The Financial Services Authority ("FSA") recently published two Discussion Papers ("DPs") that focus on related but separate aspects of hedge funds and retail investment products. DP 05/3, entitled "Wider-range Retail Investment Products – Consumer protection in a rapidly changing world" examines the regulatory regime that applies to retail investment products. DP 05/4 looks at the impact of hedge funds on the United Kingdom’s wholesale markets.
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The Financial Services Authority ("FSA") recently published two Discussion Papers ("DPs") that focus on related but separate aspects of hedge funds and retail investment products. DP 05/3, entitled "Wider-range Retail Investment Products – Consumer protection in a rapidly changing world" examines the regulatory regime that applies to retail investment products. DP 05/4 looks at the impact of hedge funds on the United Kingdom's wholesale markets.
DP 05/3: Wider-range Retail Investment Products – Consumer protection in a rapidly changing world
DP 05/3 examines the nature of the UK regulatory regime that applies to retail investment products and asks whether the regime continues to provide the appropriate degree of consumer protection, both for existing and emerging new products, taking into account the requirements of the Financial Services and Markets Act 2000 ("FSMA"). The FSA points out that techniques typical of hedge funds, such as short selling; economic leverage and derivatives for investment purposes (as opposed to hedging and efficient portfolio management) are not limited to hedge funds, but feature in a wide variety of investment vehicles that are becoming more wisely available in the retail investment market, some of which have been available for some time, such as structured capital at risk products ("SCARPs") and split capital investment trusts. The problems with these products have been well-documented.
The FSA has decided to term these products, "wider range" investment products. This term comprises those products that may exhibit high degrees of volatility, illiquidity or complexity and which appear in a variety of forms or structures. The categorisation includes products that make use of "hedge fund" investment techniques, but is not limited to those products.
The FSA identifies two main reasons for conducting this review:
- Currently, the offer and sale of wider range retail investment products to retail consumers is subject to differing regulatory requirements, depending upon historical circumstance and the type of investment. In recent times, a considerably wider range of products has become available and this is putting stress on the current regulatory arrangements. Thus, the FSA wishes to consider whether the current arrangements are sufficient for the rapidly changing investment environment.
- The already complex picture is likely to change still further. Pressures from Europe and internationally will be likely to lead to further change, such as the impact of the Markets in Financial Instruments Directive ("MIFID"), which will introduce for some products a new categorisation of "complex" versus "non-complex" and new regulatory requirements will result from this distinction. There is also growing interest across Europe in the regulation of hedge funds, which will have an impact on the UK regulatory regime.
DP 05/3 considers that there are a number of different risks to the FSA's statutory objectives of consumer protection, consumer awareness and market confidence. The DP identifies three different main risks, as follows:
1. Risk that retail consumers do not understand the changes made by UCITS III and that regulated forms do not adequately manage these risks.
Retail consumers (not to mention some fund managers and investment advisers) do not understand and appreciate the impact of the changes to the UCITS regime wrought by UCITS III. If they do not understand them sufficiently, they will not make sensible and well-informed investment decisions and this could lead to the risks of mis-selling and mis-buying.
A second risk presented by UCITS III is that significant changes have been made to the regulation of UCITS products, for example, permitting for the first time significant leverage through the use of derivatives and the use of derivatives for speculative purposes. Thus, some UCITS III funds potentially have many of the defining characteristics of hedge funds.
The FSA believes that there is a risk that fund management companies operating UCITS III funds may not have the appropriate risk management systems and controls in place to manage the new portfolios safely and effectively. However, it remains to be seen how much of an issue this will be in fact, as fund managers who would be interested in such products are likely to be of a significant size and are likely to have such risk management systems in place already.
2. Risk that retail consumers may be confused by the different forms and distribution channels of wider range products, resulting in mis-buying and/or mis-selling
The second risk perceived by the FSA is that a wider range of products will increase the confusion of the public, which could lead to mis-buying and mis-selling. This seems to miss the point that rather than the quantity of products available, it is the quality that is the issue and the focus should be on the suitability of the products, rather than how many are available.
3. Risk that different products may involve different regulatory approaches, leading to consumer detriment
The third risk identified by the FSA is that different products may involve different regulatory approaches. For example, listed investment companies can operate as funds of unregulated fund products, but collective investment schemes are unable to do this. The DP considers a number of possible safeguards. One safeguard discussed is to enhance the disclosures to be made to retail consumers, in order to make them fully aware of the risks to which they would be exposed in purchasing a wider-range product.
