Regulatory Insight
Interviews with the regulators
INTERVIEWS BY STUART FIELDHOUSE
Hector Sants, Chief Executive, Financial Services Authority
Market abuse
HS: "The continuing market volatility and market uncertainty remain, in our view, key issues from a regulatory perspective with regard to hedge funds. This 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. The FSA's Markets and Enforcement Division has 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."
Responsibility of hedge funds for market crisis
HS: "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 operational environment for managers. Brokers and investment banks have understandably taken decisions to become more risk averse."
Stability risks
HS: "We recognise that this has been a difficult year for hedge funds and we have, sadly, seen some fund failures during this period. Indeed, there may well be more. We remain focused 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."
Changes to the way hedge funds operate
HS: "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."
Industry initiatives and how far they can be involved in the regulatory process
HS: "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 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 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."
(The above comments are extracts from a speech given by Hector Sants at the Hedge 2008 conference on 22 October)
Hubert Reynier, Managing Director, Regulation Policy and International Affairs Division, AMF (Autorité des Marchés Financiers)
HR: "Our main concern is about de-leveraging, and its impact on the liquidity of various market segments, especially for hedge funds. We're very concerned about its impact, both on trading levels and liquidity."
HR: "With the markets less liquid, there is also more opportunity for market manipulation, and this creates more risk for market abuse. At the moment there is still too much reliance on financial institutions to value their own positions. More needs to be done globally to reduce opportunities for insider dealing, and in this environment it is if anything, harder to access information on a real time basis. There must be more transparency in the market, and with that, the opportunity for market abuse will decline."
HR: "We are aware of the profits hedge funds have been making, and some have still been able to be very successful in the present market. Yes, they have been key market players. We have not considered them as the source of the crisis, but they have played a role in creating the current market conditions. They are suffering now because they had access to too much leverage, and the de-leveraging process seems to be having a heavy impact on them. The potential for failures is increasing dramatically."
HR: "Yes, these do exist in the hedge funds sector, but it depends on the size of the failing hedge fund, and its counterparty risk to brokers and banks. We saw a strange situation earlier this year where hedge funds were complaining about counterparty risk themselves, but we're seeing a more regular situation now. There are also systemic issues in the CDS markets. We see value in the markets providing more solid clearing and settlement facilities, and more transparency would also help: we need clearing houses to provide better statistics on prices and the volumes from the market counterparties. I think there's a lot of value in making the market more robust."
Further regulation of hedge funds
HR: "There are different views on this, particularly regarding the registration of hedge fund managers. It relates to the type of distribution they're looking for, and whether they want access to retail markets, directly or indirectly. Access to retail investors would mean they would have to be registered. If they stay within their current remit, the issue is whether we know what is going on, for example with OTC trades. We should have more access to information as regulators and there should be better surveillance of market participants overall in OTC markets."
HR: "IOSCO has been looking at ways in which hedge funds can be encouraged to better govern themselves. Our principles have been taken into consideration at the industry level, and we would like the industry to keep focusing on this. We see a lot of value in the hedge fund industry spending more time working on adhering to the standards it has published already, and perhaps funds of funds making sure hedge funds and other investment instruments comply. They should be happy that the operations and transactions of underlying managers should be safe enough."
Additional regulatory initiatives
HR: "At the IOSCO level, at the global level, we want to maintain open relations with the hedge fund industry. Various initiatives have been undertaken by regulators on short selling. There may need to be more work in the areas of governance, particularly around the transparency of major shareholdings in listed corporates and takeovers. Regulators may need to come up with widely recognised principles and standards covering this."
Short selling bans
HR: "Temporary measures have been rapidly implemented although not in such dramatic terms in France, and we expect to see regulators now working on a future, more permanent framework. I think it is relevant to also start working on this at the IOSCO level to coordinate with the US. We could see a more permanent framework, perhaps focusing on stock lending activities, being set up in France, but such initiatives should really be considered and implemented on a pan-European level at the very least."
Robert E Plaze, Associate Director for Regulation of the Division of Investment Management, Securities & Exchange Commission
RP: "Our key concern is the current debt crisis and the potential for fraud that might arise. Our enforcement staff and examination staff remain actively engaged in the oversight of the market participants, including hedge funds. Hedge fund advisers, regardless of whether they are registered as investment advisers, remain subject to the same fiduciary responsibilities as other advisers."
Systemic risk presented by hedge funds
RP: "The principal systemic risk with respect to hedge funds in our view relates principally to their counterparties. Obviously, with the markets the way they are, liquidation of large positions by hedge funds into fragile markets presents additional concerns. The SEC was not able to comment in more detail as the question of hedge fund regulation was being discussed at Congressional level and Chairman Christopher Cox is stepping down at the end of this year.
