The IOSCO Technical Committee published its consultation report, entitled Hedge Funds Oversight on 18 March 2009. The purpose of the consultation report was to describe the operating environment of hedge funds, highlight the associated regulatory risks, review and illustrate the work and recommendations issued by IOSCO and other international organizations and regulators in this area and to make preliminary recommendations of possible principles and actions that may serve to mitigate these risks. The aim of this final report is to recommend the following six high level principles on the regulation of hedge funds, taking into account the outcome of the public consultation and the hearing held in Madrid on 20 April 2009:
1. Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration.
2. Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to:
– Organisational and operational standards;
– Conflicts of interest and other conduct of business rules;
– Disclosure to investors; and
– Prudential regulation.
3. Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds.
4. Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes, including the identification, analysis and mitigation of systemic risks.
5. Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate.
6. Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.
The Task Force on Unregulated Financial Entities, co-chaired by the CONSOB of Italy and the FSA of the United Kingdom, was established by the IOSCO Technical Committee on 24 November 2008 in order to support the initiatives undertaken by the G-20 to restore global growth and achieve needed reforms in the world‘s financial systems following the recent financial crisis. The Task Force was requested to examine issues surrounding unregulated financial entities. Given the G-20‘s particular interest in hedge funds, the Task Force decided to focus its work on hedge funds, rather than deal with other potentially “unregulated” entities such as private equity funds (which have very recently been reviewed by IOSCO) or special investment vehicles (which could as easily be described as “products” rather than “entities”). However, many of the observations and conclusions described in the consultation report and in this final report may be applicable to other market participant entities that hold and/or control large pools of capital.
The IOSCO Technical Committee acknowledges in its consultation report that there is no consistent or agreed-upon definition of the term hedge fund. Previous IOSCO works recognised that an approach for identifying these types of entities is to look at the kinds of characteristics of and strategies employed by institutions that would consider themselves to be hedge funds. On this basis, IOSCO has considered as “hedge funds” all those investment schemes displaying a combination of some of the following characteristics:
• borrowing and leverage restrictions, which are typically included in collective investment schemes related regulation, are not applied, and many (but not all) hedge funds use high levels of leverage;
• significant performance fees (often in the form of a percentage of profits) are paid to the manager in addition to an annual management fee;
• investors are typically permitted to redeem their interests periodically, e.g. quarterly, semi-annually or annually;
• often significant “own” funds are invested by the manager;
• derivatives are used, often for speculative purposes, and there is an ability to short sell securities; and
• more diverse risks or complex underlying products are involved.
Despite the broad characteristics described above, it is difficult to define hedge funds on a universal basis, given their different legal and business structures – not only across different jurisdictions but even within a single jurisdiction.
The conclusions and recommendations of the consultation report were provided as input into the G-20 summit in April 2009. The G20 favoured increasing regulatory oversight over hedge funds/hedge fund managers, as stated in its declaration of 2 April 2009:
Hedge funds or their managers will be registered and will be required to disclose appropriate information on an ongoing basis to supervisors or regulators, including on their leverage, necessary for assessment of the systemic risks that they pose individually or collectively. Where appropriate, registration should be subject to a minimum size. They will be subject to oversight to ensure that they have adequate risk management. We ask the Financial Stability Board (FSB) to develop mechanisms for cooperation and information sharing between relevant authorities in order to ensure that effective oversight is maintained where a fund is located in a different jurisdiction from the manager.
The IOSCO Technical Committee is aware of the European Commission‘s proposed Directive on Alternative Investment Fund Managers (AIFMs) which has the objective of creating a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level. Although there may be potential overlaps, the scope of this proposed Directive is broader than the scope of the work of the IOSCO Task Force. In the United States, the US Treasury Department has proposed the following approach with respect to hedge funds: required registration of all advisors to hedge funds whose assets under management exceed a certain threshold; mandatory requirements for disclosure to investors and counterparties and for regulatory reporting; regulatory reporting requirements regarding information necessary to determine whether any hedge funds could pose a systemic threat and should be subjected to prudential standards. While it is anticipated that Congress will consider legislation in 2009 regarding these proposals, it is unclear what the ultimate regulation will be.