Another possibility discussed is to create two retail investment product regimes. This would have two purposes. Firstly, consumers would be able to compare the nature of "wider range" investment products, as against other products. Secondly, if "wider range" products could be recognised, a different regulatory regime could be applied to them, without affecting existing regulation for more traditional products.
A further safeguard discussed is amending the conduct of business requirements to mitigate the perceived risks of the wide marketability of wider range products, which could take the form of placing additional responsibilities on product providers for distributing wider range products; and introducing a requirement of investors to explicitly accept the risk, by signing a short statement saying that they understand that the wider range product involves risks which are not found in more traditional products.
The DP also considers applying product regulation to wider range products. The FSA is very vague on what sort of requirements should be applied and seeks the views of respondents in this regard.
The DP notes that the majority of these safeguards could only be applied to UK product providers. However, almost all hedge funds are non-EEA funds, so unless the FSA were to make some amendments, retail hedge funds could not be marketed in the UK. The FSA acknowledges that although UK domiciled hedge funds could be included within "wider range" investments, the current tax regime would make this extremely unattractive.
The DP considers funds of funds. For funds of funds, the FSA suggests permitting a "fund of unregulated schemes" product, which would be "intermediated": that is, a professional manager would be making decisions on which funds should be bought and sold within the fund of funds. Whilst there may be difficulties in permitting the marketing of offshore products - as the FSA does not regulate offshore products - the situation would be different where a professional manager assumes the risk of product selection.
The Options
The FSA proposes three options for dealing with the risks it has identified, all of which need to be viewed in the context that they may be limited by European legislation.
Option 1 – No change to the status quo
The FSA emphasises that this does not mean simply doing nothing, as the FSA would continue to implement European legislation, as it is obliged to do, anyway. This option would mean that the FSA would decide that it is content that the present regime provides adequate protection for consumers.
Option 2 – Increase Regulation
This option would involve changes to the regulatory regime, such as increasing the marketing barrier in order to restrict the marketability of retail investment products that are currently marketed widely.
Option 3 – A new regime
This approach suggests an entirely new regime for dealing with wider range products, distinguishing between products so that wider range products are distinct from those which are not wider range.
DP 05/4: Hedge Funds: A Discussion of Risk and Regulatory Engagement
Introduction
DP 05/4 covers more controversial and slippery issues. It examines what the risk posed by hedge funds actually is and explores what role the FSA should take in the oversight of the Hedge Fund industry. The DP follows an earlier DP, DP 16, "Hedge Funds and the FSA", published in 2002 and it picks up many of the same issues. Now, the FSA views Hedge Funds as a growing sector of the Market, but considers that they do potentially pose risks to the FSA statutory objectives. The DP seeks to identify these risks and also looks at current and potential future mitigating actions.
It appears from the DP that in the last 12 months in particular, the FSA has spent a considerable amount of time interviewing managers and prime brokers and collecting data and gaining expertise in the area.
Key Potential Risks
The FSA has analysed the risks inherent in the Hedge Fund industry and has suggested a regulatory response in the context of its belief that Hedge Funds are playing an increasingly important role in financial markets, significantly enhancing market liquidity and market efficiency, and offering more diversification options for investors. The following particular risks are discussed in the DP:
Serious market disruption and erosion of confidence
The FSA believes that serious market disruption could be caused by the failure or significant distress of a large and highly exposed Hedge Fund. Alternatively, similar disruption could be caused by the failure or distress of a cluster of medium sized Hedge Funds with significant and concentrated exposures. It could also erode confidence in the financial strength of other Hedge Funds or firms which are counterparties to hedge funds – although the FSA does admit that the probability of this occurring is relatively low.
Liquidity disruption leading to disorderly markets
An increasing number of Hedge Funds are collectively making concentrated investments in complex specialist financial instruments and particular market segments. Together with the increasing sensitivity of their investor base to performance, this can engender a significant liquidity mismatch leading to enforced asset disposals and consequently volatile and potentially disorderly markets.
Insufficient information to inform regulatory action
The FSA believes that regulators have insufficient reliable information on which to base decisions concerning risk and therefore, to take the appropriate action to mitigate that risk.
Control issues
The FSA believes that certain Hedge Fund managers do not have the right skills to create an effective control infrastructure.
Operational risk
Operational issues in Hedge Fund managers, for example, late trade confirmations and non-notified trade assignments and novations, are adding significantly to market-wide operational and credit risk levels.
