Hedge funds: A discussion of risk and regulatory engagement
Briefing Note BN008/2005
23 June 2005
The FSA has published a Discussion Paper (DP) "Hedge funds: A Discussion of Risk and Regulatory Engagement". The DP is the culmination of a programme of work, designed to further the FSA's understanding of the risks posed by this sector, which has included a series of visits to hedge fund managers and advisers.
The FSA believes that hedge funds and their investment strategies are an important part of the financial markets. In particular it recognises their increasingly significant role in the provision of market liquidity. It also recognises that it would not be beneficial if regulatory action in the UK caused the hedge fund industry to move to jurisdictions where there was little or no regulation.
It is, though, keen to engage the industry in a debate about the risks this sector poses and achieve a consensus on which risks are significant and do therefore merit some further regulatory engagement.
The DP does not explicitly tackle the issue of increased disclosure of contracts for difference (CFDs) positions. In an initiative the FSA welcomes, the Takeover Panel is proposing to put CFDs and other derivatives on the same footing as shares in relation to disclosure during an offer scenario. Enhanced ongoing market disclosure (i.e. outside an offer scenario) would however require legislative change which goes beyond the FSA's remit. The FSA would welcome consideration of this issue by the Government in the context of its consultation on implementing the Transparency Directive.
Key risks
The risks identified by the FSA can be summarised as follows:
- Serious market disruption and erosion of confidence as a result of 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.
- Liquidity disruption leading to disorderly markets as hedge funds make increasingly illiquid investments in particular markets and instruments whilst offering their investors the ability to withdraw their money more quickly. This could result in a significant liquidity mismatch and require hedge fund managers to dispose of assets very quickly, causing volatile and potentially disorderly markets.
- Insufficient reliable and comparable data is available to regulators which limits our ability to make informed decisions about risk and take proportionate regulatory action to mitigate that risk.
- Control issues arise as the trading (rather than management) background of many hedge fund managers, and their typical ownership structures, means that some managers do not have the right skills or incentives to create an effective control infrastructure.
- Operational risks are developing as a result of the recent rapid growth of the sector and the inability of some hedge funds' limited operational support to keep pace. This risk is currently particularly acute in relation to trade confirmations and assignments in the credit derivatives market.
- Risk management: There are particular challenges in risk managing multi-strategy portfolios and possible improvements that could be made with respect to stress testing. A developing issue for investment banks is assessing their total risk exposures from their combined trading, prime brokerage and investment relationship with hedge funds.
- Valuation weakness methodologies and processes due to skill shortages and potential conflicts of interest are creating significant potential for ill-informed investment decisions and detriment to market confidence.
- Market Abuse: Some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation and, given their payment of significant commissions and close relations with counterparties, may create incentives for others to commit market abuse.
- Fraud: Incentive structures, light regulatory oversight and weaker control environments increase the likelihood that hedge fund managers will commit fraud.
- Conflicts of interest: Hedge fund fee structures may encourage pension fund consultants to excessively encourage investment in hedge funds. These fees structures could also encourage mixed traditional/hedge fund management firms to inappropriately favour the hedge funds when placing or allocating deals.
The FSA does not currently perceive significant risks to UK retail consumers arising in the hedge funds sector because of the extremely low levels of direct retail investor participation. The risk appears however to be rising and is discussed more fully in the DP "Wider range retail investment products: consumer protection in a rapidly changing world".
Risk Mitigation
The FSA is already seeking to mitigate the risks identified in a number of ways. As a result of its recent work it is planning some further action and is seeking views from industry on a range of other actions. These are set out below.
Current risk mitigation actions:
- Frequent non-supervisory dialogue with market participants on hedge fund sector issues;
- Increased thematic reviews of hedge fund managers;
- Application of risk mitigation programmes to relationship managed firms;
- Implementation of a regular 'Hedge Funds as Counterparties' survey that gives the FSA insight into the hedge fund/prime broker relationship;
- Highlighting the importance of performing stress testing and working with the industry to enhance the current approach to stress testing; and
- Participation in international regulatory dialogue in fora such as the Financial Stability Forum and the Joint Forum.
Planned additional risk mitigation actions:
- Reorganisation of resources to create an FSA centre of hedge fund expertise within the Wholesale Markets Business Unit which will relationship manage high impact firms and lead more thematic supervision of hedge fund managers;
- Review the way we analyse the impact of hedge funds as part of the revised ARROW model, including greater consideration of market impact;
- Undertaking increased proactive surveillance with respect to issues of market conduct in the hedge fund sector, both in relation to hedge fund managers and their counterparties;
- 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; and
- Enhancing dialogue with other international regulators with respect to issues that typically arise off-shore such as in relation to valuation and anti money laundering arrangements.
Potential additional risk mitigation actions on which FSA is seeking industry views:
- Distinguishing hedge fund managers more clearly from other types of discretionary investment managers/advisors for the purposes of regulatory oversight;
- Distinguishing prime brokers, including new entrants who may be following more relaxed risk management standards in the pursuit of market share, more clearly;
- Collecting additional data, based upon existing management data, from hedge fund managers to support enhanced supervisory oversight of high impact firms and the accurate targeting of additional thematic reviews;
- Encouraging industry initiatives to improve investor due diligence and hedge fund disclosure and providing FSA guidance on appropriate disclosure standards, in particular with respect to side letters or managed accounts;
- Encouraging improvements in hedge fund valuations by, via IOSCO or domestically:
- promoting the development of administration industry codes of practice,
- encouraging legislative developments at EU level or developing domestic rules,
- stimulating the development of market solutions by, for example, investment banks,
- including valuation issues in the risk mitigation programmes of relevant authorised firms; and
- issuing health warnings about the quality and independence of some hedge fund valuations.
- Further dialogue and co-operation in an international context with a view to sharing best practice and raising standards.
Footnote
The FSA has published another DP today entitled "Wider range of retail investment products: Consumer protection in a rapidly changing world". A separate briefing note is available on this DP.
