Introduction
Any commentator addressing the subject of hedge funds should tread carefully. They are an ill defined class (more of that later), which have been held to be responsible for such assorted ills as the exit of the United Kingdom from the ERM in 1992, the South East Asian crisis of 1997, or – most recently – the failure of Deutsche Börse and Euronext to combine to form a Euro-zone exchange that many would have liked to see. One of the most recent threats to financial stability was triggered by the demise of Long Term Capital Management in 1998. In a wider context, they are regarded as the personification of what is often and pejoratively described as "Anglo Saxon capitalism", and have been denounced as such by politicians as distinguished and varied as Franz Müntefering of Germany, Göran Persson of Sweden and Joop Wijn of the Netherlands. They, as these examples illustrate, occasion much emotion – not least in Germany, where I am speaking this evening.
Luckily, in the words of my German colleague Jochen Sanio, I am a regulator, not an entomologist. This evening I want to consider the subject of hedge funds from the much more narrow and apolitical viewpoint which I occupy: that of a financial regulator with statutory responsibilities both for prudential supervision and for consumer protection – and, since it is also relevant, for combating financial crime. I want to redefine the regulatory issues associated with hedge funds, and indicate what, in the UK – a country which, unlike many, actually does regulate those who manage hedge funds – we believe to be practicable and useful steps to tackle those issues. En passant, I will indicate possible approaches to these issues which I regard as less practicable and less useful – or, indeed, quite counterproductive. And I will end by suggesting that many of the real regulatory issues, as distinct from the emotion, associated with hedge funds actually extend far beyond hedge funds themselves.
It will be a theme of my remarks that we should refocus regulatory efforts away from hedge funds, however convenient it may be to demonise them, to the broader regulatory issues which, although they occur in hedge funds, are by no means confined to, and may not even be concentrated within, the hedge fund sector.
Definition
Discussion of any subject should start with agreement as to what is being discussed. Nowhere is this truism more relevant than in a discussion of hedge funds, for the definition of hedge funds is far from clear. There is, for example, no legal definition of a hedge fund in either the UK or Germany. Indeed, when IOSCO carried out a survey, none of the responding jurisdictions reported a legal definition. So the phenomenon we are discussing is not a legally defined class. But the features which distinguish hedge funds are generally accepted to be:
- they tend to be unregulated collective investment schemes – but share this characteristic in the UK with, for example, some occupational pension schemes;
- they make extensive use of derivatives – but share this characteristic with banks, insurance and securities companies;
- they use shorting techniques – as do others;
- they use extensive leverage – again not a characteristic unique to them;
- they have a charging policy which is typically described as 2 per cent and 20 per cent – that is an annual charge of 2 per cent and 20 per cent of the increase in the value of assets under management. It is worth observing that this charging policy is not confined to what are normally thought to be hedge funds: in a recent interview, Blake Grossman, CEO of Barclays Global Investors, normally regarded as a mainstream asset management company, reported that about a fifth of its actively managed funds were managed against a fee structure which is comparable to what is normally regarded as hedge fund fees;
- they tend to seek investment opportunities across the market widely, looking not only at established markets in equities and bonds (and their derivatives), but also at commodities, and at more esoteric investment opportunities: catastrophe insurance contracts, film finance and other non mainstream asset classes. In that, of course, they are again not unique: banks, insurance companies and securities firms all pursue these opportunities.
So my first point is that hedge funds are an ill defined asset class. Indeed, the categorisation of hedge funds as an asset class is really rather odd. They are asset managers who utilise an investment approach (shared by many), who call themselves hedge funds. I find it difficult, if not impossible, to identify an activity carried out by a hedge fund manager which is not also carried out by the proprietary trading desk within a large bank, insurance company or broker dealer. Indeed, last Friday Bloomberg reported that the hedge fund manager with most assets under management in its hedge funds was now Goldman Sachs. There is often comment on investment banks or insurance companies buying hedge funds or stakes in hedge funds, as AIG and Morgan Stanley have done this year. But there is less comment on the fact that, irrespective of the direct investments in hedge funds, many banks, brokers and insurance companies carry out activities indistinguishable from those of hedge funds. There are around 60 UK based “mainstream” asset managers who manage hedge funds (that is, adopt investment policies with the characteristics I have described) alongside traditional funds. These managers are competing with around 300 UK based specialist hedge fund managers. I – and many commentators – see increasing convergence between what has hitherto been regarded as two distinct activities: "traditional" asset management on the one hand and non traditional "hedge funds" on the other. This, in itself, should give rise to thought about what unique regulatory approach is justified for hedge funds.
