Regulators worldwide have been busy over the last few months taking emergency measures to address the financial crisis. Everyone has been keen to identify scapegoats and apportion blame to specific market sectors. Hedge funds have come in for much of the criticism.
It has become clear that many commentators do not fully understand what hedge funds do nor their potential impact on global financial markets. What is clear, though, is that the regulation or otherwise of hedge funds is a global issue. New thinking on their treatment is now emerging in the wake of the financial crisis:
- G20 has committed to extend regulation to all systemically important financial institutions including hedge funds and to require regulatory disclosure of information by funds and their managers. It also wants a set of unified best practices for hedge funds;
- G30 recommends that regulators should have the authority to require funds to provide certain information and, where funds are above a certain size, regulators should be able to set standards for capital, liquidity and risk management;
- IOSCO has made recommendations for hedge fund oversight;
- the European Commission will propose a supervisory regime based on recommendations of the influential de Larosiere group;
- the US looks set to introduce registration and filing requirements for many funds previously exempt from supervision; and
- in the UK Lord Turner, the Chairman of the Financial Services Authority (FSA), recommends that institutions which behave like banks, such as some hedge funds, should be treated as banks and regulated accordingly.
The international picture
At April’s G20 Summit in London, G20 committed to regulation of all systemically important financial institutions, products and markets, which will for the first time include hedge funds. This announcement was not surprising, and it came together with an attack on offshore centres which have levels of tax transparency now perceived to be unacceptably low. These include some popular hedge fund domiciles. However, no organisation has proposed exactly how to bring within the scope of direct regulation those funds that are set up in secretive jurisdictions which are not members of the main global policy-driving units such as the G20 or IOSCO.
The international drive for change is spearheaded by G20 and G30 and complemented by IOSCO. These organisations are powerful and persuasive not least because they bring together Europe with other major regulatory jurisdictions, specifically the US. Traditionally, jurisdictions have differed significantly in their approach to hedge funds: the US of all key jurisdictions has perhaps allowed the least regulatory involvement. But, whatever the past, major powers agree the need for change. The question is whether, and if so how, to regulate hedge fund vehicles or whether a combination of regulation and reporting requirements on managers and counterparties will be enough.
IOSCO, which appointed a task force on unregulated financial entities chaired by the UK and Italian regulators, has recently consulted on draft recommendations on:
- requirements for hedge fund counterparties: banks and prime brokers, which provide various services to hedge funds, will be regulated and should work with regulators to report information on systemically significant hedge funds. The entities themselves should have strong risk management controls over their hedge fund exposure;
- regulation of hedge fund managers: it is important to have a consistent approach to regulation of hedge fund managers which is risk-based and focused on systemically important or higher-risk fund managers;
- regulation of hedge funds: in principle, an attractive option would be to regulate the underlying fund, so regulators could have comfort on the service providers used and get regular data on funds and the risks they face;
- industry best practice: all regulators value industry standards and IOSCO strongly recommends a consolidated set of global best practice standards; and
- regulatory cooperation: a common theme is that supervisors must cooperate better. In the hedge fund sector this is extremely important and IOSCO stresses the need for buy-in from regulators or supervisors in the offshore centres popular with hedge funds.
Although the recommendations appear detailed and radical, their main drawback is not only the failure to define a hedge fund (something no organisation has succeeded in doing) but also the failure to provide guidance on what makes a hedge fund “systemically important”. Many of the other recommendations reflect what is already law or good practice in several sophisticated jurisdictions.
The European picture
The European Commission consulted on hedge fund activities some months ago and has recently released the results of its consultation. It had been satisfied that various EU and national measures and industry codes have combined to give the right safeguards against significant risks hedge funds present. Also, many entities associated with hedge funds, such as a fund manager, administrator or prime broker, will already be regulated if based in an EU state.
The Commission sought feedback on:
- Systemic risks: Do regulators have the mechanics to monitor and react to risks originating in the hedge fund sector?
- Market integrity and efficiency: Do the activities of hedge funds threaten the efficiency and integrity of financial markets?
- Risk management: Should authorities worry about the way hedge funds manage the risks to which they and their investors are exposed, value their asset portfolios and manage any potential conflicts of interest?
- Transparency and investor protection: Are hedge fund investors adequately protected and do they get the information they need?
The Commission got 104 responses (21 per cent from the UK), which highlighted several key messages:
- hedge funds are complex products best saved for sophisticated investors;
- it would be difficult to design a regulatory model for funds. Funds differ so much that a “one size fits all” model would be inappropriate;
- a global and international response would be better than just an EU one;
- concerns ranged from the need for more monitoring through operational issues to specific techniques funds use; and
- many respondents felt regulating hedge fund counterparties did not address all relevant systemic risks. Over 60 per cent of respondents thought regulators should have more information about hedge funds.
