The FSA has published a speech by Dan Waters (Asset Management Sector Leader, FSA) entitled Regulatory challenges for fund managers.
At the start of his speech Mr Sants briefly discusses the causes of the financial crisis as set out in the Turner Review. He then discusses three of the Review’s proposals that are likely to be of interest to fund managers and these are:
- Credit rating agencies (CRAs).
- Market infrastructure.
- The FSA’s scope of regulation.
Mr Sants states that poor quality credit ratings and poor use of credit ratings played an important role in the financial crisis. He also states that there is a global consensus among regulators that CRAs should be regulated and that they should only rate instruments that are simple enough and with enough historic record to make consistent rating possible. Mr Sants also mentions that ratings agencies and regulators should ensure that communications to investors about the appropriate use of ratings make clear that they are designed to address credit risk, not liquidity or market price. However, Mr Sants states that improvements will not address the shortcomings in the use of ratings by the financial industry. It remains the responsibility of investors (and fund managers as their agents) to perform their own due diligence and research when making investment decisions and to use credit ratings responsibly.
On market infrastructure Mr Sants refers to the Discussion Paper that accompanied the Turner Review which discusses the robustness and effectiveness of the market infrastructure in supporting the trading process and reducing systemic risk, in a way which is appropriate to each asset class. Mr Sants also mentions that the FSA is reviewing whether arrangements could be put in place which more effectively support the holding and protection of client positions at clearing houses, and also whether the arrangements for settling defaulted OTC equity transactions could be improved.
On hedge funds Mr Sants starts by reiterating the point made in the Turner Review that so far there has not been any concrete evidence to support the view that hedge funds made a significant direct contribution to the underlying causes of the financial crisis. However, this does not mean that the effective regulation of the potential systemic impacts of hedge funds or clusters of hedge funds should not be an important part of the future regulatory framework.
Mr Sants states that there is a global consensus that the institutional and geographical coverage of hedge fund regulation needs to be reviewed and that coverage should focus on the economic substance of institutions and vehicles and not legal form. The next key stages in the debate are the publication of a consultation paper by the European Commission in mid-April and the G20 summit on 2 April.
Mr Sants then summarises what the FSA considers to be the key components of an effective regulatory framework for hedge funds:
- The mandatory authorisation and supervision of all hedge fund managers and systemically important hedge fund counterparties by the relevant regulator in their home domicile, including conduct of business, governance and prudential requirements (for instance in Europe appropriate elements of the Markets in Financial Instruments Directive, Capital Requirements Directive and Market Abuse Directive being extended to all hedge fund managers).
- An enforcement regime in respect of fund managers, including hedge fund managers and their counterparties, which creates credible deterrence, by the relevant competent regulator in their home domicile.
- Regulatory powers to take remedial action where a hedge fund itself is domiciled offshore and poses a significant systemic risk which cannot be mitigated by direct regulation of the hedge fund manager and its counterparts.
- Collection and sharing of data from hedge fund managers and counterparties and from other key market participants in systemically important or particularly vulnerable markets, for the purposes of identifying systemic and financial stability concerns.
- Convergence in industry good practice standards at a global level, building upon the work already done by the Alternative Investment Management Association and the Hedge Fund Standards Board in the UK and by counterparts in the United States, to support but not replace an enhanced regulatory framework.
- Mr Sants states that the FSA believes that it is appropriate that hedge fund managers in the UK are not subject to the UK’s prudential requirements affecting their capital adequacy and liquidity. This is because hedge funds in general do not perform “bank-like” activities.
- Mr Sants then turns to “business-as-usual” issues for fund managers. In this part of his speech he looks at the Internal Capital Adequacy Assessment Process (ICAAP) in the fund management sector and then managing liquidity in open-ended funds.
- The FSA has recently completed the first iteration of its supervisory review and evaluation process of the capital adequacy assessments it received from asset managers over the last 18 months. Whilst asset managers generally appear to have met the substance of the FSA’s requirements under Pillar 2, going through the ICAAP for the first time has been a challenge for many firms. The FSA will shortly publish an update to its observations made in August 2007 on the early ICAAPs it received from asset managers. However, Mr Sants does mention some initial observations in his speech covering capital planning, operational risk analysis and the calibration of stress and scenario tests.
- On managing liquidity in open-ended funds Mr Sants makes two general points. Firstly, fund suspensions are a last resort for exceptional circumstances only. They are not a convenience for dealing with problems which have been caused by poor liquidity management of open ended funds. Secondly, the FSA expects managers to carefully consider on an ongoing basis, the liquidity profile of both their current and potential future underlying investments as well as the interaction with the scheme’s overall liquidity requirements.
View FSA speech - Regulatory challenges for fund managers, 24 March 2009