DP05/4 - HEDGE FUNDS: A DISCUSSION OF RISK AND REGULATORY ENGAGEMENT ABI RESPONSE TO FSA DISCUSSION PAPER INTRODUCTION 1.1 In June 2005 the FSA published a discussion paper on the impact of hedge funds on the UK s financial markets, identifying the risks inherent in the sector and seeking appropriate regulatory responses. 1.2 This paper is the response of the Association of British Insurers whose 400 Members as managers of life and general insurance funds have some 1,200 billion of funds under management including some 300 billion in the equity securities of UK companies and a further 150 billion in fixed interest securities of UK issuers. Insurers are responsible for investing a large proportion of the savings of the UK public including the funds providing their pensions. Our Members therefore have a strong interest in the integrity and efficiency of the financial markets and promoting the confidence of the investing public in these. GENERAL COMMENTS 2.1 We welcome the FSA s recognition of the importance of this subject and preparedness to pursue appropriate regulatory solutions. The hedge fund industry is now an established player in the markets though it is less easy to characterise it as a mature sub-sector of the investment management industry. This relatively undeveloped nature of the hedge fund industry allied to the particular techniques employed by those funds creates significant regulatory challenges. Developing approaches to dealing with new techniques should not be confused, however, with regulatory action that is required because of activity that is unethical or illegal regardless of the type of fund or market participant that perpetrates it. In particular, the FSA already has powers to pursue and deal with market abuse. These powers should be used. 2.2 ABI members, who are constituents of what may be termed the mainstream fund management sector, recognise the legitimacy of the hedge fund sector and believe that its existence contributes to liquidity provision, price formation and therefore improved efficiency of markets from which all market users benefit. It is also right that investors with
the requisite knowledge and understanding should have the choice as to with what type of fund manager and fund to place their assets. What, however, would not be reasonable would be to require traditional mainstream managers to comply with a comparatively large burden of regulatory requirements and transparency obligations with all the cost implications and restrictions on freedom of movement whilst leaving hedge funds in a largely unregulated environment. 2.3 It is important that there should be, as far as practicable, a level playing field. A relatively light touch regulatory approach applied on a comparable and consistent basis would seem to be the most sensible approach to achieving acceptance of regulatory standards whilst nurturing confidence in the integrity of the markets. 2.4 One aspect of transparency where improvements should be sought relate to disclosure of substantial interests in shares where the Companies Act definition has fallen well behind developments in market practice, notably as regards the use of options and related derivatives, the taking of short positions and the acquisition of holdings in the form of contracts for differences. There is a strong case for requiring comprehensive disclosure of economic interests in shares. It is certainly not reasonable to afford almost blanket exemptions from disclosure requirements for the most active and short-term investors. 2.5 It would also be unreasonable to exempt hedge funds from any requirements that might be introduced on mainstream institutional investors to publish their voting in company shares. Indeed, given the potential impact of hedge funds ability and willingness to use their voting weight to influence key corporate actions the case for transparency in the public interest over the impact of hedge funds is rather more evident. 2.6 Investor protection should be a further important objective for the FSA. Those who choose to place money in hedge funds need to recognise the risks involved but they should not be exposed to unacceptable practices that are in the nature of unequal treatment of investors. Issues such as valuation methodology and the existence of, and disclosure requirements in respect of, side agreements need to be tackled. 2.7 With increased flexibility at the UCITS 3 level likely to lead to funds with exposure to hedge fund techniques being more accessible to the investing public, the need for appropriate regulatory oversight increases further in importance. 2
SPECIFIC COMMENTS Q1 Are the risks to our statutory objectives outlined in this paper the correct ones? These risks include: serious market disruption; an erosion of confidence in the financial strength of hedge funds and/or their counterparties; a significant liquidity mismatch leading to enforced asset disposals and disorderly markets; insufficient information to inform regulatory action; significant control, operational and potentially credit risks; weaknesses in risk management; ill-informed investment decisions and detriment to market confidence as a consequence of valuation weaknesses; market abuse by hedge funds or their counterparties; fraud; money laundering; and conflicts of interest. The lengthy list of key potential risks identified by the FSA reflects a considerable breadth of concerns over the impact of hedge funds. These need to be tackled. However, for this to be done effectively will require a significant level of resource allocation. We therefore call upon the FSA to allocate appropriate resources to the task. We agree that the FSA should pursue its planned additional risk mitigation actions in addition to those it currently undertakes. The potential additional risk mitigation actions on which industry views are being sought, appear also to have merit, in particular distinguishing prime brokers more clearly and encouraging improvements in hedge fund valuations. Distinguishing hedge fund managers more clearly from other types of discretionary investment managers/advisers for the purposes of regulatory oversight, may be desirable though the definition of hedge fund is clearly problematic. More importantly, we wish to emphasise the concern of conventional investment mangers at the need to ensure a level playing field between hedge funds and others. It would be quite wrong for hedge funds to enjoy a laxer regulatory framework than applies to investment managers of traditional type pursuing more conventional strategies. This is particular so in respect of illegal activity such as market abuse fraud and money laundering where FSA already has the responsibility to deal with such abuses irrespective of the type of manager involved. Cooperation with regulators in other jurisdictions is an important dimension. There is little point, in a sector where capital will be largely unconstrained by the existence of international boundaries, in placing obstacles to the industry in the UK as this is likely to drive fund management activities into jurisdictions with lax controls. This will be of no benefit to the UK financial services sector. Neither will it be in anyway beneficial as regards concerns at the impact of hedge funds on the UK s financial markets which would be likely to continue to a similar extent regardless of the jurisdiction where the fund manager is located. 3