But, for the moment, let us take a very simple view, and pragmatically accept that those who describe themselves as hedge funds are indeed hedge funds. What is it that we can say about this pragmatically defined population?
here are no concrete estimates for the number of hedge funds in existence globally, not least because of the difficulties I have described inherent in defining just what a hedge fund actually is, but various commercial databases provide estimates. (Slide 1) Hennessee and IFSL estimate that there are around 8,500 hedge funds globally, HFR estimate that there are around 9,200.
(Slide 2) Total European industry assets reached some $400bn at the end of June this year, an increase of 44 per cent from the June 2005 total. The asset growth came partly from the impact of fund performance, but mostly as a result of fresh capital inflows from “institutional” investors.
The top 25 European managers accounted for $180bn, or 44 per cent of overall industry assets, at the end of June, and several of the biggest groups have seen assets grow by more than 50 per cent, and in some cases more than 100 per cent, over the previous 12 months. This analysis highlights the dominant position of the UK in Europe, when measured by number of funds and assets under management. Nearly 80 per cent of all European hedge fund assets are in fact managed by FSA authorised managers. Next by asset volume came French-based managers, who managed $21bn, or 5 per cent of all European assets, while Swiss based managers' 102 funds represented assets of just $9bn.
Until now, I have spoken of hedge funds as if they represented a single, albeit ill defined, category. Of course there are considerable differences in the strategies adopted by different hedge funds as Slide 3 shows. The most popular continues to be "Long/Short" equity" – something which is now promoted (in a watered down form) for onshore passportable funds under the more liberal UCITS 3 regime. "Event driven" has been one of the fastest growing strategies in the past year – something which is cause for thought for those corporate executives and others who fear shareholder activism. Multi strategy funds have continued to attract new investment undaunted by the sudden dramatic losses at Amaranth. What has happened across the general category of hedge funds is increasing differentiation between strategies, and closer definition of the strategy adopted.
That much is familiar. But it is worth observing that the population of hedge funds is marked by high mortality rates: (slide 4) the half life of a fund is probably about 5 years. I say probably because of definitional and statistical difficulties: the universe of hedge funds is difficult to measure; hedge funds can appear on more than one database; and a fund may be marketed under various names. Most funds which end do so simply because they are unprofitable, failing to attract enough assets under management to become or remain viable, and returning capital to investors. The number of fund collapses tends to be relatively small, running at about 0.3 per cent of the funds in existence – so that, with over 8,000 funds in existence, we might expect slightly over 20 to come to collapse this year.
What are the regulatory issues?
Let me now turn to the regulatory issues which we should consider in relation to hedge funds. These fall under three broad headings: prudential – that is the extent to which hedge funds pose a risk to financial stability; consumer protection – the extent to which retail customers should be allowed to invest directly in hedge funds; and market behaviour – the extent to which hedge funds pose risks to objectives of preventing market abuse. For each, I will set out the issue as seen by the FSA, and the regulatory response which we believe appropriate.
Before doing so, a classification is called for. I have spoken, for the most part, until now of hedge funds, without distinguishing between hedge funds and hedge fund managers. For regulatory purposes, however, this distinction is essential. As a generalisation, there are no hedge funds as such in the UK or Germany. The funds themselves are located in offshore tax efficient jurisdictions. What exists in the US, the UK and – to a much lesser extent – in Germany are the hedge fund managers. What lies within the jurisdiction of the FSA are more than 300 asset managers based in the UK managing hedge funds, who are responsible for managing about one quarter of the world's hedge fund assets. I make this obvious point because it is central to the practical issue with which regulators deal, namely what is it that can in practice be controlled or influenced? In practice, the answer is hedge fund managers, and those who distribute and invest in hedge funds, within a jurisdiction. It is not the funds themselves.
Prudential issues
The first set of concerns which a financial services regulator has relates to prudential issues: the prospect that failure of a hedge fund would trigger a systemic risk to financial markets and hence to financial stability. It was, of course, this fear which led the US authorities at the time of the LTCM collapse to organise a market solution designed to avoid the collapse of a particular fund causing wider damage.
In this, as in all instances of threats to financial stability, it is important to identify the probable transmission mechanism: what would be the process by which the collapse of one or more hedge funds might lead to wider threat to the financial system? After all, the collapse of a hedge fund, unattractive though this is for those who have invested in it, is not of itself a prudential issue. The direct transmission mechanism would be the effect of a hedge fund collapse on the hedge fund's counterparties, and in particular on the prime broker dealers so much of whose business is now with hedge funds. It is this which has led the FSA, in the first instance, to seek to address the prudential risk of hedge funds by ensuring that we understand the exposure to, and management of, hedge fund risk by the prime broker dealers.
