Regulatory change looks set to play a critical role in the ongoing development of the hedge fund industry.
According to Tim Rooke, a Partner at Ernst & Young, FSA scrutiny, transparency, valuation issues and the debate over whether hedge funds should be made available to the retail market, all serve to focus the minds of both managers and the lawyers advising those managers.
Andrew Shrimpton, who leads the hedge fund supervision team at the UK’s FSA, seems satisfied that the relationship between the UK regulator and the British-based hedge fund industry is working well: “I think that’s a model for the way the FSA wants to regulate, that is setting out the high level principle position and then maybe using industry guidance to help people understand better where we’re coming from, and people following the spirit of an initiative rather than getting bogged down with rules,” he says.
One legitimate concern has been the issue of the FSA intervening in fund-related issues on the question of side letters, as it has been the funds rather than the managers that issue these letters. “I’d reassure people that it’s not the thin end of the wedge,” Shrimpton says in response. “Our whole philosophy is about being risk-based and focused, so we will only make these interventions from time to time, where we think there is a problem and an issue.”
The FSA is already working hard in the valuations area and Shrimpton says the regulator has developed its own views on good practice, especially with reference to reconciliations, documentation of pricing policies and the segregation of duties. It is still discussing the issue with IOSCO for example, and will publish further details on its findings in April next year, including how this will feed into the FSA’s ongoing work. He thinks the findings are unlikely to be full of surprises but expect to see segregation of duties, including the practice of portfolio managers sending prices directly to administrators, on the agenda. “The one controversial area...is the degree to which managers can use prices from banks as a kind of reconciliation tool,” Shrimpton says.
Clash of cultures
The side letters issue may have been borne out of a clash of cultures between the way hedge funds have conducted themselves, and the way more institutional players behave. “The analogy I always use is that between a private sale of shares and a public IPO,” says Ben Jaffey, a barrister and a specialist in financial regulation from Blackstone Chambers.
Jaffey sees this debate over what is private, and what is public, at the crux of the regulatory question. Hedge funds have traditionally viewed themselves as private investment vehicles but now, with increased institutionalisation of the leading firms, the FSA is making it clear that they should now be regarded as public organisations, and regulated accordingly. Capital raising by hedge funds, while not what it used to be, has not graduated into the realm of an IPO, but private deals being conducted as part of the fund-raising process are being frowned upon. “They will view this as a breach of Principal 1, of honesty and integrity, the most serious allegation which the FSA has in its regulatory armoury,” Jaffey says.
The Bank of England, the UK Treasury and the FSA share very similar views on hedge funds, and liaise quite closely. The Bank of England in particular has voiced its concerns over the use of derivatives and their potential threat to financial stability. The best form of supervision is by keeping a close eye on the prime brokers and the managers: direct regulation of the funds themselves remains less of an issue. This is in direct contrast to the US, where there has been mixed signals from the Federal Reserve, and where, following the defeat of the SEC’s first hedge fund initiative, there remains confusion over what a future regime will look like.
According to Jaffey, the FSA knows that heavy regulation of the hedge fund industry in London will not be helpful to market stability. Hedge funds are “pretty flighty things” in his view, and can easily be managed outside the UK if necessary. “That doesn’t change the reality of what you’re doing – your transactions, your trading, will still take place on the London markets, and if you get your risk management horribly wrong, the collapse will still be felt very strongly on the London markets.” Massive swathes of new regulation are therefore considered unlikely, although increased supervision of risk management is likely to
continue.
Hedge funds and the retail sector
Retailisation of hedge funds has been an issue under discussion formally between the FSA and the hedge fund management community in London since summer 2005, when the FSA published its discussion paper on regulation. However, it has not sat at the top of the agenda. Shrimpton sees this as a process that will continue and anticipates a working paper on the subject will be issued in early 2007.
