International Capital Markets

1. International Capital Markets Hedge Funds

2. Background: the hedge fund market I • Hedge find investment management techniques: - short selling; - derivatives for investment purposes; - debt leverage as well as leverage embedded in financial instruments such as derivatives. Other characteristic of hedge funds: - pursuit of absolute returns; - charging performance-based fees as well as management fee based solely on assets under management;

3. Background: the hedge fund market II - hold broader mandates than traditional funds thereby giving managers more flexibility to shift strategy; - high trading volumes/fund turnover; - frequently setting a very high minimum investment level (e.g. US$ 100,000 or more)

4. Background: the hedge fund market III • Structure of UK managed hedge funds: - fund manager/advisor located in UK and supervised by FSA; - prime brokers in London generally used to execute trades and for financing, stock lending and research; - funds typically based in non-UK domiciles (e.g. Cayman Island, Bermuda and BVI); - administrators typically based offshore (Ireland, Cayman Islands, Luxembourg).

5. Strategies • Dynamic investment strategies: - can go long or short; - use leverage to obtain higher exposure; - depending on stated strategy, can invest in a wide range of asset classes, instruments, markets, etc.; - macro, long/short, distressed debt, event-driven, multi-strategy, etc. • Seek absolute returns, not vs benchmark – but changing with development of hedge fund indices.

6. Limited regulation of UK hedge fund industry I • Regulation constrained to those parts of industry within national jurisdiction. • FSA authorises credit providers to hedge funds, but do not authorise funds themselves, nearly all domiciled offshore • Nor does FSA authorise most of the administrators (offshore). • Contrast with traditional fund management industry (authorised collective investment schemes), with managers and administrators generally located in the UK.

7. Limited regulation of UK hedge fund industry II • Supervision of hedge fund managers is not intensive because they attract a low impact/risk rating. • No separate authorisation to be prime broker – firms authorised as commercial or investment banks. (But activities – execution, financing and stock lending – are regulated.)

8. Limited regulation of UK hedge fund industry III • Hedge fund manager authorisation under Financial Services and Markets ACT (FSMA) because they carry on activities under: - article 37 (managing investments); - article 53 (advising on investments). • Authorisation – fit and proper. • FSA rules on systems and controls, and conduct of business rules.

9. Risks to financial stability and market confidence I • Serious market disruption and erosion of confidence. • Liquidity disruption leading to disorderly markets. • Insufficient information to inform regulatory action. • Control issues. • Operational risk.

10. Risks to financial stability and market confidence II • Risk management. • Valuation weakness Market abuse. • Fraud. • Money laundering. • Conflicts of interest.

11. Risks to individual funds or clusters of funds • Failure could: - cause severe market disruption; and - erode confidence in financial strength of: - other hedge funds; and/or - counterparties to fund(s). • LTCM (1998); GM & Ford downgrades (2005).

12. Risk of ‘long tail’ events • VaR models rely on normal distribution of outcomes. • But very low probability events occur ,ore often than implied by normal distribution – ‘long-tail’ events. • Example: Russian default crisis (1998); summer 2007 market turmoil.

13. Impact of markets and market confidence • Any significant hedge fund event could potentially lead to disorderly markets. • Risk is largely unknown. • Transmission of shocks (and potential for ripple/domino effect) not truly tested in recent history.

14. Risk mitigation • FSF ad hoc Working Group on Highly Leveraged Institutions (HLIs) – recommendations (2000): - stronger counterparty risk management; - stringer risk management by hedge funds; - enhanced regulatory oversight of HLI credit providers; - building a firmer market infrastructure; - enhanced disclosure by HLIs. 1-4 national initiatives (5 less significant moves).

15. Risks to market confidence I • Hedge funds have potential to (FSF, 2000): - materially influence market dynamics; - amplify market pressures; - compromise market integrity.

16. Risks to market confidence II Hedge funds: - dynamic and innovative; - can significantly enhance market liquidity and market efficiency; but - augment risk through leverage; - may test boundaries of acceptable market practice and alter market dynamics

17. Market risk • Hedge fund with $1bn AUM may have far greater market impact than traditional asset manager with $1bn AUM because hedge funds characterised by: - high transaction volume/fund turnover; - concentrations in less liquid markets; - concentrations in innovative/complex products; - concentrations in high profile corporate events/market movements; - use of risk augmenting (e.g. leverage).

18. Liquidity risk (market liquidity) • Surveys show hedge fund managers comfortable with market liquidity, but…. …monitoring slippage (the difference between the prevailing price when they decide to trade and the realised trade price). • Liquidity may be illusory if it is all concentrated among hedge fund manager with similar strategies/risk management models – all exit positions/market at same time.

19. Opacity • Due diligence is reportedly increasing, esp. by some particularly well-run funds. • But hard for investors to understand increasingly complex strategies or to track style drift. • Prospectuses broadly drafted so as not to restrict investment opportunities. • Detailed newsletters for investors in many cases.

20. Counterparty risk • Counterparty risk, and hence contagion risk, is complex, based on investments, trading relationships, stock lending and borrowing, etc. • No evidence of significant loosening of majority of banks’ credit standards, but late entrants may unusually flexible on credit terms to enter prime brokerage business.

21. Control/operational issues • High start-up costs and many new entrants • Survival rate and industry consolidation. • ‘Star traders’ set up business with no proven management skills. • Rapid growth can lead to back-office pressures (e.g. unconfirmed and unsettled trades).

22. Risk management • FSA concluded risk management generally fit for purpose but framework less robust/documented than in investment banks. • Investors focused on two high-level metrics: - a fund’s experienced loss-levels for month, year-to-date and drawdown the previous high-watermark; - performance against an annualised volatility target.

23. Issues • How should one distinguish hedge fund managers from other discretionary managers/advisers? Is such a distinction desirable? • Should supervisory oversight be enhanced and, if so, how? FSA already enhanced monitoring of counterparties – should it step up supervisory oversight of funds with significant market impact? • Enhanced data collection – what data?; cost-benefit analysis.

24. Due diligence Encouragement of improvements in disclosure and due diligence. Limitations: - due diligence only possible on available data (inadequate or inaccurate disclosure will impair due diligence); - due diligence per se does not reduce risk – it merely allows effective assessment of risk and consequent informed decision-making; - shocks can still occur.

25. Valuation I • Administrators valuing illiquid or complex assets use: - counterparty quotes; - valuation models (frequently developed by hedge fund itself); - direct valuations from the hedge fund manager.

26. Valuation II • Difficulties in promoting improvements in valuation: - largely unregulated nature of hedge fund administration industry; - international, frequently offshore, nature of hedge fund administration industry; and - the level of skill required to value complex assets.

27. Risks to market cleanliness • Market abuse – i.e.: - some hedge funds testing the boundaries of acceptable practice with respect to insider dealing and market manipulation; and - given their payment of significant commissions and close relations with counterparties, there are incentives for others to commit market abuse.

28. Risks to FSA’s financial crime objective • Fraud: - incentive structures, light regulatory oversight & weaker control environments raise likelihood that hedge fund managers will commit fraud (e.g. false valuations); - money laundering: evidence suggests no greater likelihood of failure to fulfil anti-money laundering responsibilities than traditional asset managers.

29. Risks to FSA’s consumer protection objective • Key concern – conflicts of interest: - hedge fund fee structures may encourage pension fund consultants to encourage excessive investment in hedge funds; - fee structures could also encourage mixed tradition/hedge fund investment firms to in appropriately favour the hedge funds when placing or allocating deals.