Regulations, Disclosure and Sound Practice

AIMA tackles some of the key questions

Originally published in the May/June 2009 issue

The Alternative Investment Management Association (AIMA) is pleased to provide this statement in connection with the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises’ hearing “Perspectives on Hedge Fund Registration” held on 7 May 2009.

Committee’s specific questions
As detailed in the Financial Services Committee’s invitation, AIMA has been asked to address a number of specific questions; this written testimony is structured around answering these questions.

1. Your views on H.R. 711, the Hedge Fund Advisor Registration Act of 2009, and suggestions on how it can be improved.

AIMA supports the registration of investment managers, including hedge fund managers, with the appropriate national authorities in the country in which they are principally based, as envisaged above. On 24 February AIMA announced a policy platform which consisted of major proposals to increase transparency and to support the concept of manager-registration globally. Such a process of registration leads to a supervisory relationship between managers and the appropriate national supervisor, creates a relationship and dialogue which supports greater understanding of hedge fund activities and allows for increased oversight of markets more generally.

AIMA is aware of discussions taking place regarding a de minimis threshold for registration and/or reporting requirements; if this debate is being driven by considerations of the ability of a manager to provide systemically relevant information and broad market insights, we would advocate that managers with $500m of assets under management (AUM) or more be obliged to register. Indeed, as a practical matter, it may be very difficult to gather such information from so many firms and managers, and a larger figure (e.g. $1bn or $2bn minimum AUM), may both be more practical and still capture the majority of AUM in the industry.

This Bill would seem to put the US registration approach on substantially the same basis as that operating in the UK, which we have found to provide effective oversight and supervision. One important difference would remain however – the UK’s current approach is not extra-territorial, and non-UK based investment managers who do not operate from a place of business in the UK are not registrable with the UK’s Financial Services Authority, even if they have UK clients, whereas AIMA assumes that, pursuant to this Bill, any non-US investment managers with one or more US clients would be registrable under the Advisors Act even though they do not have a US presence. This raises the issue of dual registration – a process that is not endorsed by the G30, as can be seen in Recommendation 4 of the G30’s January 2009 Report; AIMA shares the view of the G30 in this respect.

Other countries with a significant hedge fund management industry presence favour an approach which involves authorisation/licensing and/or registration of hedge fund managers, together with a continuing supervisory dialogue with a specialist supervisory team. These registration templates, together with ongoing supervisory dialogue, have assisted authorities to achieve their two main objectives of enhancing investor protection and monitoring issues concerning market integrity and financial stability. The details vary by country, but the essential components comprise some or all of the following:

• A fit-and-proper persons test, with a suitable business plan, providing for robust systems and controls.

• Notification/pre-approval of certain material changes, such as changes to ownership control.

• Periodic reporting of key firm, client and risk metrics.

• Cooperation in the conduct of ad hoc, themed supervisory visits to assess current market practices.

These requirements and ongoing controls help to ensure professionalism, soundness and qualification of the management company and foster market integrity and investor protection. A very important component to the success of such a registration and supervisory regime is the ongoing dialogue between the regulated manager and the supervisory authorities.

2. How you believe Congress can achieve the appropriate balance between providing appropriate regulation of the industry aimed at protecting investors without unduly inhibiting the benefits hedge funds provide investors and the market more broadly?

AIMA believes that a combination of manager registration and greater transparency is the most appropriate mechanism for achieving this balance.

As stated in Question 1, AIMA supports the registration of investment managers, including hedge fund managers, with the appropriate national authorities in the country in which they are principally based. There are clear and demonstrable benefits to this approach in those countries which already operate such a regime.

Whereas investor protection for hedge fund investors is perhaps best served by increased transparency and disclosure by managers. There is much anecdotal evidence to suggest that this balance has recently shifted materially in favour of investors). However, it is it is possible that there may be inadequate risk data provision in the aggregate by larger, more systemically relevant managers to their national macro-prudential supervisors, and in turn there may be insufficient dialogue internationally between national supervisors to track composite activity. There may also be a gap that could be filled by confidential dialogue between the Senior Supervisors’ Group, the International Organisation of Securities Commissions (IOSCO) and/or the Financial Stability Board if concentrated risk exposures are identified that may present a financial stability risk.

AIMA is promoting the concept of a Systemic Data Reporting Template which is explored in more detail in the answer to Question 4. This template would be shared by the main national regulators and would be completed by the managers with AUM in excess of a specified de minimis level.

3. The degree to which institutional investors and pension funds affect your industry, their recent demands for increased transparency, and their recent efforts at negotiating your fee structure.

Historically, high net worth individuals and private banks accounted for most of the AUM in the hedge fund industry globally; however, in this decade institutional investors have steadily increased their investments with hedge funds and other alternative investment managers and, according to our research, now constitute an absolute majority of AUM within the alternative investment industry.