Jaffey remains uncertain about the benefits of retail hedge funds, as he anticipates this will require a whole new level of regulation. Black box trading applications are likely to encounter the most problems when seeking access to retail money. “They’re very difficult for anyone to actually work out what is going on,” he says. If splits and zeroes, precipice bonds and even endowment policies have fallen foul of the regulators because of their sophistication, expect program-driven investment strategies to go the same way. “I’m worried that selling your average hedge fund, even via a fund of funds, into a mass retail market, is going to end up to be nothing short of a long-term nightmare,” he adds.
Enforcement of market abuse has also created interest amongst hedge fund managers, particularly following the recent GLG case, and Jaffey himself, who represented GLG’s Philippe Jabre in that case, expects further cases to emerge in the near future. “I think the consequences of the GLG case are more balanced than people actually think,” he says. Accordingly, one of the important issues deriving from the case is the fact that the FSA is holding firms responsible for any alleged misconduct committed by an individual trader. “The message that’s been sent to firms is that firms are not separate from individuals,” Jaffey says. “Firms will also be pursued, even when the alleged conduct is committed by an individual.”
The other key point emerging from the GLG case is evidence that the FSA’s decision-making processes have become much more robust and independent, with the formation of the Regulatory Decisions Committee (RDC), tasked with ensuring that cases pursued by the Enforcement Division stand up to scrutiny. This will no doubt improve the quality of the cases brought by the Enforcement Division. In the GLG case, the RDC disagreed with the proposal that Jabre be stripped of his authorisation and also reduced the fine. It was an internal decision within the FSA, which would not have happened, in all likelihood, two or three years ago.
“What has happened as a result of that case...is that systems and controls in the bigger hedge fund managers and the use of restricted lists are now more widespread,” Shrimpton says. “Some firms are bringing in the policy where the portfolio managers can’t be approached by the banks. They approach the CEO or the head of compliance first. At the other end, they’re adopting systems and controls which mean they can’t place a trade in a stock once it’s on the restricted list. It’s very much following the institutional theme and what happens in the large institutional managers.”
According to Tim Rooke, a Partner at Ernst & Young, FSA scrutiny, transparency, valuation issues and the debate over whether hedge funds should be made available to the retail market, all serve to focus the minds of both managers and the lawyers advising those managers.
Andrew Shrimpton, who leads the hedge fund supervision team at the UK’s FSA, seems satisfied that the relationship between the UK regulator and the British-based hedge fund industry is working well: “I think that’s a model for the way the FSA wants to regulate, that is setting out the high level principle position and then maybe using industry guidance to help people understand better where we’re coming from, and people following the spirit of an initiative rather than getting bogged down with rules,” he says.
One legitimate concern has been the issue of the FSA intervening in fund-related issues on the question of side letters, as it has been the funds rather than the managers that issue these letters. “I’d reassure people that it’s not the thin end of the wedge,” Shrimpton says in response. “Our whole philosophy is about being risk-based and focused, so we will only make these interventions from time to time, where we think there is a problem and an issue.”
The FSA is already working hard in the valuations area and Shrimpton says the regulator has developed its own views on good practice, especially with reference to reconciliations, documentation of pricing policies and the segregation of duties. It is still discussing the issue with IOSCO for example, and will publish further details on its findings in April next year, including how this will feed into the FSA’s ongoing work. He thinks the findings are unlikely to be full of surprises but expect to see segregation of duties, including the practice of portfolio managers sending prices directly to administrators, on the agenda. “The one controversial area...is the degree to which managers can use prices from banks as a kind of reconciliation tool,” Shrimpton says.
Clash of cultures
The side letters issue may have been borne out of a clash of cultures between the way hedge funds have conducted themselves, and the way more institutional players behave. “The analogy I always use is that between a private sale of shares and a public IPO,” says Ben Jaffey, a barrister and a specialist in financial regulation from Blackstone Chambers.
