Dan Waters, FSA Director of Retail Policy and Themes and Sector Leader, Asset Management 8 April Testimony to the European Parliament ECON: Economic and Monetary Affairs Committee Public Hearing on Hedge Funds and Private Equity Thank you very much for inviting me to speak today. I plan to address three main topics in my speech: (i) the FSA s approach to regulation of the hedge funds sector, (ii) specific comments on some of the ideas raised in the Working Paper and finally (iii) why we consider that there is currently effective and proportionate regulation of hedge funds in Europe and no need for additional, potentially intrusive intervention. The FSA s approach to regulation of the hedge funds sector The United Kingdom enjoys a complex and in some respects unique relationship with hedge funds. The hedge funds themselves are not located in our jurisdiction. For tax reasons they are located offshore, principally but not exclusively in the Cayman Islands. But the UK is a major global centre for the managers of hedge funds: there are some 450 hedge fund managers in the UK, managing 80% of Europe's $450bn (c. 290bn) of hedge fund assets. So our regulation focuses on those entities over whom we have jurisdiction: the hedge fund managers Page 1 of 12
themselves and the banks who finance and support their trading strategies and operations. Hedge funds include a very wide and flexible range of investment strategies and techniques. We treat hedge fund managers as what they are, a particular type of asset manager. Like all UK fund managers, hedge fund managers located in the UK are subject to our prudential and conduct of business regulatory requirements, which implement the relevant European directives. Our regulatory approach to hedge fund managers does not extend, however, to prescribing or secondguessing their investment strategies, or preventing those who invest in them from losing money. The vast majority of investors in hedge funds are institutional investors or sophisticated investors with access to portfolio investment advice. We expect investors of this nature to exercise a substantial degree of responsibility for their investment decisions and to bear the risks of high rewards and significant losses that can occur. Our regulatory approach is risk-based, focusing resources where we consider the greatest risks to our statutory objectives of market confidence, consumer protection and fighting financial crime. We closely oversee a group of 35 of the larger managers from within a specialist supervisory team. This team visits and performs risk-assessments on these firms. We supervise smaller hedge fund managers in the UK like any other small wholesale market firm, through a series Page 2 of 12
of reactive and proactive projects and firm visits, and through reviews of their regulatory returns and other data. We seek to ensure that hedge fund managers adopt systems and controls appropriate to the scale and nature of their business. We seek to deter and enforce against poor market behaviour. In respect of financial stability, an issue of particular concern in today s hearing, our regulatory efforts are focused less on the question of whether particular hedge funds may or may not be losing money and more on the interaction of hedge funds with the banking sector which finances their activities and which itself is central to the sound, safe and efficient operation of the financial system. We agree with the sentiments of the European Parliament report on hedge funds and financial stability (one of the three reports this committee published at the turn of the year), that the main risk resides in hedge fund failures that may bring down a bank and thereby also endanger the stability of other banks and the payment system. We therefore focus our financial stability efforts on the interaction between large banks and their hedge funds counterparties. Our banking supervision regime requires these firms to manage their counterparty risks to hedge funds arising from direct lending and derivative or other transactions. In addition to our regular supervisory work, we conduct a six monthly survey of prime brokers' hedge fund exposures which looks at the counterparty credit exposures of the 15 banking institutions which have the largest exposure to hedge funds. This helps us to Page 3 of 12
gauge the risk appetite of both the hedge funds and prime brokers covered by the survey, to target any outliers for further supervisory work, to identify hedge funds of growing importance, and to assess the ability of the banks to manage their counterparty exposures. We consider our approach to regulating hedge fund managers and managing systemic risk to be robust and appropriate. The relatively small losses experienced by banks after hedge fund failures in the current market turmoil suggest that banks are adequately managing their counterparty risks. This is consistent with another observation from the European Parliament report which I referred to a moment ago; that the banks and hedge fund investors themselves have a lot at stake in their relationships and have the resources and incentives to monitor the hedge funds, over and above any measures required by regulators. Our approach to hedge fund manager supervision, developed from our experience over the last 10 years, has benefited from engagement both with the industry and co-ordination with other international regulators. We contributed significantly to the FSF s work in 1999 on Highly Leveraged Institutions post LTCM. We first addressed in a comprehensive way the regulation of hedge funds in 2002, and have continued to develop our approach through 5 subsequent discussion papers. Naturally, we are reviewing our regime in the light of current market conditions to ensure its ongoing effectiveness and to test that market behaviour is consistent with our original assumptions. Our analysis does not suggest the need to modify Page 4 of 12
