Good morning Ladies and Gentlemen and thank you to IOSCO for inviting me to speak here today.
Hedge funds have been a significant item on our agenda for some time now. FSA authorised firms manage at least $256bn (source Eurohedge March 2006), representing over three quarters of hedge fund assets managed by European based firms and around 20% of global hedge fund assets. At the outset of these remarks may I make clear that we publicly acknowledge that hedge funds are a major source of market liquidity; they significantly enhance market efficiency and offer access to a range of investment techniques for increasing portfolio diversification. We are committed to playing our part in ensuring the UK remains an attractive location for hedge fund managers.
Today, I aim to briefly address two key issues:
- What is the appropriate engagement of a regulator with hedge funds?
- What risks do hedge funds represent for smaller (emerging economy) stock markets and how can these risks be mitigated?
1. What is the appropriate engagement of a regulator with hedge funds?
We believe that this question is best addressed from a regulatory perspective by identifying the key potential risks to our objectives; although, to be clear, "identified" does not say anything about the probability of the risk crystallising. Having identified the key risks, we can then determine whether there are any proportionate mitigating actions.
So, what are the key risks? We would see five key areas:
1. Serious market disruption and erosion of confidence
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 – could cause serious market disruption. It could also erode confidence in the financial strength of other hedge funds or of firms which are counterparties to hedge funds.
2. Market abuse / insider trading and manipulation
We believe some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation. In addition, given their payment of significant commissions and close relations with counterparties, they may create incentives for others to commit market abuse. We have supported these assertions by devising metrics to measure the incidence of unusual price movements.
3. Control and Operational issues
The recent rapid growth of the sector has been challenging for some hedge fund managers, with problems such as late trade confirmations, non-notified trade assignments and novations adding significantly to market-wide operational and credit risk levels.
4. Mis-valuation of complex illiquid instruments/fraud
Conflicts of interest arise when managers provide valuations of complex illiquid instruments to administrators, in particular where performance has been poor, the pressure on managers to provide overstated valuations is greatest.
5. Preferential treatment of investors
Some hedge funds are issuing undisclosed side letters which offer enhanced liquidity and other preferential benefits to selected investors, to the potential detriment of other investors in the fund.
What is our response to these potential risks to our objectives?
Firstly, I must emphasise the FSA is not seeking to authorise and regulate the funds themselves which are outside our jurisdiction. We believe we can mitigate the risks through our existing authority over hedge fund managers and broker/dealers who provide prime brokerage services to the funds. This I believe is a key point. Much of the debate about hedge funds raises the view that "the risk" is due to a lack of regulatory oversight. We do not subscribe to this view. We believe the issue is the complexity of risks they pose and that we cannot diminish this challenge by increases in our regulatory powers. Rather, the challenge is to use our existing powers more effectively and intelligently.
With this in mind, the FSA set up a centre of hedge fund expertise in October 2005. A priority of this team has been to enhance our oversight of 31 of the largest hedge fund managers in the UK (accounting for 50% of assets managed). These managers have a dedicated supervisor in regular contact with the firms and undertaking periodic risk assessments to develop individual risk mitigation plans with them. Lower impact firms, are subject to baseline monitoring through regulatory returns and other types of alerts. The centre of expertise advises and where relevant takes the lead on the FSA response to any hedge fund cases.
Furthermore it undertakes thematic supervision, covering a wide range of entities that have hedge fund mandates irrespective of where within the FSA that group or firm is primarily supervised – the approach is designed to address the risks, posed to our objectives by the industry as a whole.
That's how we have organised our resources, but now let me deal with our response to the specific risks to our objectives I outlined earlier.
1. Market disruption/systemic issues
In 2004, we established a regular six monthly survey on the exposures to hedge funds of the London based banks that provide prime brokerage services. The aim of this survey is to enhance our understanding of prime brokerage and to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives.
The survey targets the largest Prime Brokers (currently 15 firms) with two main data requests; the first looks at their credit exposures to hedge funds, the second focuses on the prime broker business. The quantitative benefits of the survey have worked in tandem with qualitative support; it has advanced supervisory discourse with firms, particularly those with large risk exposures and encouraged the improvement of risk management systems in the prime brokers themselves.
The FSA is also undertaking further qualitative work with the banks on collateral and margin arrangements. We recognise this approach causes moral hazard and has severe limitations in terms of the value of the content, but maintain it is a credible proportionate response.
2. Market Integrity
Our focus on market integrity has two strands. Firstly, seeking to deter abuse. We believe deterrence is preferable to enforcement. Credible deterrence has four key components – pro-active surveillance on likely 'hot spots,' a modern transaction analysis system, an effective enforcement proposition and preferably industry cooperation to ensure a steady flow of information. The second strand of our market integrity proposition is a supervisory focus on enhancing managers' systems and procedures for dealing with price sensitive information. We have been active in encouraging an improvement of the community procedures in this area.