Risk management
The FSA observes that robust risk management is essential within the hedge fund sector, although it admits it has not observed any material weaknesses in the risk management techniques being used.
Valuation weaknesses
Weaknesses in valuation methodologies and processes related to skill shortages and conflicts of interest are creating a significant potential for ill-informed investment decisions and detriment to market confidence.
Market Abuse
The FSA has found that certain Hedge Funds are testing the boundaries of acceptable market practice concerning insider trading and market manipulation. The FSA believes that owing to the payment of significant commissions and close relations with counterparties, such Hedge Funds are creating incentives for others to commit market abuse, too.
Fraud
The FSA believes that there is an increased likelihood that Hedge Fund managers will commit fraud, due to incentive structures, light regulatory oversight and weaker control environment.
Money Laundering
The FSA's assessments have found that Hedge Fund managers are no more likely than their traditional investment management counterparts to fail to fulfil their anti-money laundering responsibilities. However, the FSA believes that there is still some residual risk remaining.
Conflicts of interest
The FSA speculates that Hedge Fund fee structures may encourage pension fund consultants excessively to encourage investment in Hedge funds. These fee structures could also encourage mixed traditional/Hedge Fund management firms inappropriately to favour the Hedge Funds when placing or allocating deals.
The FSA does not currently see significant risks to UK retail consumers arising in the Hedge Fund sector. However, this is largely due to the fact that there is currently extremely low levels of direct retail investor participation. However, the FSA believes that the risk is rising.
Risk mitigation
The DP highlights a number of current and potential actions designed to mitigate the identified risks. Currently, the FSA says that it has undertaken the following risk mitigation actions:
- frequent non-supervisory discussions with market participants on Hedge Fund sector issues
- increased thematic reviews of Hedge Fund managers
- applied risk mitigation programmes to relationship managed firms
- implemented a regular "Hedge Funds as counterparties" survey
- highlighted the importance of performing stress testing and commenced work with the industry to enhance the current approach to stress testing
- participated in international regulatory dialogue (for example, the financial stability forum and the joint forum).
The FSA is also planning additional risk mitigation actions. The FSA is:
- creating a centre of Hedge Fund expertise within the wholesale markets business unit. The purpose of this is to manage the FSA's relationship with high-impact firms and to lead more thematic supervision of Hedge Fund managers
- intending to review its impact metrics as part of the revised ARROW model. This will include greater consideration of market impact
- undertaking increased proactive surveillance with respect to issues of market conduct in the Hedge Fund sector, both in relation to Hedge Fund managers and their counterparties
- in accordance with the Market Financial Instruments Directive, the FSA is considering requiring firms to identify the Hedge Fund manager rather than the Hedge Fund as the counterparty to a trade for transaction reporting purposes
- enhancing dialogue with other international regulators on issues such as valuation and anti-money laundering arrangements.
The FSA is also seeking industry views on potential additional risk mitigation actions. It is considering:
- distinguishing Hedge Fund managers more clearly from other types of discretionary investment managers/advisors for the purposes of regulatory oversight
- distinguishing prime brokers more clearly, including new entrants who may be following less stringent risk management standards in the pursuit of market share
- collecting additional data, based upon existing management data, from Hedge Fund managers to support enhanced supervisory oversight of high-impact firms and the accurate targeting of additional thematic reviews
- encouraging industry initiatives to improve investor due diligence and Hedge Fund disclosure and providing guidance on appropriate disclosure standards, in particular with respect to side letters or managed accounts
- encouraging improvements to Hedge Fund valuations by promoting the development of administration industry codes of practice, encouraging legislative developments at EU level or developing domestic rules
- further dialogue and co-operation in an international context with a view to sharing best practise and raising standards.
On reading this paper, one's impression is that the FSA has spent a considerable amount of time interviewing managers and prime brokers and assembling and accumulating data and information. However, the DP suggests that the FSA has not spent quite so much time interviewing administrators and collecting information from that source. It would appear therefore that there could be a danger of a regulatory response skewed towards certain isolated issues that concern only certain Hedge Fund strategies and sectors of the market.
Nevertheless, it is clear that the FSA intends to increase the oversight of Hedge Fund managers. The DP identifies various operational risks and the systems and controls failings of firms. The FSA has also identified the lack of robust valuation processes in certain cases and DP goes into some detail on these areas of valuation methods.
Consultation period for DPs
The FSA is inviting comments on both DP05/03 and DP 05/04 by 28 October 2005.
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 19/07/2005.
