Q&A with Andrew Crain

Manager, Alternative Investments & Asset Management Team, FSA

Originally published in the June 2010 issue

Andrew Crain joined the Financial Services Authority in late September 2008 to head the Alternative Investments and Asset Management Team just as the financial crisis was entering into its most critical phase. This ushered in heightened focus on the FSA’s supervisory responsibilities for hedge funds among parliamentarians, the financial services sector and the media. It also coincided with early moves by the European Commission to deploy additional regulation on fund managers through the proposed Alternative Investment Fund Managers Directive.

The experience that Crain brings to the challenges confronting the FSA is broad. Immediately prior to joining the regulator Crain was a senior advisor at the Public Interest Oversight Board in Madrid. In his native Australia, Crain held proprietary trading roles with ANZ Bank and BNP Paribas focusing mainly on interest rates and derivatives. He also served a period with the Australian Securities and Investments Commission (ASIC) where he was responsible at different times for supervision of market operators and relations with overseas regulators.

The FSA has had a heightened profile in recent months stemming from successfully prosecuting cases of insider dealing and dawn raids to crack down on suspected cases of market abuse. Crain’s own role is rather more supervisory in scope and focuses on relationship management of many of London’s biggest hedge fund groups. He spoke recently with Bill McIntosh, Editor of The Hedge Fund Journal in an interview at the FSA’s headquarters in Canary Wharf. The following is an edited transcript of that conversation.

Q: What is the background on the FSA’s approach to hedge fund supervision and how has this developed in your view?

A: You need to begin with disasters. That is how a lot of regulation and supervision comes about. I think you could go back to Long Term Capital Management. People were worried but not so much about what LTCM did, but rather what the knock-on effects could be to counterparties and markets and why it wasn’t on regulators’ radar. Then the Asian crisis provided more evidence that participants which were not ordinarily looked at very closely had positions that in stress situations became significant. The FSA’s supervisory approach is to determine the risk firms pose to our regulatory objectives and do what is necessary to mitigate those risks. Applying specific resources to supervision of hedge funds came about before I joined and was prompted by a desire to understand and manage the potential knock-on or ripple effect to prime brokers and other market participants of a large hedge fund or group of smaller hedge funds failing.

Another objective is to look at how the activities of hedge funds impact on market stability and confidence. Because of the way hedge funds trade there is always the potential for concentration risks: either in their own positions or through crowded trading in a segment of the market place. The other area where there is interest is market abuse. I’m not suggesting that hedge funds are the cause of, or more susceptible to, market abuse – but just like any other market participant that we supervise there is potential for market abuse and we must be alert to this.

The financial crisis has made the FSA more concerned with where regulated firms are in their life cycle and the general viability of businesses. There is a definite difference in the life cycle of hedge funds versus other financial firms like banks or insurers. There is evidence that a goodly proportion of funds, perhaps one-third, fail in the first three years. We are concerned about the knock-on effects of (hedge fund) failure but we also recognise that the industry has inbuilt failure. It is self regulating in that way.

Q: You joined the FSA 18 months ago when a great deal of change was beginning to happen very rapidly. What would you say has changed in the last 18 months and how have you had to adapt how you supervise the hedge fund sector in the UK?

A: I joined right at the time of Lehman’s (collapse). We were already looking at what the impact of failure in a fund or a manager would have on a prime broker. I don’t think anyone every thought that it could work the other way – that you’d havea prime broker relationship cause assets to be lost or frozen. That’s the biggest adaptation I have had to come to terms with in supervising these firms – how they monitor and manage their counterparty risks. The rest is about the evolution of the industry. I don’t think I’ve had to dramatically change the approach. When I joined the FSA I asked: do we have enough data; do we know enough about who they are; about what they are doing; about what positions they are running in which markets? I didn’t think we had sufficient data so we developed a survey tool. AIMA and individual managers have been very responsive and happy to engage and provide data. Managers are very conscious about not wanting their positions published on a daily basis in the press but recognise the financial stability benefits of the regulator having better information I think that’s been a fundamental change in the way we have engaged with firms to better understand them and their impact on markets. In terms of supervision, I haven’t changed the approach dramatically. We have changed the focus in response to events and occasionally ask different questions. But we haven’t fundamentally changed the approach (using our ARROW methodology) that focuses on how businesses may pose risks to our regulatory objectives. The FSA looks to understand firms’ business model, governance structure and systems and controls. Our assessment may be that a regulated firm may be sub-standard in some way and needs to improve how they monitor and manage risk, their practices and procedures, or even the organisational structure of the business itself.

Q: Is the information the FSA is getting substantial enough? What types of changes have been introduced?