Q2 In addition to the FSF and Joint Forum initiatives, are there any global or European regulatory initiatives that could helpfully raise standards in the hedge fund sectors? We have no specific suggestion to make but would emphasise the importance of international initiatives. Q3 Recognising the importance of stress testing as a risk management tool, do you believe that it is sufficiently embedded within the hedge fund sector and should the FSA take any steps to further encourage such practice? Stress testing is clearly a vital measure of potential risk in any situation where liabilities exist, whether outside the fund which are notionally being matched by assets held within the fund, or within the fund itself as is the case with many core hedge fund techniques such as shorting. Q4 Should the FSA make undertaking hedge fund management a notifiable event under the Handbook or are other alternatives for differentiating such firms preferable, such as requiring them to obtain a specific permission from the FSA before undertaking such activity? Are the investment techniques typically employed by hedge fund managers (such as short selling, using derivatives for investment purposes and the use of economic and instrument leverage), and not issues of legal structure, the optimal characteristics on which to base any definition? We agree that the investment techniques typically employed by hedge fund managers represent a better conceptual basis for identifying hedge fund activity and managers since such activity can be carried out within funds of widely varying legal structure. Indeed, hedge funds are, increasingly, to be seen not as a separate asset class. There is also likely to be continuing convergence between hedge fund activity and the investment activity of traditional managers. These funds may be located within the same investment house making the differentiation even less meaningful. Care would need to be taken, however, in drawing the boundaries so as to avoid inclusion of more conventional types of fund within the definition of hedge fund activity merely on account of investment in particular types of instrument. For example, use of derivatives maybe for speculative purposes or as a manner of acquiring greater leverage but, equally, could be used for entirely innocent risk reduction purposes. Q5 Should we also consider differentiating prime brokers from other types of regulated entity by creating a notifiable event under the Handbook or are other alternatives for differentiating such firms preferable, such as requiring them to obtain a specific permission from the FSA before undertaking such activity? 4
Identification of prime brokers seems to us to be equally important an objective as identifying hedge funds themselves. It is quite possible that risks to market integrity and stability will be more apparent through a piecing together of information from prime brokers than it would from analysing and interpreting data from hedge funds. Using data from both sources seems the best approach to gaining a proper perspective on hedge fund activity. Q6 Recognising that, in assessing potential new regulatory initiatives, the FSA will take into account the regulatory burden imposed on firms and its effect on the competitive position of the UK, what are your views on the optimal scope of enhanced ongoing supervision (focused on market issues) of those hedge fund managers who manage funds with a significant market impact and the methodology for identifying such firms? Increased regulatory oversight should be targeted towards those funds and techniques that have the potential for greatest market impact. Q7 Recognising that the FSA would take into account the costs and benefits of additional data collection, do you have any suggestions about the optimal data set to be collected from hedge fund managers and could you indicate the likely costs involved in its production? We have no particular suggestion to make. The FSA is right, however, to be seeking to identify the optimal data set. Collection of a large quantity of data is unlikely to be helpful. The FSA should critically examine the suggestions that are made, by hedge funds and others, to establish what data will best contribute to gaining an understanding. Q8 Should the FSA encourage industry initiatives to improve investor due diligence and best practice as it relates to disclosure? Are there any alternative regulatory actions that should be pursued in this area, for example would you consider it helpful to receive FSA guidance in relation to disclosure, particularly in relation to side letters and managed accounts? Industry initiatives to address legitimate areas of concern would be a welcome development not least because of the difficulty in enforcing regulatory solutions in this area. Nevertheless, we do not believe this to be a complete substitute for appropriate rules. Fair treatment of investors and disclosure of relevant matters such as side letters seem to us to be fundamental requirements. Q9 Do you believe that regulatory action is required with respect to hedge fund valuation? If so, should this aim to stimulate voluntary industry improvements or be more rules based? Should the FSA seek to encourage improvements purely in a domestic context or would 5
international initiatives be more effective? Are there any specific forms of regulatory action that you would recommend? Ensuring that hedge funds are valued on an appropriate basis that achieves accuracy and fairness within the constraints of managing the costs of the process to an appropriate degree and avoiding the pursuit of spurious accuracy should be a fundamental regulatory objective. There would certainly be merit, though, in also aiming to encourage voluntary industry initiatives from within the industry in the UK. This could help the UK s hedge fund sector to be at the forefront of improving standards globally. There will however be limits on how far in front of best practice the UK hedge fund industry can be in contributing to a raising of standards that will in practice be followed globally. Q10 Should the FSA and/or international regulatory bodies encourage the development of a hedge fund code of conduct? What would be the optimal method for facilitating such a development? Are there any particular risks in relation to which such a code could obviate the need for regulatory action? The development of an international hedge fund code of conduct would have merit. However, we are somewhat concerned at whether regulatory priorities in the USA would be sufficiently aligned to make a comprehensive code which correctly identified key objectives and priorities, an achievable proposition. We therefore encourage the FSA to pursue international co-operation in ways that appear most fruitful whilst recognising the possible limitations. On balance we would encourage priority to be given to multilateral approaches, perhaps via IOSCO, rather than bilateral initiatives or those which will be limited in geographical scope as would be purely EU-scope initiatives. 4/11/05 m:\mmck\response\fsadp05hedgefunds 6