our approach in any significant way. This does not mean that we are complacent in the current tumultuous market conditions. We continue to apply our regulatory tools diligently and to expect the highest standards of risk management and market behaviour from both hedge fund managers and their regulated counterparties. Let me turn now to specific comments on some of the ideas raised in the Working Paper. Specific comments on the Working Paper I would like to offer comments on four key themes: (i) transparency and disclosure, (ii) valuations, (iii) counterparty risk management (and prime brokers) and finally, (iv) financial stability. Transparency and disclosure The Working Paper suggests a number of disclosure measures to enhance transparency. Transparency is not an end in itself, but should be pursued when it contributes to achieving important regulatory objectives including financial stability, investor protection and improved market conduct. We do not agree with the Working Paper s assertion that hedge funds operate in the shadows and that they use investment strategies, trading techniques and financial instruments that remain largely unregulated. Most hedge funds make Page 5 of 12
use of the same financial instruments as other asset managers, investment banks and other institutional investors. The vast majority of these financial instruments are either traded on regulated investment exchanges or transacted with a regulated counterparty such as an investment bank. For example, the majority of the hedge funds managed by FSA-regulated managers are equity long/short funds, which transact on regulated investment exchanges in Europe and elsewhere. We consider that regulators, investors and counterparties already receive, or can require, sufficient levels of disclosure to achieve their respective objectives. As noted above, it is through the interaction between hedge funds and banks that risk is transmitted to the wider financial markets. We therefore see a substantial amount of the important information required for managing the risks from hedge funds already residing in the highly regulated banking system. A key issue is how this information is used and I will comment on this further when I discuss counterparty risk management. The Working Paper mentions the need to disclose preferential arrangements such as side letters, which some hedge funds agree with particular clients, potentially leaving other investors disadvantaged. We strongly agree with this. We identified this risk in a 2006 feedback paper and made clear our view that failure of hedge fund managers to disclose material side letters would be a breach of our regulatory requirements. We have focused supervisory attention on this issue, Page 6 of 12
and are pleased to observe that managers are regularly making disclosure of significant clauses in side letters, consistent with industry guidance that we have supported. Valuations The Working Paper calls for hedge funds' financial instruments to be appropriately valued according to harmonised standards applicable across borders, including robust valuation procedures and an independent valuation function. We consider that significant progress has been and is being made in respect of valuation policies and practices. I was privileged to lead the IOSCO work that resulted in the publication in November last year of the IOSCO Principles for the Valuation of Hedge Fund Portfolios. The chief aim of these principles is to seek to ensure that a hedge fund s financial instruments are appropriately valued and, in particular, that these values are not distorted to the disadvantage of fund investors. We also acknowledge and welcome industry-led efforts on good practice standards for hedge funds, such as those published by the Alternative Investment Association (AIMA), the US based Managed Funds Association (MFA) and more recently by the Hedge Fund Working Group. We consider these efforts to be a constructive addition to regulatory requirements, which hedge funds and their managers can draw upon to determine the appropriate way to conduct their businesses. Page 7 of 12
In the current market turmoil, in which valuing illiquid assets has been and remains a significant challenge, it is more important than ever that robust valuation methodologies and practices are in place, carefully monitored and made transparent to investors. We recently communicated, in our role as UK Listing Authority, information reminding firms about the requirements in our listing rules to disclose price-sensitive information so that investors have the necessary information to make informed decisions. We also highlighted the importance of providing information on valuation methodology and assumptions. Counterparty risk management (and prime brokers) The effective management of counterparty risk is a key element of our regulatory regime for banks, which incorporates and implements the Capital Requirements Directive (CRD). We believe that banks currently collect sufficient information about their hedge fund counterparties to actively manage their counterparty risk. We consider that many lessons have been learned from past hedge fund failures, such as LTCM. The relatively small uncollateralized losses experienced by UK banks in connection with recent hedge funds failures illustrate this. We do not see the use of multiple prime brokers by hedge funds as an issue, so long as each firm identifies and manages their own exposure. We have seen a tightening of the terms which prime brokers offer hedge funds over the past few months in response to recent volatility, and see this as a robust reaction to Page 8 of 12
