Proposed Changes in EU Regulation

Finding the way to hedge funds best practice

SELWYN BLAIR-FORD, FRSGLOBAL

On 1 April 2008 Charlie McCreevey, European Commissioner for Internal Market and Services, gave a briefing to the European Parliament’s Committee on Economics and Monetary Affairs, addressing the recent financial turmoil and some proposed regulatory policy responses. He discussed the roadmap on the issue of supervisory convergence.

The issues and implications for the hedge fund industry need to be put in the context of a long and concerted push from many politicians and market commentators in Europe, the USA and Asia to bring hedge funds under a formal regulatory regime. Prior to the current turmoil many observers had been convinced that hedge funds would be the instigators of the next financial crisis. It is in this context that the Hedge Fund Working Group (HFWG) in the UK and the President’s Working Group on Financial Regulation (PWG) in the USA have been working hard to establish a framework of best practice.

A speech of two halves

FINANCIAL TURMOIL
McCreevey focused on the recent turmoil in the financial markets which led to the collapse of Bear Stearns, the end of one of the UK’s best performing hedge funds and the dramatic movements in liquidity. The issues causing such upheaval were attributable to the following:

  • Weak internal validation models
  • Opaque securitisation
  • Business models that were built on disproportionate maturity mismatches between assets and liabilities
  • Weak internal controls and poor disclosure standards

The Commissioner argued that regulatory action was required to restore market confidence. This would be with particular regard to transparency, improving valuation standards for illiquid assets and removing potential conflicts of interest, most notably with the credit ratings agencies. The Commissioner also suggested that there was a need to strengthen the existing Capital Requirements Directive (CRD) framework, with securitisation and large exposure featuring prominently.

ROADMAP TO SUPERVISORY CONVERGENCE

The main thrust of this section was a suggested move to strengthen the committees, such as the Committee of European Securities Regulators (CESR) and the Committee of European Banking Supervisors (CEBS), to have a more formal role in ensuring regulatory convergence. This might include making the guidance from these committees legally binding, rather than advisory to the regulator (as they are at present). These suggestions prompted a strong reaction from the FSA and it is clear from the International Regulatory Outlook document issued in April 2008 that the UK regulator takes a different view.

IMMEDIATE IMPLICATIONS FOR HEDGE FUNDS

The weaknesses identified by the Commissioner are widely assumed not only to affect the banking and regulated financial sector, but hedge funds as well. Shortcomings concerning transparency, in this context referring to the unknown risks that are often contained in securitisation portfolios, have been consistently levelled at hedge funds. Improving the valuation of illiquid assets is another issue that many consider to be in need of re-evaluation by the hedge fund community.

This list, therefore, can be seen as a part of the catalogue of issues that hedge funds must address in order to reduce the pressure for tighter and more formal regulations. These issues are well known and many are already being addressed by the HFWG and PWG committees.


“In the long term, hedge funds need to develop and adhere to best practice”


The second half of the speech, although not immediately relating to hedge funds, can be perceived as an ominous step. The call to formally regulate the hedge fund sector is generally stronger outside the UK. Indeed, the FSA has gone on record saying that so far it does not see the requirement to regulate the funds themselves. In the event that the changes to the regulatory structure are implemented in the way indicated by McCreevey, those pushing for formal regulation of this nature would have their hand very much strengthened. The FSA by way of contrast is more concerned with extending the principle-based approach and challenging the implementation of the CRD. These principles are the same as those being addressed by the HFWG.

How the current turmoil may have changed things

Before the sub-prime and securitisations crises, hedge funds were expected to be the source of the next financial fallout. However, as is often the case, it was an area that the industry was not suspecting that ultimately delivered the next crisis. As a result, in the immediate aftermath, the calls for regulation of hedge funds have subsided. Regulation in the short term will not appear to be a major new constraint on business as the squeeze on liquidity impacting the finance sector will be of greater concern.

The hedge fund industry should be wary, as the tendency will be for commentators to associate hedge funds with investment banks and other hard-hit market participants. Hedge funds may therefore suffer some reputational collateral damage. As an industry, hedge funds should not miss an opportunity to point out that they are not the cause of the current turmoil and should certainly not be made the scapegoats.

In the long term, hedge funds need to develop and adhere to best practice. By effectively addressing the issues of investor disclosure, valuations, risks, governance and activism, the hedge fund industry will go some way towards placating those calling for increased regulation. Such a practice needs to be codified, and where appropriate, have standardised reporting. Funds may already be addressing most of these issues but no one should underestimate the work involved in building a high quality best practice environment, and the importance of organising the monitoring and reporting of these issues in a coherent and effective manner.

The issue of market transparency will remain an issue as hedge funds continue to play a significant role in the financial markets. What they do and how they do it can constitute important market information, which, if known, may impact prices. It can reasonably be argued that the lack of information available to the wider market works against market efficiency because all available information will not be factored in to the current market price.

Of course there is the counter argument that hedge funds’ market operations are usually carried out through regulated entities and hence a great deal of hedge fund actions will be known to the market. However, as long as the perception persists that the level of disclosure from hedge funds differs widely from other market players of similar levels of influence, one can continue to expect calls for further disclosure.

Selwyn Blair-Ford is Senior Domain Expert For Financial Regulation, FRSGlobal


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