear that a number of banks, notably those that became dependent on wholesale funding, went into the crisis with business models ill-equipped to survive a stress of this severity. As I have outlined, we have introduced a Supervisory Enhancement Programme to address the issues we have identified and we have already made many of the necessary changes.
This includes continuing to foster a culture that attracts and retains quality individuals, and which encourages decisive yet considered judgments. This can only be built through time and concerted action. We are clear that we need the right people in the right jobs: the right mix of career regulators and experienced market practitioners.
The more challenging and difficult task, however, will be modernising the global regulatory framework. There is no question that this has been a global failure and that all elements of the framework, need to be looked at. We will play our role, working closely with colleagues around the world, to look again at the overall regulatory framework and the standards expected on capital, liquidity and risk management. We will be publishing a discussion paper next year to set out FSA’s views on the right global framework going forward.
An additional issue has been highlighted by the failure of Lehman’s. Resolving the issues arising from the insolvency of Lehman Brothers in respect of each individual counterparty is a complicated process for the administrator. The FSA is not responsible for this process, but nevertheless we continue to encourage speedy resolution of issues. More generally, it is the case that the administrator's obligations under insolvency law in this country and our regulatory objectives do not result in obvious synergies and we continue to work with the other tripartite authorities to identify solutions to this broader issue.
I would now like to return to the main focus of my speech today, the regulator's view of hedge funds and hedge fund standards.
Current views on the regulatory environment for Hedge Funds
The past decade has seen spectacular growth in the hedge fund industry. During this period some commentators predicted, recalling perhaps the LTCM crisis of 1998, that it would be hedge fund activities that would be the centre of the next financial crisis. This has broadly not been the case with hedge fund managers and their funds, in general, weathering the market turmoil fairly well in comparison to other sectors. However, increased volatility combined with the very tight conditions in credit markets also presents a more challenging operating environment for Managers. Brokers' and investment banks have understandably taken decisions to become more risk averse. This is not necessarily indicative of a desire to reduce exposures to the hedge fund sector per se, but their approach presents challenges for the hedge fund industry as liquidity has dried up.
We recognise that this has been a difficult year for you and we have, sadly, seen some fund failures during this period. Indeed there may well be more. We remain focussed on the potential financial stability risks from the failure of a cluster of hedge funds or the collapse of a large fund, which could have the potential to impact the wider economy. In this regard, we are now onto our ninth prime broker survey designed to gauge the risk appetites of hedge funds and prime brokers, target any outliers for further supervisory work and assess the management of counterparty exposures.
From an investor perspective, the extended period of market turmoil and associated lack of confidence has triggered a reassessment of investment horizons. Some mangers have learnt the hard way that the ability to deal efficiently with investor redemptions relies on proper alignment of fund liquidity with that of the underlying assets. Additionally, gate structures that may have been established several years ago may need to be reviewed in order to avoid generating additional redemptions from otherwise satisfied investors taking steps to avoid being 'at the back of the queue'. As funds are restructured and liquidity profiles reviewed, you will need to remain mindful of one of our key principles for businesses - firms act with integrity. Managers need to be mindful of this in their provision of liquidity to all investors in the same share class.
Hedge Fund Standards Board (HFSB)
The industry too has shown a willingness to confront regulatory concerns and during these difficult times it is pleasing to see a number of industry initiatives to raise industry standards. This includes working to ensure commonality and consensus between AIMA and the HFSB in the UK, as well as with the Managed Funds Association and the President's Working Group.
Earlier this year we welcomed the publication of the Hedge Fund Standards by the HFSB. The Standards represent a number of high level fundamental principles and cover many of the areas suggested for improvement in the Rasmussen Report to the European Parliament. FSA sees the HFSB Standards as a very constructive addition to the wider regulatory architecture. It should be noted that the FSA will take compliance with these standards into account when making supervisory judgements, although of course our focus remains on ensuring compliance by hedge fund managers with our own regulatory requirements.
And it is not only regulators who have an interest in standards of good practice but it is also of course in the hedge fund manager's commercial interests, as robust procedures and controls are likely to be attractive from the standpoint of the investor. Therefore, irrespective of jurisdiction, hedge fund managers should find these standards useful to identify relevant areas they need to consider
The other three broad areas we are focussing on in respect of hedge funds, which have been long standing risks to our objectives are: Valuations, Disclosure and Market Integrity, highlighted in our discussion paper of 3 years ago and increasingly relevant in the current climate.
Valuations
Valuations that are transparent and robust are vital to our supervisory approach. The FSA supports the IOSCO valuation principles published late last year. We regard it as good practice for managers to compare their policies, sources, models and methodology for obtaining values against these and other industry standards. Policies also need to be regularly reviewed to take account of changes in circumstances. Changes to methodologies arising from current turmoil, for instance in the use of side pockets, need to disclosed to investors. This is an important risk mitigation against investor detriment if portfolios are misvalued recognising that where performance has been poor, the pressure on managers to provide overstated valuations is greatest.
I must emphasise to senior management that the current market environment increases the risk of mis-marking frauds being perpetrated. These incidents may not only affect banks and broker-dealers, but also portfolio managers. Weak systems, inadequate valuation policies and inadequate independent challenge of price verification all increase the susceptibility of firms to this risk.
In response to this risk, in September we published a Dear Chief Executive Letter to the CEOs of banks and investment firms with large and/or complex principal trading operations. I would encourage all managers to consider how this letter might apply to their business models. We will continue to focus on valuations in our supervisory engagement.
Disclosure/Transparency: Contracts for Difference
Let me now turn to disclosure and specifically the work we have done here that will impact the sector in relation to the issue of disclosure of Contracts for Difference (CfDs) and other derivatives.