This approach has sometimes been misunderstood or misrepresented. It is not because, as some have suggested, the prime broker dealers are regulated and the hedge fund managers are not. In the UK, both are regulated. Rather it is a recognition of what is the direct transmission mechanism from hedge fund failure to financial stability, and hence a view of where a regulatory or supervisory input will have most effect.
The form of FSA supervision for this purpose of the prime broker dealers is a six monthly survey of their exposure to hedge funds. We examine the prime brokerage exposure to hedge funds of some 15 financial institutions. It covers more than 150 funds, which in total comprise some 20 per cent of global hedge fund assets under management. The data requirements are broadly two: first, to identify credit exposure to hedge funds; and second to examine the relationship between prime broker and hedge fund manager: aggregate and top 10 fund data on net equity, long/short market value, cash balances, margin requirement and excess collateral. From this, we want to be able to gauge the risk appetite of both hedge funds and their prime brokers, identify any outliers for particular supervisory intervention, identify the convergence of hedge funds of growing importance, and assess the ability of the prime brokers to manage, across their business units, their counterparty exposure.
The latest survey for which I have data was carried out in April 2006 (we will shortly have the results for the October survey). The most important points I would draw from it are (Slide 5):
- hedge funds to which these broker:dealers are exposed are continuing to grow strongly, with assets under management in total (on an equity basis) now US$494bn, a 29 per cent increase in six months;
- exposure to hedge funds is concentrated in two prime brokers, which had approximately half the business. For detailed reasons I won't go into, we believe this concentration figure probably misrepresents the true position, which is less concentrated;
- aggregate leverage (calculated as long market positions divided by net equity) increased slightly between October 2005 and April 2006 from 2 ¼ times to 2.4 times. It is worth pointing that LTCM routinely operated on a long leverage of 25 times, and as it approached crisis more than 50 times;
- average excess collateral increased very slightly, from 100 to 102 per cent;
- contrary to the view that funds divide and rule between many broker dealers, only 21 of 152 hedge funds had more than one prime broker;
- 13 of 192 individual exposures were on margin call, representing 0.3 per cent of total individual exposures.
Overall, this is not an alarming picture, although there are elements which we believe merit further enquiry, notably practices in margin calculations (which we are looking at in a joint exercise with the Federal Reserve Bank of New York and the SEC), and the extension of the database we have from UK data to global information (our measurements are mostly but not exclusively of UK exposure; where we have global data they are consistent with the UK data).
There is a second strand to our regulatory approach to the prudential issues associated with hedge funds. We can identify the largest hedge funds – few in number but potentially large in impact – which matter for financial stability purposes. (Slide 6) The FSA has selected some 30 UK hedge fund managers whom we are supervising with greater intensity than the other smaller hedge fund managers – an approach entirely in keeping with our normal risk based approach. These hedge fund managers, who are subject to more intensive supervisory oversight, control about half the UK hedge fund assets under management – and therefore more than 10 per cent of global hedge fund assets. They are subject to more detailed supervision of systems and control, arrangements for managing conflicts of interest, and compliance. We believe the combination of the prime brokers survey and selective supervision of major hedge fund managers provides us with appropriate means of guarding against prudential risk.
Note that we do not seek, nor would we find it useful, to have information about specific large positions of individual funds or their managers. I do not see what the FSA – or, indeed, any other regulatory organisation – would do with such information if it were made available; and I see very considerable moral hazard in regulators seeking and holding information which is not used, but is known to be collected. And a requirement on hedge funds – or on other major market operators – to disclose open positions is not obviously a form of transparency which will aid financial stability. There are often demands for greater transparency in relation to hedge funds and their managers. Those who make those demands have a responsibility to be clear as to what information they seek; to whom it is to be made available; and to what use it is to be put. Otherwise, the demand for transparency becomes an empty requirement.
I will in a moment set out what forms of transparency the FSA would regard as useful. But it does not include reporting of positions, something which could easily prove destabilising to markets; and for which no practical benefit has been identified.
Consumer protection
A second strand of regulatory concern relates to the extent to which retail investors should be allowed to invest directly, as distinct from indirectly via pension funds or asset managers, in hedge funds. It has long been accepted that high net worth individuals, who are expected to be able to look after their own interests, should be able to do so. And under the amended UCITS Directive it is now possible for authorised collective investment schemes to invest more freely than before in derivatives which give many of the economic efforts of at least some hedge fund strategies. In particular, it appears increasingly anomalous for UK investors to be prevented from investing in an authorised fund of unregulated schemes, and the FSA therefore plans in early 2007 to consult on plans to introduce such a fund, thus permitting the sale of an authorised "fund of hedge funds" – as is already possible in Germany, and therefore, if conducted from Germany electronically, in the UK as well. There are some UK taxation issues that would need to be resolved to make this regime a reality.