Martin Wheatley, Chairman, Hong Kong Securities & Futures Commission
Key market issues
MW: "In Hong Kong we have had a large mis-selling investigation as a result of the Lehman Brothers collapse. The bank had issued a lot of credit-linked structured products which had been sold into retail hands, allegedly inappropriately. Post the Lehman failure, these investors have suffered substantial losses, including all their capital in some instances. Broadly, it was either a function of poor implementation, or the regime is flawed. Hong Kong lawmakers have formed a sub-committee to investigate). It is a significant issue, and it is interesting that certain overseas regulatory regimes have been affected by this, and not others."
MW: "We've not seen this particularly in Hong Kong, although we are aware that in other parts of the world there has been a belief that financial stocks were being manipulated. Because of the regulatory structure here in Hong Kong, we have not seen the need for any changes in the short selling rules, despite the volatile markets. In this kind of climate, rumours simply take on more credibility."
Responsibility of hedge funds for the market crisis
MW: "Two years ago we were saying the crisis would begin with hedge funds, but instead it was the investment banks. Funds are having to deleverage quickly, in order to meet redemptions, and credit lines are being pulled. The shorting ban has rendered some strategies unviable. The current unwinding process is being driven by these factors."
Regulation of hedge funds
MW: "In Hong Kong we regulate the manager, not the fund. The manager is licensed on the basis of his competence, personnel, systems, and other factors. We always want to see segregation of assets, including a separate custody agreement. I think the current desire to regulate further is being prompted by a lack of some important parts of this jigsaw in other markets. In Hong Kong we are likely to see a requirement for greater disclosure of short positions, but whether to the market or only the SFC remains to be seen."
Industry-led initiatives
MW: "This is needed in markets where no equivalent structure is in place today. I think they are a good thing, because they address that lack of structure. They are a step in the right direction, but right now there is a danger of the regulatory structure over-reacting."
Short selling ban
MW: "This has volatility, reduced spreads, and destroyed some strategies completely, notably the convertible arbitrage market. Our system works, and we won't be knee-jerked into a political reaction."
Restrictions on stock lending
MW: "Until now people have signed custody agreements without thinking, and now they are looking into those agreements again. Naked short selling should be banned. We have never allowed it in Hong Kong, and managers should only be allowed to short sell if they can deliver the stock. If you have a ban against naked shorts, you don't get situations like the recent Volkswagen trade."
Oskar Ode, Financial Supervisor, Finansinspektionen, Sweden
OO: "It is important that funds be able to handle the valuation of assets and provide sufficient liquidity for their shareholders. This is where problems might occur, especially with funds that have hard to value assets, or with funds of funds that have funds with hard to value assets closing in their portfolio."
Likelihood of market abuse in current environment
OO: "We have received more reports of market abuse recently, but it is hard to say whether the possibility has been enhanced by the crisis."
Role of hedge funds in the crisis
OO: "From the Swedish perspective, we think this has been overhyped. Hedge funds did not cause this crisis, although it becomes more difficult to assess their role in exacerbating it."
Stability risks posed by collapse of a hedge fund
OO: "If a hedge fund collapsed with large exposure to the wrong bank, then yes, it could cause a stability problem. It's hypothetical at the moment, so I can't really say more than that. The response is based on the conditions for the Swedish market; it is difficult for us to anticipate the consequences in other countries where the structures may be different."
Changes to the way hedge funds are regulated
OO: "We consider that hedge funds in Sweden are appropriately regulated. They operate under the same type of regulations as other Swedish funds – they have to comply, even if just selling into Sweden. They could be targeting retail investors. We have some exceptions like investment limits, but disclosure and organisational requirements are the same for all funds."
Value of industry bodies in regulatory process
OO: "It is always positive when the industry takes the lead in improving the way it works and operates. Coordination with other regulators would be an additional positive, if regulation and supervision could be harmonised to create a level playing field."
Is further regulation needed?
OO: "It is still too early to say whether this will be necessary. Hedge funds in Sweden face the same regulatory set up as other Swedish funds. We check their holdings on an ad hoc basis, and they have to comply with the same disclosure regime as retail funds. Swedish regulation is based on the UCITS 3 directive, which gives hedge funds a few exceptions, for example opening less frequently for dealing."
OO: "There is no ban in Sweden, however it should be noted that it is illegal to unduly influence the price of a share. During the fall we have intensified our supervisory activities regarding short selling, stock lending and price trends including more frequent reporting. We don't see the need presently for a ban. If further restrictions are needed, one answer might be to look at stock lending activities instead."