Corporate Blawg UK: Hedging bets against regulation

After recent criticism of the FSA, Corporate Blawg UK is glad to have found an area where the pragmatic and cool judgement of the FSA sets them apart from their U.S. counterparts. Although the need for debate and development has clearly been promulgated from the U.S., the FSA have responded with practical steps that may actually benefit the market, and not simply be a bamboo-crunching panda to the U.S. giants.
The key point is that hedge funds are largely secretive in their investments and operation. Since the failure of large hedge funds, or hedge fund clusters, have the potential for impacting the confidence in a capital market as a whole, there are calls for greater disclosure and industry regulation. But how to go about this when the secrecy in the investments, strategy and portfolio gives hedge funds their industry advantage? The U.S., FSA and IOSCO are still working on this issue, but the detail below should give a summary of the current standing:

The U.S. debate

The risks faced by the hedge fund industry have been apparent since the collapse of Long-Term Capital Managament in 1998. In 1999 the U.S. Federal Reserve considered the policy issues raised and releaed a report entitled "Hedge Funds, Leverage, and the Lessons of Long Term Caputal Management". The lessons of this report have since been reviewed by the Chairman of the Federal Reserve, Ben Bernanke in May this year. BB found that the main mechanism for regulating highly leveraged investors and other aspects of risk taking in the market is the creditors, counterparties and investors. As a result of the 1999 report, regualtory authorities in the U.S. issued guidance on risk management practices, and bank sueprvisors now actively monitor and conduct targetted review of banks' dealings with hedge funds. This paper did not recommend direct regualtion of the hedge fund market. This is because direct regulation is throught to impose costs in the form of moral hazard, the likely loss of private market discipline and the possible limits on the funds ability to provide market liquidity.
BB Chairman said that this approach has been found to be largely effective. The general perception is that hedge funds are less highly leveraged than in 1998. Some of this progress is due to industry-led efforts such as the report by the Counterparty Risk Management Policy Group (CRMPG) that lay out the principles that institutions should use in measuring, monitoring and managing risk. Despite this progress there are four concerns that BB highlighted in his speech:

competition for hedge fund business has eroded initial margin levels
increasingly complex transactions increase counterparty exposures and may not be measured accurately
more extensive stress-testing should be done
the assessment of counterparty risks should be better tied in to the amount of transparency offered by hedge funds.

Concerns about hedge fund opacity and possible liquidity risk have motivated a range of proposals for regualtory authroities to create and maintain a database of hedgefund postions. BB remains sceptical of the value of such databases.
The day after this speech, Cynthia Glassman, the Commissioner of the U.S. Securities and Exchange Commission ("SEC") noted that in December 2004 the SEC adopted its rule to requiring certain hedge funds to register with the SEC. The paper points out that in June 2005, the FSA published a discussion paper entitield "Hedge Funds a discussion of risk and regulatory engagement", In March 2006 the FSA published feedback on the potential next steps.
When the Chairman of the the SEC, Mr Cox, spoke on 27 July 2006 on the benefits of hedge funds being "capital formation, market efficiency, price discovery and liquidity", he added that "there should be no portfolio disclosure provisions". This directly aims to conserve the secrecy of the hedge funds in the US, but will they leave themselves open to another 1998 Long Term Capital Management debarcle?

The U.K. solutions

On 21 September, Hector Sants spoke at the IOSCO meeting in Shanghai. He pointed out that the FSA authorised firms manage at least $256bn representing over three quarters of hedge fund assets. The FSA see five key areas of risk:

The failure or significant disterss of a large and highly exposed hedge funds, or a cluster of smaller hedge funds can cause serious market disruption.
Some hedge funds may be testing the boundaries of acceptable practice, creating incentives for market abuse.
Problems such as late trade confirmations, non-notified trade assignments and novations add significantly to market-wide operational and credit risk levels.
Mis-valuation of complex illiquid instruments / fraud.
Some hedge funds issue undisclosed side-letters which offer enhanced liquidity and other preferential benefits to selected investors.

Now the FSA certainly seem a lot more focussed on the issues that the U.S. counterparts, except where the FSA then state "Firstly, I must emphasize the FSA is not seeking to authorise and regulate the funds themselves which are outside our jurisdiction". Well that's okay.
In order to prevent market disruption the FSA suggest supervisor discourse, and six-monthly surveys of exposures to hedge funds. The FSA are also undertaking further work with banks on collateral and margin arrangements even though they recognise tthat this approach may have severe limitations on the value of the content, and may cause moral hazard.
The FSA maintain that Market integrity can be maintainted by "credibled deterrance". There are four key components to this:

(a) pro-active surveillance on likely 'hot spots'
(b) modern transaction analysis system
(c) an effective enforcement proposition and
(d) industry cooperation to ensure a steady flow of information.

The FSA notes that the US Federal Reserve have assisted in establishing a co-ordinated global response, especially in relation to the concern for significant trade information backlogs in credit derivative markets. Following from Cynthia Glassman's comments, it appears that mutual backslapping is never amiss.
      Close work with IOSCO on the valuation of hedge funds have helped, and a project on the hedge fund valuations will be completed in April 2007. The FSA have presented views on good practice to IOSCO valuations working group and intend to write a more formal letter outlining the views, which will become public later this month.
      And finally, the FSA believes that failure by hedge fund managers to make adequate disclosures is a breach of Principle 1 of their Principles for Business ("A firm must conduct its business with integrity"). The FSA is working to produce 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. update in monthly news letters).
      The FSA also point out the risk that hedge fund positioning and momentum under certain conditions can be self-fulfilling. Fundamentally, efficient capital markets need to embrace diversity, whilst ensuring good behaviour by all market participants.
      Corporate Blawg UK expects that the amount of regulation of hedge funds will depend on whether future hedge fund failures can be boiled down to regulatory inefficiencies. If so, greater regulation will be forthcoming. If the status quo is maintained, and hedge funds do not find themselves on the wrong side of the market abuse fence, it will take a particular risk-averse regulatory authority to push through new measures for greater disclosure. It is likely that the hedge fund industry will only have itself to answer to, in regard to the destination of its navigation through these turbulent regulatory waters.

Comments

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Know where I can find any additional info on the other players?

Posted by: Charlie Mann | 02 May 2007 at 04:14 PM