3. A co-ordinated global approach reduces CDS backlogs
We, together with regulators in other major financial centres (notably the US Federal Reserve Bank) became very concerned about significant trade confirmation backlogs in the credit derivative markets last year. In assessing this risk we became aware that the assignment of trades by hedge funds, without prior approval or even notification of their counterparty, was significantly contributing to this backlog. Our response has been to work as a group to set targets and encourage the banks to improve. An approach, which as you know is currently working.
4. Mis-valuation of complex illiquid instruments/fraud
Internationally, we have been at the forefront of work among regulators on the issue of valuations and strongly support the work of IOSCO on the valuation issue. IOSCO SC5 has a mandate (with input from IOSCO SC3) to complete a project on hedge fund valuations by April 2007. We undertook our own valuations project which involved onsite visits to a sample of twelve hedge fund managers reviewing their systems and controls. We have presented our views on good practice to the IOSCO valuations working group. We intend to write a more formal letter to IOSCO outlining our views that we will make public in October.
5. Transparency/ side letters
We believe that failure by UK based hedge fund managers, to make adequate disclosures is a breach of Principle 1 of our Principles for Businesses (‘a firm must conduct its business with integrity’). As a minimum we would expect acceptable market practice to be for managers to ensure that all investors are informed when a material side letter is granted. We will undertake a review of a sample of firms’ practices in this area in November. We are working with our local trade body AIMA to produce examples of material and non-material side letters (e.g. special redemption rights are material but preferential fees are non-material) and possible methods of disclosure (e.g. an update in monthly news letter). AIMA are looking to publish something in September.
2. What risks do hedge funds represent for smaller (emerging economy) stock markets and how can these risks be mitigated?
One of the ways hedge funds may influence market dynamics is through the establishment of large and concentrated positions relative to the market and other market participants. Such positions can be established as part of their overall strategy. However, they may also arise inadvertently if inadequate account is taken of other market participants’ positions or if there is an unexpected contraction in liquidity after positions have been established. Such large positions may, if known or rumoured, have a paralysing effect on other market participants especially in nervous markets, or lead to significant volatility as other investors decline to participate in an asymmetrical market. Large positions can also provide hedge funds with significant information advantages in relation to other market players.
Hedge Fund investment styles can also be an important factor in determining how they can influence markets. A common approach of global macro hedge funds is to take strategic positions ahead of perceived weaknesses in economic performance. Such positioning implies that Hedge Funds may be ‘on the scene’ at time of financial crisis. Hedge Funds may add further to other sources of market momentum if they employ momentum trading. Hedge Fund positioning and momentum might under certain market conditions become self-fulfilling. We accept the risk that self-fulfilling pressures exist but we believe they are relatively low when economic fundamentals are strong, and the risk of significant asset price movements is likely to be higher where there are some fundamental macroeconomic vulnerabilities and sentiment is fragile. Also it needs to be recognised that, the less constrained style and greater risk appetite that hedge funds exhibit can also make them more likely to invest in a market perceived to be in crisis than mainstream funds with a lower risk appetite.
While hedge funds do pose potential liquidity risks, it has proven very difficult to reach firm conclusions on the extent to which hedge funds increase volatility from the numerous (contradictory), academic studies and the large official reviews such as the April 2000 report published by the Financial Stability Forum ("Report on the working group on Highly Leveraged Financial Institutions).
The benefits that are brought by hedge funds are easier to establish. In the early stages of markets developing the more entrepreneurial tendencies of hedge funds make them early movers and can help develop markets liquidity to the point where more cautious investors are inclined to participate in the markets. This pattern has been observed in the development of a number of emerging markets in recent times and the development of instruments such as credit derivatives. Hedge funds can also play an important role translating views about the fundamentals into prices and they face the same incentives as other market participants to avoid outsized positions.
How can these potential risks be mitigated?
We believe that regulators should not respond by discouraging participation in markets by hedge funds but rather managing conduct to ensure trading behaviour is fair and risks effectively minimised. We recommend the following approaches.
1. Effective deterrence of market misconduct through:
- Good intelligence
- Effective use of enforcement
- Effective co-operation amongst regulators cross border
- High level of regulator expertise
- Industry co-operation and dialogue
2. Effective risk management by firms through:
- Effective stress testing
- Effective collateral management
3. Effective regulation of exchanges through:
- Trading rules which are proportionate to circumstances
- Encouraging liquidity
Conclusion
We have talked about the risks that hedge funds pose - the reality is that users of capital markets are becoming ever more diverse and that if you want efficient capital markets you need to embrace diversity but also seek to ensure good behaviour by market participants.
