Q&A with Sally Dewar, FSA Wholesale Division

“We have to move on from a regime of no disclosure”

Originally published in the March 2009 issue

Sally Dewar became managing director of the Financial Service Authority’s wholesale division in early 2008. She has built a reputation as a quiet, but tough regulator over nearly seven years with the FSA and succeeded Hector Sants, now Chief Executive. Dewar is responsible for all regulated markets, regulation of firms ranging from banks to asset managers as well as UK listing rules.

Prior to her current role Dewar was director of markets and displayed a consultative approach to gathering ideas from market participants, particularly around how best to tackle market abuse. She studied pure mathematics and French at UMIST, now part of the University of Manchester, before qualifying as a chartered accountant with KPMG.

Dewar has also worked in corporate finance with BOC, the industrial gases group, and spent a year as chief financial officer with LeisureHunt.com, an early rival to lastminute.com. She also spent two years as equity markets manager for the London Stock Exchange with responsibility for creating the listing rules for high-tech and dot-com companies to float.

Bill McIntosh, editor of The Hedge Fund Journal met her to discuss the controversial treatment of short-selling, including the recently ended ban on shorting financial stocks, at the FSA’s Canary Wharf headquarters in early March.

Q: There has been a lot of comment about the short selling arrangements introduced. What’s the FSA’s perception of this response?

A: There were various things we did through the course of 2008. The ban, the measures affecting rights issues and the lifting of the ban, the disclosure measures and then in January we published our Discussion Paper (DP). It was quite deliberately a DP because we want to try and get international consensus. There is a lot of debate going on in Europe and elsewhere about what the longer term regulatory framework should look like. One of the messages we have got from our market participants is that there needs to be international consensus. If we are dealing cross-border and we are trying to serve a truly global market, to have difference regimes in different jurisdictions isn’t helpful. We are committed to trying to get an international consensus. If we can achieve that, it is definitely the right way to go. There are committees within IOSCO and CESR that are looking at short selling. What we are trying to do is have a collective view from our market of what works best in terms of a long term regulatory framework for short selling. Then we can use this to feed into the international debates that are happening now. Our DP was positioned to help set the framework to get the right regime going forward.

Q: Is there a role for short selling,even naked short selling?

A: We don’t believe that an outright ban on short selling is a sensible position. In normal market conditions, to the extent that there is a normal, we believe that short selling of all sorts are legitimate activities which improve price efficiency and help the market operate in an optimal way. But we have moved on from a regime of no disclosure. We do believe that disclosure to the market, not just to the regulator, is a good thing. The added discipline of disclosure to the market does two things. It improves price efficiency because the market can see how equities are being priced. And it also stops aggressive short selling behaviour. We think having a disclosure regime strikes the right balance. The key thing to come to of the discussion is at what level you set that disclosure regime. Now it is 0.25%. What we are putting out in the DP is 0.5%.

Q: Why should long positions and short positions have different disclosure thresholds?

A: One thing we debated was a symmetrical regime between longs and shorts (with a common 3% disclosure threshold). But we think it is two different things. The long position is all about economic control and voting. The short regime is about the impact on the share price at a particular point in time. Instinctively we don’t think they should be set at the same level. The big debate we will have both across Europe and internationally is when you set that disclosure position to make it meaningful but not restrictive. That is what we are trying to achieve. If you set it at 3% you are not going to catch enough to give you a good position to stop abusive short selling. That’s why we pitched it at 0.5% but let’s wait to hear what the market suggests.

Q: Has there ever been a case of abusive short selling that has resulted in a really good company going out of business? In all of your consultation and research did that ever crop up?

A: If you look at what has happened over the last six to 12 months in terms of the actions we took … you couldn’t say all the market instability or market volatility was caused by short selling. You couldn’t say that. You could say that short selling might have been a contributory factor which is what we believe it was. There were also other things that were happening in the market. There was general noise about a sector; concerns about the fundamentals of a particular firm; people just selling; short selling. There is a whole range of things that were going on. So you couldn’t say that short selling in itself was the main contributory factor. What we can show is that what happened pre-ban, when the ban was on and when we lifted the ban. We can also look at what happened in the US. If you look at our DP we try and bring some of those things out.

Q: Are you optimistic that the UK market will agree the same type of short selling rules that would be appropriate with quite different political regimes in France and Germany where activist investing is considered to be a threat to the national business elites?

A: I think you can set a regulatory framework that in normal market conditions can be applied across the board. What we are being very clear about and this is reflected in discussions we have had with European counterparts, is that you still have to recognise that each market is different, that each market is driven by different factors at any one point in time. For example, when we first introduced our ban we did it because of the severe market instability in our market. Other European jurisdictions, especially in the CESR context would say, we should have all got together and taken that decision jointly. But that’s a real example of how a national regulator has to act quickly. It has been recognised by our counterparts across Europe that you would want to maintain that flexibility even though you have a framework that works in normal circumstances. If at any point in time a national regulator needed to impose a ban, it has the capability to do that. So one of the proposals is that we do make changes to some of the directives to deliver that.