In the past year, it can very clearly be seen that investors are demanding – and receiving – greater transparency and disclosure, improved provisions related to liquidity, segregated or managed accounts, and a wider diversity of fee structures. In some cases this is resulting in lower fee levels, changing the mix between base fees and performance fees, and better aligning fees with expected investment or return durations, size of investments, and balance between hurdle rates and relative performance. As such, a much greater differentiation of fee structures is emerging, which tends to reflect an even greater alignment of interests between investors and managers. On a variety of operational issues, institutional investors are also demanding – and receiving – increased third-party services, such as independent administration, including NAV calculation and verification, as well as independent custody.
4. What type of information you will voluntarily disclose to improve investor confidence and increase transparency – as well as any other self-imposed reforms the industry is considering and the consequences of not abiding by these policies?

AIMA believes, as a result of extensive consultation with its larger manager members globally, that the industry is not only ready but also willing to provide specific and regular transparency across a wide variety of investment and operational risk metrics to national supervisors (the regulator of the jurisdiction in which the manager is located and registered to operate), with the objective of contributing to an improved understanding of the hedge fund industry’s activities and a broader contribution to a national and international analysis of financial stability related issues. To obtain a complete picture, the same information should be gathered from all bank and non-bank industry groups.

AIMA is working with international policy makers and regulators to develop an appropriate risk reporting and increased transparency system, allowing regulators to better understand hedge fund and market activities, and thus be better able to prevent future events of potential market or financial instability. AIMA advocates that managers of larger hedge funds provide regular periodic reporting of systemically relevant information and risk exposures to their national supervisors.

Harmonisation of sound practices
Over the last 10 years, the hedge fund industry has developed a vast body of work on sound practices. The importance of this work should not be underestimated, as it has not only been developed by those with vast amounts of industry knowledge, but it has been endorsed by regulators around the world and serves asa very useful tool in enhancing regulation and helping managers adhere to sound practices.

Many of the core principles in existing sound practice guidelines are substantially similar, and in October 2008 AIMA, together with the International Organization of Securities Commissions (IOSCO), the Hedge Fund Standards Board (HFSB), the Managed Funds Association (MFA) and the Asset Managers’ Committee of the US President’s Working Group on Financial Markets (US PWG) created the Hedge Fund Matrix ( The Hedge Fund Matrix, a website bringing together all the sound practice works by the aforementioned bodies and allowing users to compare the various guidelines side-by-side, was the first step towards harmonisation of existing sound practices on a global basis.

5. Your views on the recently issued EU directive on the regulation of collective investment trusts (including hedge funds).

Although the proposed Directive will apply to all alternative investment fund managers established in an EU member state which provides management and administration services to one or more alternative investment funds, it is our understanding that, as currently drafted, it may severely impact any non-EU, including US-based managers, (not just hedge funds and hedge fund managers, but many types of funds and fund managers as explained above) and may prevent them from accessing EU-based institutional and other professional investors, therefore raising possible issues of financial protectionism.

AIMA regrets that there has been no coordination between the Commission and the G20-ordered work in this area, particularly the IOSCO Task Force on Hedge Fund Oversight and the work being carried out by the Financial Stability Board, all seeking to identify and provide a globally consistent approach and appropriate solutions. Neither does the proposed Directive take into account the highly effective existing regulatory framework for European hedge fund managers.

The proposed Directive draws on several other European Directives, primarily those regulating the UCITS products which are solely aimed at the retail sector. Therefore the proposed Directive does not logically or practically address the way many of the investment sectors covered by this proposal are structured, organised, or operate.

The proposed Directive will now undergo a complex consultation and negotiation process which could last many months.

6. There is always a tension between market efficiency and market integrity. In the last few years, a good bit of the integrity disappeared. What steps has the industry taken, and what steps will it take, to restore this balance?

There are a number of industry-led initiatives which have either taken place or are due to take place that AIMA would like to bring to the attention of the Committee:

In late February 2009, AIMA issued an important press release stating its intention to work closely with regulatory supervisors and policymakers on universal templates for manager registration, systemic data transparency, reporting disclosure for short positions and the harmonisation of hedge fund practices.

AIMA has developed, over many years, a substantial number of specific sound practice guides for the industry on hedge fund management, administration, valuation, business continuity, governance, anti-money laundering and due diligence for managers and service providers. Other important guidelines have been produced by IOSCO, the US PWG on Financial Markets, the MFA and the HFSB.

AIMA believes that investor education is as important as transparency from managers. Many of the world’s leading investors have joined AIMA’s global Investor Steering Committee and, in 2008, produced AIMA’s Roadmap to Hedge Funds – the world’s first collaborative educational guide for institutional hedge fund investors. The guide, which provides guidance on investing in hedge funds, also meetsthe Financial Stability Forum’s Highly-Leveraged Report (2007) recommendation that industry and investors work more closely to develop positive initiatives.