managing their own risk. We also see this behaviour being consistent with our risk mitigation efforts in respect of financial stability. On this theme, I would like to share an observation from our participation in the Senior Supervisors Group work on Risk Management Practices during the Recent Market Turbulence. We noticed that firms which avoided problems demonstrated a comprehensive approach to viewing firm-wide exposures and risk, employed a wide range of risk measures to gather comprehensive information and different perspectives on the same risk exposures and importantly, they employed more effective stress testing with more challenging use of scenario analysis. Financial Stability Let me turn now to financial stability. The FSA's view is that hedge funds are neither the catalyst nor the drivers of the current financial market turmoil. Hedge funds, like other institutional investors, have shared in the pain (and some in the profit) in financial markets resulting from serious failures in the US sub-prime mortgage market and in securitizations backed by such assets. The Working Paper questions the role of hedge funds in structured credit products and CDOs. We consider that hedge funds losses in this area are a consequence, rather than a cause, of problems which have their origin in the banking sector. While a minority of hedge funds may have been buyers of these instruments, the genesis of the current turmoil clearly lies in astonishingly inadequate mortgage Page 9 of 12
credit practices and in the perhaps not fully appreciated risks of the originate-anddistribute model for asset securitisations adopted by banks in recent years. On the more general theme of financial stability, we agree with the sentiments expressed in the two European Parliament reports on hedge funds which I have referred to already. These include statements that hedge funds increase the efficiency of financial markets in allocating capital and that they provide benefits which are not available from the traditional investment industry. We also agree with the sentiment that an appropriate level of engagement and focus on corporate governance by hedge funds, and of course other investors, is a sensible exercise of their duties as owners. Conclusion The Working Paper points out that hedge fund managers are already required to comply with European regulation such as the Market Abuse Directive (MAD) and the Transparency Directive (TD). The Paper also notes that exposures to hedge funds need to be taken into account by banks and other counterparties under the Capital Requirements Directive (CRD) and by insurers under the relevant directives. Where hedge funds are sold in an on-shore form, they need to comply with MiFID and the Prospectus Directive. We fully agree with the European Parliament report on hedge funds and financial stability, which concluded that direct regulation of hedge funds did not seem to be Page 10 of 12
appropriate and that indirect oversight of hedge fund activities through active regulation of banks (brokers and creditors) and hedge fund managers was the better approach. That paper, as well as the subsequent paper on hedge funds and transparency, also highlighted the important role of self-regulation through the various industry standards and codes which I mentioned earlier. The Working Paper poses what it describes as the following crucial question : What is the rationale in having lightly or unregulated private pools of capital such as (private equity funds and) hedge funds operating in the market alongside tightly regulated institutions such as pension funds, insurance companies, banks and others? We think that the short answer is that banks - and to a lesser extent insurance companies - are critical to the economic infrastructure and therefore to financial stability. Pension funds, representing the long term financial future of millions of relatively unsophisticated retail investors, are important enough to merit direct regulatory grip in the interest of protecting the underlying members. The evidence on hedge funds, on the other hand, is that they do not pose a systemic risk to stability; hence their regulation may be expected to differ significantly from that applied to banks. Moreover, hedge fund investors are overwhelmingly institutional or sophisticated individual investors, who are in a position to assess the risks involved and bear responsibility for their decisions, profitable or not. Page 11 of 12
We have highlighted the interaction between hedge funds and banks as the key method of transmitting risk to the financial system, and explained that this is why we focus our attention on banks and their management of counterparty risk and on the behaviour and risk management practices of authorised managers of hedge funds. We consider that this approach, coupled with strong international regulatory cooperation and robust industry self-regulatory efforts, forms the basis of an effective and proportionate regulatory response. Page 12 of 12