The form of consumer protection for such UK funds has not been decided. But it is unlikely to involve any substantial constraint on the investment strategy that the managers of the underlying hedge funds can pursue, and instead to concentrate on structural questions such as the functional separation between the manager of the fund and custodian, or the pricing of the fund. There may also be scope, although this is less clear, for establishing principles governing the due diligence that the manager of the authorised fund should carry out in selecting the hedge funds in which he invests. If these aspects of a hedge fund are subject to greater clarity – if this is what is meant by "transparency" – I would be a strong supporter of this approach.
There is a particular form of investor protection which is already being tackled. There has been a practice among some hedge fund managers to grant preference in terms of redemption rights to preferred investors: to allow them more speedy redemption than other investors, or redemption linked to the continuing investment by certain core investors. These preferential treatments have typically been conferred by means of side letters, which have not been made public. We regard this lack of openness as unacceptable, and expect any material terms contained in side letters to be made public, so that all investors are made aware of their position, whether preferred or non preferred. We have worked constructively with the hedge fund managers and the UK trade association to agree both what constitutes a material terms and appropriate notification methods. We will be conducting thematic work to establish conformity with the FSA's principles.
Market integrity
The third strand of regulatory concern relates to market integrity. The problems of market integrity – of misuse of insider information, of mis-valuation of complex instruments, of preference given to preferred (because important) clients by brokers – are important, and the FSA treats them as important. But they are general, not specific to hedge funds. The fear that is expressed by critics of hedge funds is that the very large financial rewards offered to hedge fund managers will induce bad behaviour. Although there have obviously been examples of such behaviour (against which the FSA has taken enforcement action), there is no evidence of which I am aware that these problems of market integrity, which present real issues across markets, are concentrated within the hedge fund sector. Nor is this surprising. After all, large bonuses and strong financial incentives are not the monopoly of the hedge fund sector.
The FSA's regulatory response is therefore market wide, not concentrated on the hedge fund sector. It is based on deterrence: active oversight of what we regard as particular points of vulnerability; means of analysing transactions, including transactions in indices rather than individual stocks; effective enforcement, so that those who may be tempted have that temptation tempered by the prospect of public action against them; and flow of information from the market to the regulator which enables suspect areas or types of transaction to be identified.
Transparency
Against these three regulatory objectives – prudential, consumer protection and market integrity – it is worth considering what a call for greater transparency of hedge funds might usefully cover. I have already explained why I believe that reporting of large investment positions, either to the market or to the relevant regulator, would be at best useless, and probably significantly counterproductive. But there are classes of information which would be useful, and which the FSA believes should be clear. These include:
- fees: the fee structure characterised as 2 per cent and 20 per cent has many complexities associated with its calculation: hurdle rates, allowable expenses, equalisation structure. Any hedge fund manager – like other asset managers – should disclose these clearly to potential investors;
- redemption policy: it is again important for investors (and also for counterparties) that the terms of redemption, including restrictions on redemption, are clearly set out. And, as I have explained at some length, we regard it as essential that material terms in any side letters giving particular investors preferential redemption rights should be disclosed;
- valuation procedures: hedge fund managers should set out the basis on which their funds are valued. Critically, this should start by establishing whether there is an independent valuation, but there is a need to go substantially beyond this, to cover policies and procedures such as the separation of duties between portfolio managers and back offices; the reconciliation of values between hedge fund manager, prime broker and administrator; price sources; and procedures for dispute settlement;
- investment strategy: hedge fund managers should set out, for investors and prime brokers, the investment strategies they intend to follow;
- administration: we would expect hedge fund managers to set out the procedures they will follow in terms of visiting the fund administrators, the audit of those funds and the reporting of this;
- result reporting: hedge fund managers should provide regular reports on the valuation of their funds to investors, and regular information to their prime brokers to allow margins to be adjusted on a continuous basis.
The FSA has made recommendations to IOSCO on these issues in detail. I would refer those interested to the letter published on our website on 29 November.
I consider transparency on these issues would prove beneficial in promoting all three regulatory objectives I have discussed. I hope IOSCO, rating agencies and national regulators will pursue these issues.