AIMA is working with industry participants to take forward the proposals of the G20 and the Financial Stability Board to develop a common set of principles for the hedge fund industry. As mentioned earlier in Question 4, AIMA and other industry groups are devoting a large amount of time and effort to developing these principles, which will be applicable to hedge fund managers globally.

7. Additionally, any other information or opinions you deem relevant to this hearing.

“Systemic importance” versus “systemic relevance”
AIMA does not believe that hedge funds pose a systemic risk to the capital markets in which they operate. To put matters in context, there are single banks, insurance companies and single traditional investment management houses, which are larger in terms of assets than the entire global hedge fund industry.

On the other hand, hedge funds are responsible for a number of positive features within the financial markets, such as enhancing pricing efficiencies and improved liquidity. Many issues affecting the capital markets are still, despite the undeniable evidence to the contrary, wrongly attributed to hedge funds alone, rather than being recognised as symptomatic of a wider more complex system. If all hedge funds disappeared tomorrow, all these issues would still exist. One would, though, have lost an important contributor to market efficiency across numerous and important markets. During these very difficult times hedge funds should be seen as part of the solution for recovery and a return to properly functioning markets.

Most commentators accept, as mentioned above, that the current crisis has been caused by substantial failures in the regulated banking sector. Banks because of their size, leverage and concentrated positions, pose a systemic risk to the markets. Hedge funds are not banks or bank-like, and operate a completely different economic model.

The need for global coordination
There is currently much national and international activity aimed at identifying and correcting regulatory deficiencies in financial services, including those of the hedge fund industry.

In the realm of industry-led initiatives, AIMA has been working with other global associations to develop a common set of principles for the hedge fund industry, which will still allow for local interpretation of hedge fund standards and practices.

Short selling
Short selling is a legitimate investment technique; its beneficial role in the efficient operation of markets is widely recognised by regulators. Short selling is a technique that is used by the wider asset management industry including, but not limited to, hedge funds in order to reduce risk to investors.

As a matter of principle, AIMA believes that new regulations should only be introduced if and when there is demonstrable evidence of market failure. In the case of short selling, there has been no such demonstration. The market is already well placed to regulate the level of short selling. The holders of long positions are best placed to be able to police whether short selling is permissible or not by their acceptance or refusal to lend stock.

AIMA believes that transparency and the timely provision of information to regulators should be the central feature of any global short selling regime and is developing a template for a global reporting regime.

In addition to AIMA’s template, AIMA would like to highlight the following reporting considerations:

• AIMA believes that it is quality of information, rather than quantity, that should drive disclosure to regulators.

• Disclosure of positions should be made privately to the regulator and kept confidential. Cross border exchange of information should be subject to appropriate controls in order to ensure confidentiality. Also, the amount and nature of information exchanged should be proportionate to the purpose of the exchange. Any information provided to the market on short positions should be provided on an aggregate basis.

• The cost, quality and utility of the information requested by regulators should be very carefully considered – AIMA highlights the situation in Canada where the local regulator has, in fact, attempted to discontinue the twice-monthly position report due to issues associated with its cost, usefulness and accuracy.

• There is potential for moral hazard, with regulators seeking information from the market which they may lack the means or expertise to interpret fully. This is a regulatory risk but also poses the danger of giving false comfort to the market, namely that the regulator is happy that the market is functioning properly or condones existing practices.

• AIMA’s members do not, in the main, undertake ‘naked’ short selling to any significant extent. However, members pursuing certain investment strategies (e.g., statistical arbitrage) legitimately make use of short selling without locate/pre-borrowing activity and it should be noted that it is settlement failure, rather than ‘naked’ short selling per se, that is a risk to orderly markets.

• Furthermore, any attempt to ban ‘naked’ short selling requires a clear and consistent definition of what is a ‘naked’ short sale, something that, in practice, would be very difficult to achieve. AIMA, therefore, believes that a better approach is to regulate the settlement side of short selling. Penalties should not be applied to those who can demonstrate that they have taken all reasonable steps to provide for settlement (e.g. if the locate counterparty fails to deliver resulting in settlement failure).

• AIMA broadly supports greater transparency by alternative investment managers to regulators. However, thought should be given by regulators as to what information they require to achieve their aims, and to select the least costly and / or disruptive means for obtaining it.

• Ultimately, AIMA would wish to see convertibles, warrants and rights included in the denominator in the net short position calculation (subject to this information or calculation being workable on a global basis) but it is assumed that, initially, the denominator would be the current issued equity share capital (since information providing a diluted denominator is not yet widely available).

• AIMA believes that a globally agreed and adopted approach to short selling disclosure is required.