A: We look at the footprint of each large manager to understand how big a fund is in real terms and how significant it is in the market in terms of size and daily turnover. It is about understanding the landscape and being able to contact people if something goes wrong in a market. If there is trading we are concerned about in the oil market, for example, we want to know the major participants in that market.

The data (from the first survey) is quite good. The second survey is currently underway. With a time series of data we will be able to measure differences and changes in the landscape and where products are moving. We have made some minor alterations in the second survey. The original survey looked at counterparty exposures and tried to differentiate between exposures resulting from a prime broker relationship and exposures to other counterparties including unregulated entities, such as funds dealing with other funds without intermediation. In the current survey we’ve also asked about exposures to central clearing counterparties. When there is a change in the overall market structure, with products moving to centralised clearing we want to know how it is affecting fund exposure and what impacts this may have for us in terms of supervision.

Q: What feedback mechanism do you have to determine the veracity and relevance of the information that the FSA is receiving? What process do you have to verify what they are telling you?

A: The survey is not designed to verify to portfolio levels. I am interested in establishing the significance of the fund manager within and across markets from a financial stability perspective and identify potential concentration risks. We have been conducting a different survey of prime brokers for about five years which captures their exposures to hedge funds. The data points should marry up between the two surveys and if I see large differentiation between them then I know the data is not good. We haven’t seen that but we have only done one survey.

Q: When Brevan Howard issued a prospectus for the listing of the BH Macro Fund in 2007 they included a balance sheet that ran to some 60 pages. It outlined thousands of positions and detailed $300 billion in gross exposure. How can you reconcile somethingas complicated as that with something that a prime broker might tell you?

A: I’m not trying to reconcile it or have a detailed understanding of all the positions. Some of the data points for a manager will be the number of open positions. This helps segment managers. Some will have, say, 1,000 open positions, some mangers may have 50,000 open positions. I don’t want to reconcile 50,000 open positions! I’m not here to replicate their business. What I’m trying to determine is whether a manager across a range of funds – or take Brevan Howard where they have a large flagship fund – in some way poses systemic risks in terms of their exposure across markets, to single markets or single counterparties. Then I try to aggregate that information across all the respondents to see if other financial stability risks emerge. I’m trying to take a picture: the picture may be a bit fuzzy but if you stand back from it you can get a general view of the landscape.

Q: In the 18 months you have been with the FSA how has the staffing developed and where have more resources been applied?

A: We have put resources into doing the survey. The staffing of my team has remained relatively constant. What I have done is change the population we relationship manage to more effectively capture and deal with the risks they pose to our regulatory objectives. While all hedge fund managers are subject to FSA supervision, the more intensive relationship management performed by my team naturally tends to focus on the larger end but I don’t target a specific level of Assets Under Management (AUM). For our internal impact metrics, manager AUM is one factor. It is not only the impact in terms of total AUM it is also about having the right picture of different investment strategies and business structures: global managers with a UK presence versus a UK manager which has global offices. It is about engaging with the right spectrum of firms. I also think that the population we supervise will continue to change of over time as firms change. Focusing, say, on long/short equity, if we are relationship managing five managers in this space, looking at the various business models, investment strategies and control frameworks. I’m looking at them as a peer group and I have to be sure that relationship managing a sixth manager will deliver a better supervisory outcome than doing something more thematic across the whole industry.

Q: What are some of the other criteria in determining which firms you relationship manage?

A: Some data from The Hedge Fund Survey is on (position) turnover in the market place and the importance to particular markets. You can have small residual positions at any point in time and still be significant in the market place. The metrics that we use are internal; we aren’t prepared to put them out to the market place. The intention is that we use these as a means of establishing the impact of a firm’s failure. This supports our risk-based approach in determining the level of supervisory resources to be applied.

Q: So in addition to AUM and trading volume, is leverage a metric that is used?

A: Leverage is difficult. People measure it in different ways. We’ve tried to talk about some of the inputs: where does the financing come from; is the financing through traditional prime brokerage or is it through repos; is it through derivatives? We look at these inputs rather than trying to standardise a measure of leverage that a fund is applying.

Q: Is there an attribution on the part of the FSA in terms of the hierarchy of risk and different ways of financing?

A: I wouldn’t necessarily say that some forms of financing are more risky. But I want to be aware of the changes. If the market moves away from a prime brokerage financing model to much more of a synthetic financing model, I need to be aware that has happened and be able to understand the implications for how I should be supervising firms.

Q: What changes in financing have you seen since the demise of several prime brokers in 2007-2008?

A: The prime broker model is still there. We have moved from a market that is dominated by a couple of large brokers to having some other participants who see this as an opportunity to move into this area.

Q: It is more a multi-prime model?

