Consultation Paper on Hedge Funds
Working Document of the Commission Services
We would like to welcome the present initiative of the Commission on a matter that has raised in the past few years an intensive debate on whether Hedge Funds (HF) should be subject to tightened regulatory standards.
During this period, a lot of significant material has been produced on the issue, of which we may cite the standards put forward by IOSCO relating to the ‘Principles for Evaluation of Hedge Funds Portfolios’ and the ‘Proposed Elements of International Regulatory Standards on Funds of Hedge Funds: Related Issues Based on Best Market Practices’.
Having in mind the evolution registered by this type of investment vehicle, the Portuguese legal framework for HF itself has been evolving also in the past few years, since it was launched in 2003, making it possible the incorporation not only of Funds of HF (FoHF) but also ‘pure’ HF. These funds, created under the legal regime for Special Investment Funds, that also encompass other types of collective investment vehicles different from HF, may be sold to retail investors with the observance of specific transparency, valuation and risk diversification requirements, this last imposed on a case by case basis. In fact, in what respects transparency and valuation, rules on disclosure of information and valuation techniques were imposed that are similar to those observed by UCITS and, in what concerns the composition of the portfolio, although HF are not bound to the tight UCITS limits, a principle of diversification presides always the authorization process. Furthermore, a thorough scrutiny of the proposed investments on certain off-shore funds is performed by the regulator, namely to ensure the soundness of their governance and regulatory structures.
In this scope, we aim to contribute to the present public consultation not only in the light of the experience gathered by the CMVM in participating in the IOSCO Standing Committee 5 (that has produced the above mentioned standards) but also taking advantage of the background of our knowledge in approving and supervising this type of funds.
- Scoping the issues
Question 1: Are the above considerations sufficient to distinguish HF from other actors in financial markets (especially other leveraged institutions or funds)? If not, what other/additional elements should be taken into account? Do their distinct features justify a targeted assessment of their activities?
This question, in fact, endorses three different sub-questions.
The first one relates to the characterization made in the paper of how HF can be defined.
We agree in general with the three main items used to characterize HF, although some of them do not fit necessarily to all types of HF. In fact, of the several investment strategies that are typically attributed to a Hedge Fund, there is not always the need for using high and systematic levels of leverage, as it is the case of strategies such as ‘Equity Market Neutral’, ‘Event Driven strategies’ or ‘Emerging Marketsstrategies’. Furthermore, narrowing the target investors of HFonly to Institutional or sophisticated investors, is a notion that is more and more out of date since the retailization of these products has grown significantly in the past few years, even if through the indirect form of FoHF (an estimated number of more than 2700 FoHF were operating in the end of 2008 according to the company Hedge Fund Research -).
The second sub-question respects to otherother/additional elements that should be taken into account to characterize HF.
In this particular, we believe that more elements for the characterization of HF may be included. HF may have an higher percentage of complex strategies or assets that are widely recognized as being ‘hard’ to value assets’, due to their complexity and the inexistence of market prices. Even if this is not an unique feature it is not uncommon to find out higher relative percentage of both of them. The second one concerns to the liquidity of HF themselves which is normally subject to specific timeframes (windows of redemption). Again, this could be used as another element to distinguish HF from other funds (e.g. UCITS). The third one, even though this is not the case for Portuguese HF, respects to the fact that HF lack public disclosure of their portfolios and investment strategies contrary to other (more) common types of funds.
Finally, the third sub-question queries if HF’s distinct features justify a targeted assessment of their activities.
Our answer is positive to this question.
Firstly, in a more broadly scope, we believe that in what respects to systemic risks brought to financial markets, the activity of HFwhether or not their strategies involves high leverage and its prime brokers should be subject to tighten monitorization to avoid cross linked failures or severe impacts in the financial markets (locally or globally).
Secondly, for the reasons pointed out in sub-question 2, we feel that the rules for the valuation of HFportfolios should be rigorously defined and monitored by independent third parties, which could be done taking advantage of the ‘nine principles for valuation’ proposed by IOSCO. This is a very meaningful aspect not only because fair valuation is decisive to ensure that investors subscribe and redeem their unit shares also at a fair price, but also because the issue of valuation raises conflicts of interest that must be dealt with because the Hedge Fund managers payoff rely heavily on performance fees.
Question 2: Given the international dimension of Hedge Fund activity, will a purely European response be effective?
A European response will not be entirely effective but may trigger other jurisdictions to follow similar approaches. This is true in the sense that most HF still operate from non or less regulated jurisdictions such as off-shores and these funds, in some cases, e.g. via FoHF, may be sold to retail investors. Additionally, the dialogue with US Authorities/regulators on this matter is essential to guarantee a worldwide response to this phenomenon since the ‘local ‘industry is further more developed than the European one.
- Systemic Risks
Question 3: Does recent experience require a reassessment of the systemic relevance of HF?