The recent financial crisis has uncovered a series of vulnerabilities in the international financial system. The market events of the last year illustrate that investment risk can spread across global economies, asset classes and capital structures. Financial institutions and individuals have been exposed to the systemic risks associated with the broken trust and loss of confidence in the capital markets. The spreading lack of investor confidence has also had an adverse impact on investment funds. Frozen credit markets combined with recent large scale frauds have weakened existing and potential investor confidence in every category of investment fund and have made investors suspicious of non-transparent investment activity by large capital pools. For investor confidence to return to these funds and to the financial sector in which they operate, coordinated and consistent action is necessary, recognising that global economies are interconnected and financial instruments and investment vehicles are interdependent. Restoring investor confidence will require the application of common approaches to regulatory risks and co-operation across multiple jurisdictions and different financial instruments. In this respect, the IOSCO Technical Committee believes that the six high level principles on hedge funds regulation that it recommends in this final report will be essential in restoring investor confidence through improved investor protection and better detection and avoidance of systemic risks and other regulatory risks posed by hedge funds. Despite these issues, the IOSCO Technical Committee in its consultation report and industry representatives in their responses to the consultation recognised the benefits hedge funds may provide to financial markets. Hedge funds can provide liquidity, price efficiency, and risk distribution, can contribute to the further global integration of financial markets and can offer diversification benefits. A balanced and measured approach to regulating hedge fund activity is therefore needed to ensure these benefits continue, while the risks noted above can be effectively mitigated.
Developing the six principles
The consultation report discussed the regulatory issues presented by hedge funds. It focused on the recent financial crisis and issues around systemic risk but also touched on on-going regulatory concerns regarding hedge funds, including investor protection and market integrity issues and monitoring and investigating cross border activity. Importantly, it recognised that the recent financial crisis is not actually a hedge fund crisis. Indeed many of the financial firms that failed or required governmental intervention were already subject to a high degree of regulatory oversight. However, the activities of hedge funds may have amplified the consequences of the crisis. This occurred, for instance, because of the need for hedge funds (along with many other market participants) to quickly unwind positions because of liquidity restrictions in meeting margin calls or significant requests for redemption by investors. Questions have also been raised regarding whether, and to what extent, it is appropriate to rely on existing industry led initiatives to develop codes of good/best practice. Even if the coverage of such standards, coupled with the official sector recommendations, is quite broad, open questions remain as to the effectiveness of such standards. This is primarily because:
• the number of hedge fund managers adopting the different standards varies and adoption of some of the standards remains relatively low;
• there are a number of different industry standards in force that cover a range of various issues;
• regulatory standards differ between jurisdictions; there are still open questions regarding the enforceability of such codes either by regulators or industry associations.
It is very important to emphasise, as recognised by some industry members in their responses, that any regulatory measures or standards need strong collective global action and application – as the hedge fund industry is highly global and mobile.
Having considered the public comments received on the consultation report, the IOSCO Technical Committee has developed the six high level principles [above] which should be applied to the regulation of hedge funds. These principles should enable regulators to address, in a collective and effective way, the regulatory (including investor protection) and systemic risk posed by hedge funds. It is envisaged that this can be achieved, for instance by either strengthening the existing standards and practices comprising national regulatory regimes and/or by introducing additional requirements.
Some recommendations are not in the IOSCO remit to deliver in isolation but will need support from banking standard setters (Basel Committee on Banking Supervision) and other regulators. There is also a general need to strengthen regulatory resources and expertise in the area of hedge fund regulation and improved information sharing by, and amongst, regulators.
Public comments received on the consultation report
Many comments received by the respondents are broadly consistent with the approaches endorsed in the final report. In line with the position expressed by the majority of the contributions, the Report recommends a balanced mixture of indirect and direct regulation of the hedge funds and/or their managers/advisers, consistent with the principle of proportionality and a risk-based approach. This regulatory option is also consistent with the G-30 recommendations and the last G-20 declarations, where it is recognised that hedge funds or their managers should be subject to registration and ongoing supervision.
Some specific proposals have been opportunely incorporated into the report, including more detailed references to the systemic impact of counterparties and an integration of the list of information to be provided to the regulator at authorisation/registration. Moreover, the report recognises that many of the conclusions and observations may be applicable to other under-regulated entities that control large pools of capital.
The section concerning international cooperation and regulatory convergence reflects the call for a more level playing field and consistent worldwide supervision. However, it should be considered that the views and concerns expressed in the responses were often divergent. Therefore, the IOSCO Technical Committee has agreed that some proposals received were not to be taken forward. In particular, those contributions strongly against registration/authorisation and prudential regulation of hedge funds/ managers appear to be in contrast with the guidance clearly provided by the G-20 and G-30 ministers. Similarly, the need to ensure that compensation structures are subject to strong governance has been recommended by the FSB and cannot be overlooked.