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FSA Director Reaffirms Efficacy of U.K.'s Regulation of Hedge Fund Managers

The current approach of regulating hedge fund managers and the banks that finance them is the proper approach for both the European Union and the U.K., in the view of Dan Waters, Director of Asset Management at the Financial Services Authority. In remarks to the Economic Committee of the EU Parliament, he said that there is no need for additional and potentially intrusive regulation.

In the FSA's view, hedge funds are neither the catalyst nor the drivers of the current financial market turmoil. Hedge funds, like other institutional investors, have shared in the pain of the financial markets caused by serious failures in the asset securitization market. Further, hedge fund losses in structured credit products and collateralized debt obligations are a consequence, not a cause, of problems that have their origin in the banking sector.

The U.K. enjoys a complex and in some respects unique relationship with hedge funds. For tax reasons, the hedge funds themselves are located offshore outside the FSA's jurisdiction. Thus, regulation focuses on the hedge fund managers and the banks who finance and support their trading strategies and operations. U.K.-based hedge fund managers manage 80% of Europe's hedge fund assets.

The FSA treats hedge fund managers as what they are. Which is a particular type of asset manager, noted Waters. Like all fund managers, U.K. hedge fund managers are subject to both prudential and conduct of business regulatory requirements, which implement the relevant EU Directives.

The FSA's risk-based regulation focuses resources on the greatest risks to the statutory objectives of market confidence and consumer protection. A group of 35 of the larger fund managers are closely overseen from within a specialist supervisory team, which performs risk-assessments on these firms. Smaller hedge fund managers are regulated like any other small wholesale market firm, through a series of reactive and proactive projects and firm visits, and through reviews of their regulatory returns. The FSA ensures that all hedge fund managers adopt systems and controls appropriate to the scale and nature of their business.

The FSA particularly focuses on the interaction between large banks and their hedge fund counterparties. The banks must manage their counterparty risks to hedge funds arising from direct lending and derivative transactions. The FSA conducts a six-month survey of prime brokers' hedge fund exposures, which looks at the counterparty credit exposures of the 15 banking institutions with the largest exposure to hedge funds. This survey helps the FSA gauge the risk appetite of both the hedge funds and the prime brokers and assess the ability of the banks to manage their counterparty exposures.

Turning to the specific issue of transparency, Waters said that the FSA does not agree with the assertion that hedge funds operate in the shadows through the use of unregulated trading techniques and financial instruments. In fact, he emphasized, most hedge funds use the same financial instruments as other asset managers, investment banks and other institutional investors. The vast majority of these financial instruments are either traded on regulated exchanges or transacted with a regulated counterparty such as an investment bank. For example, the majority of the hedge funds managed by FSA-regulated managers are equity long/short funds, which transact on regulated exchanges.

In addition, the FSA believes that investors and counterparties already receive, or can require, sufficient disclosure to achieve their respective objectives. The key issue is how this information is used for counterparty risk management. In this regard, the FSA believes that banks currently collect sufficient information about their hedge fund counterparties to actively manage their counterparty risk.

Moreover, according to Waters, the use of multiple prime brokers by hedge funds is not a problem so long as each firm identifies and manages their own exposure. The FSA has seen a tightening of the terms which prime brokers offer hedge funds over the past few months in response to recent volatility. The agency believes that this is a robust reaction to managing their own risk and consistent with the FSA's risk mitigation efforts in respect of financial stability.