We are not against the use of CfDs, which provide valuable liquidity to the market. But we do want to, and need to, address the problems caused by their use on an undisclosed basis in ways that the disclosure rules were designed to prevent. Accordingly, in July we published a policy update setting out our decision to implement a general disclosure regime for CfD disclosure that will require the aggregation of CfDs and shares and the disclosure of those aggregated positions above the existing threshold that we have implemented in the UK of 3%. We have concluded that this approach is the best way of addressing the market failures that we have identified around access to voting rights and influence on corporate governance on an undisclosed basis.
As you would expect, this issue has drawn strong and conflicting views from across the spectrum of market participants, including issuers, institutional investors, CfD writers as well as hedge funds. We have taken all views seriously, and have been grateful for contributions to our thinking. Nevertheless, we are clear that we are doing the right thing by increasing disclosure here. We will explain in more detail in our forthcoming feedback statement the basis for this decision, and we are continuing to work with the industry to ensure that the rules to deliver this policy decision are framed in the most effective way.
Market Integrity
Turning now to market integrity. Market integrity and market stability remain, in our view, key issues from a regulatory perspective with regard to hedge funds. The continuing 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. I would like to focus on three areas in this respect: short-selling; insider dealing; and market rumours.
We have shown that we will act quickly if we consider it necessary for market integrity or financial stability reasons. Earlier this year we introduced a disclosure regime for significant short positions in the stocks of companies undertaking rights issues. Then, along with many global regulators, we introduced last month further short selling rules, in our case in a limited number of financial stocks. These measures were taken in response to our concerns that in the current turbulent market conditions, financial institutions could be targeted and subject to extreme short selling pressures, thereby creating the potential for abuse and spill-over effects to financial stability.
I would like to make it clear that we still regard short-selling as a legitimate investment technique which can contribute to market efficiency and is a genuine approach based on a view of value. But in recent extreme circumstances we considered it was contributing to disorderly markets in certain sectors. I also appreciate that the events of recent weeks and the emergency introduction of new regulatory rules on short selling in many jurisdictions will have presented a number of short-term challenges to managers’ business models, including operational and legal issues. However, I make no apologies for taking swift and decisive action to protect the fundamental integrity of our markets and to help counter further instability in the financial sector and would like to make clear we will do so again if circumstances warrant. As you will know, the measures automatically expire in January and we also committed to undertaking a review 30 days after their introduction to consider their impact and effectiveness. As part of this exercise we sought views from a number of market participants, including hedge fund managers. It will not surprise you that we have concluded we should maintain the measures and we have announced today that we are not making any significant changes to the regime. In current market conditions we consider that both the prohibition on creating new short positions in UK financial sector stocks and the disclosure requirements need to remain. We are now carrying out a full-scale review of short selling and will come forward with a paper and proposals in January. There will then be a full period of consultation and – no doubt – lively debate on the long-term framework.
The FSA's Markets and Enforcement Divisions have also been active in implementing a long term plan to tackle insider dealing. We remain committed to driving forward our key initiatives to tackle financial crime. We will continue to use all the powers at our disposal – civil, criminal and administrative – to combat market abuse and insider dealing. This is part of a concerted effort to ensure all market participants take this issue seriously. This year we have brought three criminal prosecutions for insider dealing, and anticipate there will be more to come.
We have recently undertaken thematic work on market rumours and firms' internal approaches for dealing with rumours. We included a number of hedge fund managers in this exercise but I emphasise that it is not concentrated on the sector. Market volatility and uncertainty creates a climate which provides the opportunity and incentive for false rumours to be deliberately spread and market abuse. Dealer gossip is a component of markets, but earlier in the year we were concerned about a number of factors that were potentially affecting price and market sentiment to a destabilising extent. As a result, we wrote to a number of firms asking them for their policies including details as to how these policies are communicated to staff. We have reviewed these responses and had follow-up meetings with a number of firms to discuss their policies and procedures. We will be setting out the findings, including examples of good and bad practice, in our Market Watch publication shortly.
Stress Testing
My final remarks, given ongoing turbulent market conditions relate to stress testing. The severe market conditions and related failures have emphasised the importance of ongoing stress testing and in particular testing that incorporates multiple events occurring simultaneously. For hedge fund managers, stressing scenarios should take account of the impacts of higher than expected levels of redemptions, poor fund performance, and incorporate the management of secured and unsecured funding.
We understand that stress scenarios for managers, such as a fall in the FTSE may be of less relevance in terms of stress testing than for other types of financial firms, although this will obviously depend on strategy. Managers however should be planning in the event of a sudden fall in funds under management and key man risks, as well as the impact of forced liquidations. We will also look to see the interactions between stressed events such as poor performance and a significant reputation or operational risk event. We believe that stress testing should serve as a useful trigger for senior management to consider remedial and mitigating action.
Concluding remarks
It has been a difficult time for all of us and there are undoubtedly important changes which the industry- and those who regulate it- need to make. There are no easy answers and I hope we, and you, will develop solutions to the failures arising from the turmoil which continues to unfold. There is a lot of pressure for more regulation at the moment, given the recent events, however, you can be assured, we intend to stick to our guiding principles of proportionality, and outcome-focused regulation.
Regardless of the current climate and all that has happened we still believe the sector is positive for capital markets, with the community as a whole continuing to provide liquidity to a market in which it has been severely lacking. Despite the difficulties and current challenges, there are opportunities and reasons for the sector to remain positive. We hope that the UK remains an attractive location for managers to operate in and managers continue to be successful market participants.