THE IRISH FINANCIAL SERVICES REGULATORY AUTHORITY (FINANCIAL REGULATOR) RESPONSE TO THE CONSULTATION PAPER ON HEDGE FUNDS

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1 THE IRISH FINANCIAL SERVICES REGULATORY AUTHORITY (FINANCIAL REGULATOR) RESPONSE TO THE CONSULTATION PAPER ON HEDGE FUNDS The Financial Regulator welcomes the publication of the consultation paper and considers it timely to reassess the appropriateness of existing approaches to the regulation and supervision of hedge funds. By way of background I would like to mention that Irish investment funds, other than UCITS, may be authorised for sale to professional investors (PIF) or qualifying investors (QIF). Many of these funds, and QIF in particular, employ the generally observed characteristics of hedge funds in that they can short sell securities, engage in significant levels of borrowing and invest in derivatives. In the case of PIF, effective leverage is limited; however no limit applies in the case of QIF. Both PIF and QIF are subject to other supervisory requirements - for example, the requirement to appoint a trustee/custodian who has a dual responsibility in holding assets of the fund and monitoring the activities of the fund's management and requirements to publish a prospectus and periodic reports. In the case of QIF all assets of the fund can be passed to a prime broker to support financing arrangements. Scoping the issues: It is useful at the outset to try and establish the universe under review. However we may find that it is not possible to arrive at a common understanding under which hedge funds can be distinguished from other market participants. It may be that the best solution is to try achieve certain outcomes which address concerns in relation to 1

2 financial stability and investor protection. With regard to financial stability issues the debate may need to focus on market participants in general. The investment strategies carried out by hedge funds are also carried out by proprietary trading desks within banks and insurance companies. With regard to investor protection, concerns arise principally from investment in unregulated funds, particularly where these may ultimately be accessed by retail investors, for example through pension fund investments or retail funds of hedge funds. From a macro perspective, the characteristics of hedge funds outlined in the consultation paper, which refer to absolute returns, relatively high leverage arising from unconstrained investment strategies and profile of typical investors, are reasonable. However it should be recognised that there are hedge funds which do not employ leverage and there is an increasing use of hedge fund strategies by the regulated investment fund sector, including UCITS. It should also be recognised that hedge funds are either regulated 1, or and in many cases, unregulated. In most cases the hedge fund will have a legal identity, as a limited liability company or limited liability partnership. In the case of European regulated hedge funds it would be possible to impose regulatory requirements directly. In the case of unregulated hedge funds, particularly those established in third countries this is not possible and any regulatory requirements can only be applied indirectly, through European based management companies or other service providers such as prime brokers. 1 For example, hedge funds are authorised in some EU Member States although they are generally not subject to the same level of regulation as that applied to funds established for retail investors. 2

3 Ideally, any initiatives undertaken would be taken in co-operation with other jurisdictions, particularly the United States given that it is the leading location for hedge fund managers. This would not preclude specific European measures which are identified as being necessary in the European context. Systemic risks: Hedge funds and other highly leveraged investors have the ability to destabilise financial markets. Prudential authorities need further, comprehensive and harmonised information about all financial products, exposures and participants. It would not appear appropriate to focus specifically on hedge funds in relation to systemic risk issues, particularly when it may not be possible to require information directly from many of them. From both a transparency and supervisory perspective, value would be gained if market participant and product-specific information was required from European based entities. Prime brokers are an integral part of a hedge fund's operations, providing custody, clearing and most importantly financing services to the funds. Direct credit exposures of credit institutions and prime brokers to hedge funds are a channel through which hedge funds might potentially affect the health of the financial system. However, it would appear that most of the exposures to hedge funds are collateralised and the largest banks/prime brokers make extensive use of stress tests to quantify potential future credit exposures. There is also increased transparency with hedge funds increasing the flow of information to prime brokers. 3

4 Recent market difficulties have been attributed to inappropriate lending policies in general. Lending to hedge funds has not been part of this debate. Most recently hedge funds have themselves experienced difficulties because of their exposures to prime brokers. Hedge funds and their investors have now to consider the extent to which their assets are held on a proprietary basis by counterparties such as prime brokers or OTC derivative counterparties, a concern which has not arisen heretofore. Mention has been made of the difficulties experienced by hedge funds from largescale withdrawals by investors. It should be noted in this context however that typical lock up periods and deferred redemption policies commonly exercised by hedge funds might contribute to more orderly and gradual asset liquidations by this sector. Management of micro-prudential risks: Over time there has been a number of failures of hedge funds and in general these can be attributed to a either a failure to manage risk or to fraud. The common view appears to be that a significant number of hedge funds will not survive the downturn in financial markets with a substantial number expected to close. Whatever the outcome, moves by the industry to apply best practice standards in relation to the important areas of disclosure, valuation, risk management, fund governance and conduct as shareholders are to be welcomed. Unfortunately, at this time it appears that while the majority of hedge fund managers welcome self-regulatory actions they may not adopt industry standards for competitive, cost or regulatory burden reasons. Therefore, a review of the extent to which authorities can require or encourage hedge funds to adopt appropriate standards, including their adoption by unregulated hedge funds should be undertaken. For example, while it may be open for authorities to require hedge funds authorised in the European Union to comply with appropriate 4

5 standards, this type of regulatory action could result in the funds moving to an unregulated jurisdiction. It may be possible to require appropriate standards in the context of market access or indirectly through the regulation of European based hedge fund managers and prime brokers or other financing counterparties. Transparency towards investors and investor protection: The sale of hedge funds to retail investors by Irish based managers or intermediaries is subject to our statutory Consumer Protection Code or to MiFID rules. As a general principle, all relevant material information must be disclosed to investors. This type of regulatory approach could be enhanced at European level through statutory requirements to issue designated health warnings, particularly on websites and all informational material, regarding risks attached through investment in hedge funds. We and many other regulatory authorities in the European Union authorise retail funds of hedge funds. We do not believe that retail investors should be excluded from participation in the alternative investment sector but we support calls for a harmonised approach in this area. For example, minimum requirements to ensure diversification, appropriate audit standards and appropriate custodial arrangements could be applied to a harmonised product for European retail investors. Michael Deasy Senior Adviser 30 January