Q: Is this to give the FSA or another national regulator flexibility?

A: The emergency proposals we put in place were sufficient to deal with the emergency we had. But we want to embed that much more firmly within one of the directives in the future.

Q: How is this type of regime going to work for European active fund managers most of whom are based in either the UK or Switzerland? Presumably the rules the FSA makes will be quite influential in terms of how those people are allowed to operate.

A: The whole point of doing a DP is that it is not rules that are being proposed now. The DP will lead to us getting international or European consensus. Some of the regimes that have been put in place in these emergency situations are very similar to ours. We didn’t take the US regime because it didn’t deliver some of the objectives we wanted.

Q: What were some of the specific things that the US regime didn’t deliver?

A: The US regime, for example, was very much focused on naked shorts. When we looked to our regime we wanted to be able to cover more broadly than just equities to include what was happening across options. This is why we looked at net short positions. We weren’t saying to people you couldn’t short sell but that your net short position had to remain unchanged. So you had to be following a broader strategy.

Having done that, others took it on board. Most of the jurisdictions that put in a ban after ours followed the net short regime. This has influenced the discussions we are having now on what the long-term sustainable regime should look like. I am optimistic as there is a real head of steam to get something that is embedded within the European directives that everybody will adopt.

Q: What is the timeframe in which you this see occurring?

A: It is difficult to pinpoint exactly. Our DP closes in May and our disclosure regime expires on June 13. European deliberations will happen over the next couple of months and we should be in a position before our disclosure regime expires to have a view as to whether we are going to be able to reach a consensus on the European level. This will help us to decide what we do with our regime when that deadline comes.

Q: If you are able to come to a consensus would you pass some form of temporary measure to go on beyond June 30?

A: We would have to take a view at that point on what the market was looking like. Our ongoing regime currently just covers financial stocks. Our long term regime is to cover all stocks. What we would do is look at what is happening with the financial sector in June.

Q: Issuing a discussion paper rather than consultation is effectively a step back. Why?

A: To take account of the fact that we do think the regime has to be as far as we deliver it more of an at least European, if not global regime. We brought it back to DP to allow us to feed that into the debate. While the DP is set out we are doing a huge amount of informal consultation. We are not just waiting for May 1 until we get all the feedback. We are building up our picture all the time.

Q: What avenues are you going down to put that picture in place?

A: It’s mainly through bilateral discussions with interested parties – hedge funds, the investment banks, buy side and sell side, the trade associations.

Q: Do they have conflicting ambitions for these rules? Is there some consensus?

A: At this point it is difficult to say. Before we put the DP out we had been taking a huge number of soundings from across the market about what we should and shouldn’t do. The general consensus was that we had moved on from where we were. In some camps there was reluctant acceptance, but nevertheless a broad acceptance that some form of ongoing framework was going to be required. The best form of that framework was a disclosure regime as opposed to a ban or a restrictive regime. The question then becomes should that be a public disclosure or just disclosure to the regulator regime? And at what level? It’s not really around whether there should be more disclosure. I think that is accepted. Rather, it is just the degrees within that.

Q: How would you characterise the input you have had from hedge fund management groups on this?

A: Within the hedge fund sector there are about 35 to 40 firms that we relationship manage out of a huge number of hedge funds that are authorised firms. Once you are relationship managed you go through the full formal risk assessment on a two or three year time scale. We have also had this year various round tables with the hedge fund community which went beyond the relationship managed firms. I have done two of them, Hector (Sants, chief executive of the FSA) did some as well. We also engaged closely with the Hedge Fund Standards Board. We also have some bi-lateral contacts. For example, I would ring some hedge funds directly and take their view as did other members of the team. It is not just the hedge fund supervision team but also the FSA’s markets team that are building intelligence all the time.

Q: Out of all the consultations is there any consensus that has emerged among hedge funds?

A: They felt the ban market efficiency as it widened bid spreads – but they were more receptive to a disclosure regime of some sort. Disclosure regimes seem to be what people are thinking about in terms of the way it has to go. The debate is whether it is public or private and at what level.

Q: How much does the FSA think market efficiency has been impaired by the ban on short selling in financial stocks?

A: I think we recognised that there would be an impact on market efficiency. The compelling reason for bringing in the ban was market stability. We thought it was a justified action at that point in time. We did it knowing that there would be an impact on the market. That’s why in setting out the regime going forward it is a disclosure regime rather than a permanent ban regime.

Q: Is there any likelihood of a future ban?

A: We would say that any short selling in a normal market is beneficial to the market in providing liquidity and price efficiency. So we are not proposing that it gets banned, but instead a general type of disclosure regime.

Q: Does the FSA have any estimate of the opportunity cost that the ban incurred from September to January?

A: We asked the market – hedge funds, prime brokers – what the opportunity cost was. Largely they were unable to quantify it. They knew there had been a cost but we haven’t been able to get any reliable statistics.