A: Yes. Hedge funds traditionally had one dominant (prime brokerage) relationship but maybe to be more effective in their business – perhaps some brokers are better at certain transactions – or maybe in the event of needing to move (their business) to someone else – they have (developed additional prime brokerage relationships). Its no surprise that the access to financing through alternative means has grown since if we go back 5-10 years CDS or TRS weren’t really there, for example. In order to draw out more analysis we really need a time series of data. Something may be there and growing but it is hard to tell with only one point of data reference.

Q: In the survey, in Section II – it refers to performance and redemption aggregates, the proportion of OTC used by managers, aggregate Var – are these criteria in determining which firms you supervise?

A: Firstly don’t forget that all hedge fund managers operating in the UK are authorised and regulated by the FSA. The use of impact metrics is the FSA’s way of allocating scarce resources across a large population of firms in a risk-based way and thereby determining the relative need to apply supervisory resource to a major UK bank against a hedge fund manager, insurance intermediary or financial adviser. The survey questions are intended to better inform my team in relationship managing a number of firms and to identify potential sources of systemic risk from this market segment. The survey covers firms that my team does not relationship manage.

Q: The FSA sought data about markets and asset classes where hedge funds are substantial contributors to liquidity. With deleveraging ongoing does the FSA see the role of hedge funds increasing or decreasing?

A: I try not to have a view on where it will go. As a supervisor I don’t want to try and get ahead of the game. If I can stay a step behind that is close enough for me. Regarding the provision of liquidity it is an open question. The term shadow banking gets used a lot. We are alive to the argument that additional regulation of banks may change the format or focal point for trading and risk transfer. Partly the survey is trying to see that landscape and to determine whether there are changes. The extent to which hedge funds provide liquidity is part of that picture but that is not to say that I want them to play a particular role – I am interested in how their business model, whatever form it takes, interacts with and impacts on markets.

Q: Going back for a moment to how hedge funds finance themselves, is it your perception that that has changed in a fundamental way or just at the margins?

A: I think it has changed in a fundamental way. There is certainly more access to synthetic financing than there was. That’s happened as markets have become more complex. Certainly the reliance on particular prime brokerage relationships is reduced. Funds recognise that for the longevity of their business they need alternative forms of financing.

Q: Regarding the FSA’s interaction with European and other regulators, would you say there is a coordinated approach or that the coordination needs to be improved?

A: Coordination can always be improved. The focal point of this work at the moment on an international basis is at the International Organization of Securities Commissions (IOSCO) and there is a task force that is looking at data collection from hedge funds. There is agreement that as at the end of September there will be an exercise across a number of jurisdictions to try and capture information so we can look at how we would aggregate data and whether this throws up any systemic issues. The objective is to collect data and aggregate that in a way to get a better view of global systemic risk.

Q: Is the FSA working with the SEC to put together some kind of template for this?

A: Discussions both at an IOSCO level and on a bilateral basis are ongoing about getting a template. Then again you can have a conversation with two different parties on how you would capture something like leverage and not agree on what it is or how you would capture it. I don’t want to say there will be a definitive template agreed. This is the first time we have tried to capture information on a global basis and some jurisdictions may want or need to ask things in a particular way. The most important point is that lots of jurisdictions go through the process. Then we’ll see what we get in data capture. Ultimately that may lead us to a global template.

Though the SEC’s process of registration of investment managers is somewhat different to ours there is a population that are dual registrants or registrants in our two jurisdictions as well as elsewhere. A focus particularly between the SEC and ourselves has been to coordinate better how we are engaging with those entities we both have an interest in. This will invariably be the bigger global participants. It’s about determining how to better share information and improving coordination. There are different regulatory objectives, different organisational structures and different supervisory methods. It is about meshing those over time to get a better engagement. It is also better for the firms. The ones we have engaged with jointly appreciate knowing where the regulators will engage and share the information.

Q: Assuming at some point an Alternative Investment Fund Manager’s Directive is passed, will the FSA be the main touching point for UK hedge funds to be subject to whatever scrutiny that is introduced?

A: It is a bit hard to say what the structure will be. If the AIFM Directive was introduced today I would expect the FSA to be a touch point with London-based managers. First the Directive has to go through. Then things go to the next level when the means of implementation get taken up. From a practical perspective it will have to come back to national regulators to be the touch point. If the financial crisis showed us one thing it was the interconnectedness of markets. That is why the IOSCO work is quite important in getting experience about how to aggregate data across different jurisdictions.

Q: Markets remain in a state of near-unprecedented volatility. Given this backdrop, what has the FSA learned in an institutional sense about how hedge funds and prime brokers have operated in this type of environment?

