A Contribution

to the Consultation[1] of the EU Commission on

HEDGE FUNDS

by

The Czech National Bank

on January 30, 2009

General Standpoint

The introduction of any regulation should always be assessed from the point of view of the objectives (reasons and benefits) to be achieved and the costs incurred. The regulation of hedge funds is not considered desirable on our part, because we are of the opinion that for one thing, hedge funds cannot be effectively regulated, and for another thing, their regulation might not be beneficial to markets and investors.

Hedge funds, being very diverse entities operating in different jurisdictions and applying differing investment strategies, are particularly difficult to define exactly. It can be agreed that hedge funds can be characterised by certain features which they frequently possess, such as their focus on the delivery of absolute returns, considerable amount of financial leverage and orientation towards institutional and sophisticated investors. However, such characteristics alone do not suffice to establish a clear definition of a hedge fund for the purposes of regulation (some of these characteristics are possessed by a number of other market participants and it will be difficult to resolve what still constitutes a hedge fund and what does not). If we cannot clearly define an entity, we cannot subject it to effective regulation either. If we tie hedge funds with regulatory requirements, the funds will be deprived of their diversity and their freedom of choice of investment strategies, thereby denying a specific category of investors the option to invest their money while accepting a higher level of risk.

Hedge funds are primarily aimed at professional investors (institutional or high net worth private investors). These investors can be expected to possess enough erudition and experience to be able to make their own assessment as to whether investing in hedge funds is appropriate for them or not. As a rule, small investors do not have access to direct investment in hedge funds and, consequently, there is no need to introduce regulation aimed at protecting these investors. On the contrary, the introduction of regulation with the aim of protecting investors (or even with the aim of creating conditions for the funds’ public offerings) would be counterproductive, because it might lead to misguided conclusions of a lower level of risk of investing in these entities just because they are regulated, and possibly to false impressions about investor protection or even a promise of support by the state in the event of a hedge fund failure.

Hedge funds provide investors with alternative investment strategies involving above-average returns, portfolio diversification and other benefits which regulated collective investment schemes can seldom offer. If acknowledging that the existence of hedge funds is beneficial in normal market conditions (increasing the liquidity and efficiency of markets), it cannot be reasoned that their functioning is unwelcome or even intolerable and should be restricted if market conditions become non-standard. The introduction of regulation aimed at imposing restrictions on the risk profile or investment strategies of hedge funds may reduce their positive impact on the performance of financial markets.

Financial stability is not put in danger directly by hedge fund activity, but it may be affected indirectly through banks of systemic importance which have exposures to hedge funds as counterparties to deals, loans or investments. Therefore, measures to ensure financial stability should be primarily focused on banks and their risk management systems. There is no reason to regulate hedge funds in order to lower the risks for banks (as other entities to which banks have, for example, credit exposures are not regulated likewise). Banks should aggregate their overall exposures to hedge funds within their risk management systems, quantify the risks attached, including stress scenarios, select techniques for mitigating them and have enough capital to cover them. Banks should also require hedge funds to provide enough information relevant for these purposes.

Hedge funds are frequently domiciled outside the EU, typically in off-shore centres (the Cayman Islands, the Bahamas etc.), i.e. jurisdictions outside the reach of EU regulation (and also of the regulation of other advanced countries such as the United States). Regulatory measures adopted in the EU would undoubtedly fail to achieve the desired effect. An alternative might be regulation by imposing requirements on hedge fund managers, which are EU entities in many instances, often even regulated entities. However, a risk arises that some of the entities falling under such regulation would move their activities to other locations in order to avoid regulation.

It is essential to state clearly whether a substantial reason for the regulation of hedge funds exists. Two principal reasons suggest themselves for consideration, namely to regulate hedge funds from the point of view of financial stability or from the point of view of investor protection. Our above-mentioned opinion implies that it is considerably more important from the financial stability viewpoint to insist that the regulatory requirements for risk management be consistently observed on the part of banks and other regulated entities which have material exposures to hedge funds. Regulation motivated by investor protection seems groundless to us, because hedge funds are not primarily aimed at retail investors that need protection.

Answers to the individual questions

1. The definition of a hedge fund

Question 1

Are the above considerations sufficient to distinguish hedge funds 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?

Hedge funds are difficult to define exactly in legal terms. These entities are characterised by a high degree of diversity with respect to both their legal form of existence and their way of conducting business (investment strategy). Agreement can certainly be found on certain characteristics of hedge funds, such as their focus on the delivery of absolute returns, financial leverage and orientation towards sophisticated investors. However, these characteristics are not confined to hedge funds only.