Yes. More transparency is welcomed in what regards the information to be disclosed to regulators and other investors about theHF portfolios, their strategies and their valuation methodologies. This will allow regulators and other stakeholders to havebetter assess to how HFand their prime brokers influence the financial markets.At least in what it respects to on-shore HF.
Question 4: Is the ‘indirect regulation’ of hedge fund leverage through prudential requirements on prime brokers still sufficient to insulate the banking system from the risks of hedge fund failure? Do we need alternative approaches?
No, it is not sufficent. Prudential requirements for prime brokers exist to allow them to meet their obligations vis-à -vis their clients and to avoid the insolvency of those institutions. To have prudential requirements in “one leg” of this very complex financial activity and not on the “other leg” (HF) means a skewed approach and allows arbitrage.
Question 5: Do prudential authorities have the tools to monitor effectively exposures of the core financial system to HF, or the contribution of HF to asset price movements? If not, what types of information about HF do prudential authorities need and how can it be provided?
No, we believe they have not and will probably never have it on a global basis. Even if regulators are informed of the strategies and positions of regulated HF in several assets, allowing for the privacyof this information not to undermine competition among HF managers, there will always remain the question of off-shore funds that may not be bound to such obligation. The road to follow seems to be the one of cooperation and continuous striving to bring such jurisdictions to sign effective MoU, namely under the scope of IOSCO MMoU.
- Market Efficiency and integrity
Question 6:Has the recent reduction in hedge fund trading (due to reduced assets and leverage and short-selling restrictions), affected the efficiency of financial markets? Has it led to better/worse price formation and trading conditions?
There is no global empirical evidence. However, regulators around the world have recently restricted short-selling practices, in some cases only naked short-selling, with the conviction that the crisis installed in financial markets could be even deepened if these practices were not controlled. We could say that the cut verified in credit markets and these measures taken by regulators may have had some negative effects in the liquidity of the markets. It seems wiser to wait for the conclusions to be withdrawn from the recently created CESR’s Task Force that will analyze the impact of the temporary measures taken by its members on this issue.
Question 7:Are there situations where short-selling can lead to distort price signals and where restrictions on short-selling may be warranted?
In principle, short-selling should not necessarily be seen as a bad thing since it may contribute to enhance a more correct price discovery process. Nonetheless, under specific and extreme market conditions, the use of short-selling may create a (panic) pressure on the sell side that may bring prices out of any economic rationality. Under these extreme conditions to restrict the usage of short-selling, on a temporary basis, could help the price formation.
Question 8:Are there circumstances in which short-selling can threaten the integrity or stability of financial markets? In combating these practices, does it make sense to tighten controls on HF, in particular, as opposed to general tightening of market abuse disciplines?
As referred previously, the stability of financial markets under extreme conditions could be endangered by a significant proliferation namely of (naked) short-selling practices. Furthermore, this type of strategy may alsohave negative effects upon the integrity of the markets, namely if successive settlement failures occur due to uncovered positions. Nonetheless, this issue should not be exclusively directed to HF but dealt within a global framework for market abuse, namely if short-selling positions (or other long positions) are followed by rumors or misinformation about poor (bright) performance of the companies involved.
- Management of micro-prudential risks
Question 9:How should the internal processes of HF be improved, Particularly with respect to risk management? How should an appropriate regulatory initiative be designed to complement and reinforce industry codes to address risk management and administration?
We identify four areas were the management of risks may be improved and were respective regulatory measures or at least recommendations could be proposed.
The first one respects to the mandatory implementation of risk measurement tools for the HF portfolio and the obligation of reporting such information to regulators.
Secondly, in what respects FoHF,the management of liquidity risks.
Thirdly, also in the field of FoHF the operational/fraudulent risk related to the underlying funds should be managed through a thorough due diligence process to be carried out by FoHF managers for the purpose of selecting and monitoring the underlying hedge funds, namely avoiding investments in opaque or with no track record HF.
Fourthly, in what respects the valuation of HF assets, we believe that the principles proposed by IOSCO (‘the nine principles’) should be adopted as a regulatory standard since they allow for a transparent and independent valuation process.
THE CESR is conducting an analysis in the risk management policy of asset management entities that can help defining the starting point to HF managers.
- Transparency towards investors and investor protection
Question 10:Do investors receive sufficient information from HF on a pre-contractual and ongoing basis to make sound investment decisions? If not, where do the deficiencies lie? What regulatory response if any is needed to complement industry codes to make a significant contribution to the transparency of Hedge Fund activities to their investors?
We are convinced that in the case of Portuguese HF they do. However, we know this is not the common practice in the industry as a whole. The main deficiencies lie on the fact that HF are normally incorporated as private companies and due to that there is insufficient disclosure to investors. Additionally, they do not have the practice of an ongoing disclosure of the portfolio to other interested stakeholders.
Question 11:In light of recent developments, do you consider it a positive development to facilitate the access of retail investors, subject to appropriate controls, to hedge fund exposures?
Yes. HF are another class of assets that can fulfill the investors needs whenever exists transparency and supervision .
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