Q: Has the FSA any example of where a ban was imposed on short selling and the move actually improved the functioning of the market?

A: From our perspective the ban was beneficial because it dampened uncertainty during a really heightened state of market instability. Critics of the FSA have asserted that the ban was detrimental since bid/ask spreads widened and traded volumes declined. But we feel the market instability justified the ban.

Q: Given the experience of the ban is it possible that it was a mistake and is something that will never be contemplated again because of the impact that it had?

A: No. Actually we have been called up lots of times since then, when market instability in the financial sector has resumed, to reinstate the ban. We said when we lifted the ban that we reserve the right to reintroduce it at any point without consultation if necessary. We have had several approaches. When we do have an approach we sit and look at what has happened to that stock very carefully in making our judgement of whether a ban should be reintroduced.

Q: It would lead one to assume that what was done before actually didn’t work….

A: No. It is just the circumstances around what is happening to a particular stock at a point in time. Do we think it justifies a ban being introduced? We haven’t been persuaded that it has done.

Q: The government bought into banks after the short selling ban was enacted and Lloyds had sold shares at 270p. Three weeks after Sep 19 the government offered to buy £4.5 billion of stock at 173p. What is the FSA’s view of what changed over those three weeks? Given the very tight regulatory compliance of UK banks, what could have deteriorated so sharply? What material changes did the FSA observe in Lloyds in those three weeks? Is there a case for prosecution of bank executives for misleading the market?

A: Obviously I can’t comment on any enforcement action or any particular firm.

Q: Is there any material change the FSA observed with respect to Lloyds?

A: We don’t comment on regulated firms.

Q: Through disclosure of short-selling what problems are going to be mitigated?

A: The problems that we have addressed before around aggressive short selling. Also, the price efficiency should be improved because you have got public disclosure of what is happening to that stock.

Q: Is there a danger of too many regimes being set up in terms of multiple jurisdictions?

A: I think we recognise that if we can, we should have a consensus on the regime going forward.

Q: What is the feeling within the FSA of the hedge fund oversight that has been developed and how should it evolve in the next few years?

A: Hedge funds managers sit within the asset management sector. They are regulated and we think that is appropriate looking at what’s been happening. From a financial stability perspective we have looked at what impact the hedge fund sector has had. One of the things we will continue to look at is how to ensure we have the right data to ensure we can make that broader judgement call.

Q: A judgement call on what exactly?

A: In terms of the impact of various events on the hedge fund sector. If there was, for example, any one hedge fund which in itself would have a systemic impact. Could problems in the whole sector create a systemic impact? In terms of regulation of the sector we are still comfortable that what we deliver with our framework is appropriate.

Q: How would you assess the framework for hedge fund oversight put in place in 2005 functioned in practice during the recent financial upheavals?

A: I think the framework that we put in place identifying the 40 higher impact firms, having that closer relationship and creating our hedge fund centre of expertise has worked out well in terms of understanding issues facing hedge funds. This extends to the affect of redemptions and gating and the impact of funds of funds on hedge funds themselves. Also, the impact of the hedge funds on the broker-dealers. Having the close relationship with hedge funds has helped that.

Q: Are there things that were done last fall that came about due to the relationships developed and the knowledge gained about hedge funds?

A: It certainly affected the way we looked at the prime brokers and the counterparty risk issues. We also looked at the amount of risk diversification that the hedge funds had in terms of where they were putting their cash balances. In terms of the prime brokers one of the key issues during September through December was the speed with which liquidity disappears when there are market confidence issues. Understanding how the hedge funds were behaving in that context towards the prime brokers was quite important. The hedge funds diversified their risk by not having all their free cash in one firm or doing all their deals with just that one firm.

Q: Taking note of that did the FSA think that systematic risk was being dispersed and was thus a good thing?

A: There are two ways of looking at this: systemic risk in the hedge fund sector versus what was happening to our investment bank sector. It brought up two very different issues. For the investment bank sector, what we were trying to understand was how liquidity was flowing and if liquidity was flowing out of a particular bank, how that was affecting the overall stability of that institution. Also, how quickly the cash was moving – or coming in, in some cases – and how that was sitting in a global liquidity context. From a financial stability perspective that was very important for the banking sector. With hedge funds we were looking at whether there were any systematically significant hedge funds on their own. How do you define a hedge fund in that context? Do some of them have more bank-like behaviour and should our approach to those funds be any different?

Q: What do you mean by bank like behaviour? High leverage?

A: Yes. We were also trying to understand as deleveraging occurred what implications that would have for the market as a whole. Those sorts of areas are where we think we need to have more data going forward – to get behind the hedge fund managers themselves and more into what is going on within the funds. Certainly the discussions I’ve had with some hedge fund managers suggest that their investors are also asking for that sort of more detailed data.

Q: In broad terms: are hedge funds a force for good, neutral or a force for bad?

A: We have always said that hedge funds are an important part of a capital market. I don’t think our view on that has changed.