Question 2

Given the international dimension of hedge fund activity, will a purely European response be effective?

We are convinced that the introduction of regulation within the EU only would be rather counterproductive. The majority of the entities operating as hedge funds are already incorporated in off-shore centres, primarily for regulatory and tax reasons. The introduction of the regulation of hedge funds, or regulation by imposing requirements on their managers, would probably lead to the hedge fund business moving out of the EU. Therefore, we do not consider the regulation of hedge funds to be beneficial; however, it would be appropriate to strengthen the information disclosure requirements on the basis of private professional associations’ standards.

2. Systemic risks

Questions 3 to 5

Does recent experience require a reassessment of the systemic relevance of hedge funds?
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?
Do prudential authorities have the tools to monitor effectively exposures of the core financial system to hedge funds, or the contribution of hedge funds to asset price movements? If not, what types of information about hedge funds do prudential authorities need and how can it be provided?

Although it is said that hedge funds have grown fifty-fold in terms of assets under management since 1990, this figure still accounts for only 5–10% of the assets managed by the global fund industry. We do not consider the financial stability issue to be a problem relating to hedge funds; we consider it to be a problem relating to the banking sector and its regulation and supervision. Therefore, the key issue from the point of view of financial stability is not the direct regulation of hedge funds, but their indirect regulation and appropriate supervision of the risk management activities of banks having material exposures to hedge funds. Correspondingly, supervision of regulated entities which invest in hedge funds (e.g. pension funds) is necessary.

The CNB does not currently monitor the exposures of banks and other regulated entities to hedge funds. If necessary, it would be possible to obtain such data by extending the scope of information provided to the CNB by these entities.

3. Market efficiency and integrity

Questions 6 to 8

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?
Are there situations where short-selling can lead to distorted price signals and where restrictions on short-selling might be warranted?
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 hedge funds, in particular, as opposed to general tightening of market abuse disciplines?

We do not possess relevant data on hedge funds’ direct operations on the domestic financial market. However, we are of the opinion that if the presence of hedge funds as unregulated entities in financial markets is accepted as desirable and beneficial under normal conditions, we cannot say that the functioning of unregulated hedge funds on financial markets becomes undesirable if market conditions become stressed and non-standard. The same could be said about any other entity operating on the financial market and its transactions depending on market developments.

We do not consider the issue of short-selling to be a problem relating solely to hedge funds. This technique can be utilised and is utilised by other entities operating on financial markets as well. If the rules for short-selling were to be tightened up, it would need to be undertaken on a cross-market basis and apply to all entities. However, we are very cautious as to the possibility of tightening up these rules. According to preliminary assessments, the recent experience of some EU member states which introduced a temporary ban on short-selling has not produced the desired results. Additionally, the principle of short-selling can be circumvented via the use of derivative instruments. It is very awkward to label a trading technique as either acceptable or unacceptable just depending on market developments. The solution consists, in our opinion, in applying firm regulation relating to market abuse.

4. Risk management

Question 9

How should the internal processes of hedge funds 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?

Internal processes and risk management are up to each individual hedge fund. As long as hedge funds are not regulated entities, their risk management cannot be regulated either. However, we certainly support the intention of private professional associations (e.g. the Alternative Investment Manager and Manager Fund Association) to establish their own standards.

5. Investor protection

Do investors receive sufficient information from hedge funds 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?
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?

We do not consider the issue of investor protection to be relevant in respect of hedge funds. Hedge funds are aimed at sophisticated professional investors that can be expected to possess enough erudition to make a qualified decision as to whether they should invest in hedge funds or not. Sufficient information should be demanded by the investors themselves – it is up to them to determine which information they require from hedge funds before investing in them. Relevant standards should be established by private professional associations, not by regulation.

The introduction of the regulation of hedge funds with a view to facilitating the access of retail investors is not considered relevant on our part. Additionally, this concept entails a risk of moral hazard, because retail investors might get the impression that such investment is safe investment in a regulated entity. Therefore, we consider it appropriate for hedge funds to continue to be unregulated entities whose business is not supervised, and for full responsibility for the decision on, and the consequences of, such risky investment to remain with the investor.

[1] http://ec.europa.eu/internal_market/consultations/docs/hedgefunds/consultation_paper_en.pdf