The Commission will use the results of the consultation in its proposals for hedge funds and private equity funds as well as for discussions with G20. It committed to publish its proposals on 21 April (before the time of writing this article).
The UK response
The UK fund industry is concerned about FSA’s move towards looking at the effects of institutional behaviour and regulating the economic effects in the same way, regardless of the classification of the institution in question. This could potentially bring not only investment banks but also the most influential hedge funds under a similar regulatory banner to deposit-taking banks. Lord Turner has referred to the “duck factor”, whereby institutions that look like ducks and quack like ducks should be treated as ducks. However, FSA is keen (as is IOSCO) to differentiate between the structure and role of unregulated entities, such as hedge funds, and SIVs and other off-balance-sheet vehicles often discussed in the same breath as hedge funds. It feels there is an important distinction between entities and products which some commentators have not appreciated.
The UK regulators responded in some detail to the Commission’s questions. Treasury and FSA sent a joint reply. They stress the importance to the UK of the hedge fund industry and how high-profile political debate should not obscure fundamental issues. That said, they admit regulators could do more to oversee all entities, including hedge funds, that might contribute to macroprudential risk. The response says that many of the dangers identified that hedge funds could pose could equally occur in other market participants so any regulatory response should not cover hedge funds alone. It is critical to look at the behaviour that causes concern rather than assume hedge funds in themselves cause problems. However, the response notes FSA appreciates the case for ensuring effective disclosure, diversification and risk management tools are in place if the retail market can access hedge funds via funds of funds.
Key industry bodies housed in the UK, in particular the Hedge Funds Standards Board, the Investment Management Association and the Alternative Investment Management Association, support the substance-over-form tenet of the UK Government. The Commission tried to define hedge funds and asked for views on its definition. IMA’s view is that, because a definition would be so difficult to perfect, regulation of hedge funds as a product will fail. In any event, it feels the hedge fund product is not one that needs fixing and that there is no such thing as the “unregulated European hedge fund” the Commission is looking to tackle. It feels the way forward is to consider the need for further asset class regimes building from the UCITS regime and to ensure a good pan-European private placement structure is in place.
FSA has been aware for some years of the risks that hedge funds pose. In 2006, it spoke of the six key risks as:
- serious market disruption and erosion of confidence following significant hedge fund failure;
- market abuse, insider dealing and market manipulation, including the potential to incentivise others to commit market abuse. It has since addressed market crime risks in its Market Watch newsletters;
- control and operation;
- preferential treatment for some investors;
- increasing penetration of retail markets by hedge fund investment techniques; and
- conflicts of interest that arise when complex illiquid instruments are mis-valued.
Although hedge funds will see more UK regulation rather than less in future, the UK Government listened to hedge fund industry concerns following the Lehman collapse. This led to section 233 of the new Banking Act, which gives Treasury power to make rules about “investment banks” (using a definition wide enough to capture any broker dealers who hold client assets). This power could be used to set up a protection scheme for funds posting client money and custody assets with prime brokers – possibly with early pay-out along lines of the compensation scheme for bank depositors.
FSA recently described its current thinking on hedge funds. It sees five components for hedge fund regulation:
- mandatory authorisation and supervision of all hedge fund managers and systemically important hedge fund counterparties by the relevant regulator in their home domicile;
- an enforcement regime in respect of fund managers, which creates credible deterrence, by the relevant regulator;
- regulatory powers to take remedial action where a hedge fund itself is domiciled offshore and poses a significant systemic risk direct regulation of the hedge fund manager and its counterparts cannot mitigate;
- collection and sharing of data; and
- convergence in industry good practice standards at a global level.
FSA does not think it necessary at the moment to try to extend prudential regulation to the funds themselves.
The US has recently proposed laws that, if passed, would greatly increase the supervision of hedge funds, venture capital and private equity funds and similar vehicles. Up to now, most private funds at least have not had to register with SEC. Now they may become “investment companies” under the law, although they would be exempt from most provisions of the Investment Company Act. Larger funds would have to register and file certain information with SEC. A separate proposal would close a current loophole that exempts investment advisers from SEC registration if they meet the definition of “private adviser”. By removing the exemption, the new laws would bring advisers under SEC oversight.
The first proposal in particular will concern all hedge funds, as, where the US leads, others often follow.
This is an uncertain time in regulation of hedge funds. The regulators must strike a balance between regulating those who could cause damage to the financial system if left unchecked, and allowing businesses to prosper in onshore environments. The trend is clearly to regulate as much as possible as directly as possible, but in the absence of agreement on key definitions (of “hedge fund” and “systemic importance”) it is hard to tell the precise impact of current proposals. But it is clear that hedge funds should be prepared to act quickly to respond to substantial regulatory change, as well as reviewing their exposures within the existing regulatory framework – a key plank of this will be to review their organisation structures and their contracts with service providers, especially prime brokers.