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.