International Capital Markets

Hedge Funds

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;

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)

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).

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.

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.

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.)

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.

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.

Risks to financial stability and market confidence II

• Risk management.

• Valuation weakness Market abuse.

• Fraud.

• Money laundering.

• Conflicts of interest.

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).

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.

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.

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).

Risks to market confidence I

• Hedge funds have potential to (FSF, 2000):

- materially influence market dynamics;

- amplify market pressures;

- compromise market integrity.

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

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).

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.

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.

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.

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).

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.

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.

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.

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.

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.

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.

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.

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.