Jaffey sees this debate over what is private, and what is public, at the crux of the regulatory question. Hedge funds have traditionally viewed themselves as private investment vehicles but now, with increased institutionalisation of the leading firms, the FSA is making it clear that they should now be regarded as public organisations, and regulated accordingly. Capital raising by hedge funds, while not what it used to be, has not graduated into the realm of an IPO, but private deals being conducted as part of the fund-raising process are being frowned upon. “They will view this as a breach of Principal 1, of honesty and integrity, the most serious allegation which the FSA has in its regulatory armoury,” Jaffey says.
The Bank of England, the UK Treasury and the FSA share very similar views on hedge funds, and liaise quite closely. The Bank of England in particular has voiced its concerns over the use of derivatives and their potential threat to financial stability. The best form of supervision is by keeping a close eye on the prime brokers and the managers: direct regulation of the funds themselves remains less of an issue. This is in direct contrast to the US, where there has been mixed signals from the Federal Reserve, and where, following the defeat of the SEC’s first hedge fund initiative, there remains confusion over what a future regime will look like.
According to Jaffey, the FSA knows that heavy regulation of the hedge fund industry in London will not be helpful to market stability. Hedge funds are “pretty flighty things” in his view, and can easily be managed outside the UK if necessary. “That doesn’t change the reality of what you’re doing – your transactions, your trading, will still take place on the London markets, and if you get your risk management horribly wrong, the collapse will still be felt very strongly on the London markets.” Massive swathes of new regulation are therefore considered unlikely, although increased supervision of risk management is likely to
continue.
Hedge funds and the retail sector
Retailisation of hedge funds has been an issue under discussion formally between the FSA and the hedge fund management community in London since summer 2005, when the FSA published its discussion paper on regulation. However, it has not sat at the top of the agenda. Shrimpton sees this as a process that will continue and anticipates a working paper on the subject will be issued in early 2007.
Jaffey remains uncertain about the benefits of retail hedge funds, as he anticipates this will require a whole new level of regulation. Black box trading applications are likely to encounter the most problems when seeking access to retail money. “They’re very difficult for anyone to actually work out what is going on,” he says. If splits and zeroes, precipice bonds and even endowment policies have fallen foul of the regulators because of their sophistication, expect program-driven investment strategies to go the same way. “I’m worried that selling your average hedge fund, even via a fund of funds, into a mass retail market, is going to end up to be nothing short of a long-term nightmare,” he adds.
Enforcement of market abuse has also created interest amongst hedge fund managers, particularly following the recent GLG case, and Jaffey himself, who represented GLG’s Philippe Jabre in that case, expects further cases to emerge in the near future. “I think the consequences of the GLG case are more balanced than people actually think,” he says. Accordingly, one of the important issues deriving from the case is the fact that the FSA is holding firms responsible for any alleged misconduct committed by an individual trader. “The message that’s been sent to firms is that firms are not separate from individuals,” Jaffey says. “Firms will also be pursued, even when the alleged conduct is committed by an individual.”
The other key point emerging from the GLG case is evidence that the FSA’s decision-making processes have become much more robust and independent, with the formation of the Regulatory Decisions Committee (RDC), tasked with ensuring that cases pursued by the Enforcement Division stand up to scrutiny. This will no doubt improve the quality of the cases brought by the Enforcement Division. In the GLG case, the RDC disagreed with the proposal that Jabre be stripped of his authorisation and also reduced the fine. It was an internal decision within the FSA, which would not have happened, in all likelihood, two or three years ago.
“What has happened as a result of that case...is that systems and controls in the bigger hedge fund managers and the use of restricted lists are now more widespread,” Shrimpton says. “Some firms are bringing in the policy where the portfolio managers can’t be approached by the banks. They approach the CEO or the head of compliance first. At the other end, they’re adopting systems and controls which mean they can’t place a trade in a stock once it’s on the restricted list. It’s very much following the institutional theme and what happens in the large institutional managers.”