A: After Lehman, prime brokers carried on in the same way as they had done but were clearly more concerned about counterparty risk. They were concerned about counterparty exposures across the board, not just with hedge funds. Some prime brokers changed the way they perceived counterparties, including hedge funds, and changed their pricing and the way they interacted with that market. Fundamentally the prime brokerage model hasn’t changed apart from some businesses saying we need to provide a model whereby you can hold assets in a protected vehicle in case of insolvency. That’s a slight difference but they are still performing the same sort of financing relationship with counterparties. With hedge funds, the crisis and its aftershocks has shown me as a supervisor that the larger managers I engage with are fairly fleet of foot and are good risk managers in terms of managing the investment risk they face in the market place. They also responded quickly to new investment risks. The protection of unencumbered cash was investment risk they may not have considered previously, but they have been quick to respond. However they are generally not so quick in managing the internal risks in their businesses. In general, hedge funds generally start small and grow their AUM over time. As they grow, the multiples of money they are running aren’t always matched with development of control frameworks such as compliance, internal audit and operational risk management. The supervisory engagement I have with firms is about ensuring that they continue to build out sufficiently in these areas. It is often stop-start. It is not driven by the crisis per se but managers have seen how easily their businesses can be threatened and this is making them more active in managing business risks in an equivalent way to investment risks. I use the engagement I have with firms and my ability to see across firms to get them to a point where they have an appropriate level of management of those business risks for the size and complexity of their business.

Q: Are firms poaching staff from the FSA to help with managing these facets of the business?

A: We are not adverse to people coming to do a stint with the FSA and then going out again. We look to encourage engagement with the wider world. But our turnover has been pretty low and we have actually recruited from the marketplace during the crisis. We can be an attractive employer for people on the other side of the fence.

Q: Tell us a bit about the supervisory team you oversee.

A: I have around 13 individuals with varied backgrounds. Building a supervisory relationship with firms requires ongoing engagement at all levels so my team need to be able to communicate with both investment and compliance professionals. The more experienced supervisors will have the more complex larger firms. People are involved in data collection and analysis. We change between looking at things on a thematic basis and responding on a day to day basis to supervising a regulated entity. Most of the resource is applied to undertaking risk assessments of firms.

Q: Under the financial stability objective the FSA has just received increased disciplinary power. Is there any way this is relevant to hedge funds?

A: It could be applied to anybody. It is a universal power not specifically related to hedge funds.

Q: Given the concerns in some instances, dating back to 1998 and LTCM, this gives you a pre-emptive right to take charge of a situation if you think that is necessary.

A: Putting aside the financial stability point for a second, we’ve always had the power to vary people’s permissions. That’s not a change. I supervise firms now where tomorrow I could take action to vary their permission if that was necessary. That would be based on the risk that firm poses to our regulatory objectives. The financial stability aspect is merely saying that you could have a situation that would unfold very quickly and we need to be sure that we can respond appropriately. I don’t think it is a fundamental change in what we are hoping to achieve. It is just saying the environment could be such that you need to have the ability to do something quickly when you see things unfolding in a messy way.

Q: How does this power advance on the power the FSA already has? Is it just about allowing for the FSA to give a faster response?

A: It is more about saying that in matters impacting financial stability the regulatory structure is not necessarily set up to act quickly in a situation of market turmoil. When you get into situations like that you need to be able to act quickly but appropriately at the same time. It is about responding to a crisis in a controlled way – giving the regulator the power to act to minimise the escalation of crisis.

Q: Compare what the FSA does in regulating alternatives managers with what the Australian Securities and Investments Commission does?

A: I wasn’t involved with hedge fund supervision there. ASIC is an active member of the IOSCO taskforce.

Q: Do you think the UK is moving in the direction Australia has already gone, especially with the development of UCITS funds?

A: Ithink UCITS have the potential to change the landscape both with hedge funds using these structures as well as traditional managers including more alternative investments within them. In the firms I supervise those that are using UCITS structures are not currently using them to access retail distribution. That’s what I’m seeing thus far, though it is not to say that the landscape won’t change because of UCITS and I can’t really say where the industry will end up in two or three years. My approach is to stay in contact with the industry both in terms of our relationship with firms and also in terms of data collection so that we get a view of those changes as they come about. Investors in UCITS need to understand both the structure of the product and the underlying investment strategies as they would with any other investment product.

Q: In the last 10 years the hedge fund industry went from being off the map to being a significant player. Do you see the UK holding on to its position as the main European hedge fund centre or do you see it as at a high water mark with a gentle decline from here?

A: My primary role is to supervise firms not postulate on the structure of the market in the future. But to give you a personal, rather than an FSA view, there is a certainly a lot of weight put on the fact that managers are supervised by the FSA. Investors draw some level of comfort as part of their due diligence from managers being regulated by the FSA. I think there are reasons for people to do their business in London and for that business to continue to expand if allocations to alternatives stay. I think the allocations of investors to alternatives will continue to grow so I see the general AUM of London-based managers continuing to grow. It might also grow in other jurisdictions as well.