Wider issues
I have described how the FSA approaches the issues of financial stability, of consumer protection and of market integrity which are commonly associated with hedge funds, and how we believe transparency can be made a practical help. Let me turn to the wider issues which, while they arise in the context of hedge funds, also arise more generally, and which I believe deserve serious attention. There are three I would particularly draw attention to.
Valuation of complex instruments
The first is the problem of valuing complex instruments, which are normally traded on an OTC basis, and have to be marked to model rather than marked to market. This is a problem which arises with instruments as varied as CDOs, CLOs, or catastrophe bonds, and has both a dimension of competence (who validates the models? Where are the objective data for volatility?) and also a potential for dishonesty, in that there is the possibility of collusion between those who provide validating data and those with an interest in the valuations derived from that data. These represent real regulatory issues, and I am pleased that they are being tackled by IOSCO. In relation to hedge funds, they are an aspect which I have explained the FSA would expect the managers of funds to consider when selecting the underlying funds in which to invest; and which I would expect credit rating agencies to address when rating managers. But, although these issues occur within hedge funds, they are a general phenomenon. All those concerned with prudential issues would do well to consider the question of valuation of complex instruments as a priority; and to consider it wherever it occurs, not simply or principally in the context of hedge funds.
Correlation between asset classes
Linked to the question of the valuation of complex financial instruments are the assumptions about correlation or lack thereof between asset classes. The models upon which the valuation of complex instruments depend, assume different volatilities for various asset classes. Yet in a world of high liquidity and low volatility, these assumptions are increasingly tested by shocks, with asset classes which were thought independent of one another moving together. The down rating of Ford and GM last year, for example, exposed the fact that assumed correlations between different asset classes did not correspond to what occurred when an event stressed the system. I regard this as a major risk to financial stability, and as such one which authorities with responsibility for financial stability should address. But, again, it is a risk which is not in any way special to hedge funds. It occurs wherever assumptions are made about correlations between asset classes. It affects banks, insurance, reinsurance and brokers. It requires regulatory attention, and in particular for those affected to perform, and act upon, realistic and demanding stress tests.
Confirmation of derivatives
A third issue relates to confirmations for derivatives, both credit risk and equity, where extensive backlogs or – a worse problem – lack of agreement on the legal basis for settlement can create blockages which in turn would prevent markets operating to smooth shocks. This is a very real problem which, because it is system wide, is not amenable to action by any individual market participant; instead it requires a general solution, either industry wide from a trade association such as ISDA or from regulators. The problem was evident last year in relation to credit risk derivatives, which led to the joint initiative by the Federal Reserve Bank of New York, the FSA and the SEC which has largely eliminated the then extensive backlog for credit risk derivatives. We now need to ensure that this problem does not simply migrate to the admittedly smaller population of (more complex) equity derivatives.
Hedge funds, who accounted for a significant part of the trading in credit risk derivatives, undoubtedly contributed to this problem. But the problem was concentrated in the main broker:dealers who traded the instruments; and the regulatory solution was to concentrate attention on them, and to require them to reach particular standards – which in turn required them to ensure that all those with whom they traded, including hedge funds, had adequate systems and administrative processes. The problem was again general, although hedge funds were clearly heavily involved. The regulatory response was to identify the part of the system where intervention would prove most effective. As a practical question, it did not involve direct action against hedge funds.
Conclusion
This evening, I have tried to put hedge funds into context – a context which makes them much less distinguishable from many other parts of the financial system. I have suggested that the process, already under way, by which hedge funds share many characteristics with what is often regarded as a different category, namely mainstream asset management, will continue. I have examined the regulatory response which is appropriate to problems of prudential, consumer protection and market integrity objectives, and have explained how, in the UK where we do authorise and supervise hedge fund managers, we have defined our regulatory policies. This includes both direct regulation of hedge fund managers, something which is not customary in all countries, and, as a policy choice, a risk based approach which involves both direct supervision of major hedge fund managers and indirect supervision via the major broker:dealers. It has required us to define what transparency we seek from hedge fund managers. So our regime for hedge funds is at least as rigorous, and probably more rigorous, than that in other jurisdictions. But this regime is only a part, and not the principal focus, of our concerns to promote financial stability, appropriate consumer protection and market integrity.
Throughout this analysis, I have been concerned to identify what are the real threats to financial stability, to consumer protection and to market integrity; and the most effective regulatory responses to those threats. My thesis is that these threats are real and important, but are best first identified clearly and then tackled directly, rather than being addressed indirectly through the prism – and possibly distorting mirror – of an attack on hedge funds. The issues – and the risks – are too great for misdirection.
Hedge funds Presentation slides
