The director of the UK’s Financial Services Authority (FSA), Daniel Walter, spoke to Mint about creating a set of best practices to regulate the hedge-funds industry. Edited excerpts:
Hedge funds are increasing their exposure to India. How does one regulate hedge funds?
Although around 25% of assets under management by hedge funds are managed out of London, there are no hedge funds based in the UK. But estimates suggest they could contribute up to 40% of market turnover. This is similar to other markets. That raises some interesting questions for the regulator. There is a set of questions around the behaviour of the hedge-fund managers themselves. We have done thematic work around the controls they have in place to prevent market abuse and leaking of information. The impact of this will be felt in the prime brokerage community, which loans money to the funds to leverage their activities. We conduct a prime brokerage survey every six months that gathers information about the exposure of the investment banks to hedge funds and we can learn a lot about risk management services of investment banks themselves. It also gives us a window into the dealings of the hedge funds themselves. We have important information on their average level of leverage. It ranges from two-times capital to six-times capital, which is declining. So, the figures don’t look disturbing.
They may not be raising money from within the UK...
A substantial percentage of the total lending is from outside. There is a lot of work going on with respect to these wider financial stability concerns. It is very different from saying we need to regulate hedge funds. We don’t think the solution is to try to figure out a way to regulate hedge funds. We think it’s very unlikely to work. Our view is that if you try to apply the same regulations as we do to mutual funds and other such products, you would kill hedge funds. They will not have the freedom to innovate or to leverage their investments, and they will simply not be able to provide the kind of investment alternative that they are providing now.
Is it a tightrope walk to regulate these flows without scaring away investors?
Our view is that markets work best when capital can flow freely, and attempts by the regulator to control that are likely to be counter-productive. They are likely to inhibit flows as well. What you need are robust domestic institutions which are prepared to invest in the market. And you need a wider framework of financial stability. So, it seems it is a much saner strategy to regulate the fund managers and put the responsibility upon them to disclose properly, behave with integrity, and have enough capital to manage flows properly.
The other element to look at is what the global community can do in terms of standards, which is where the International Organization of Securities Commissions work comes in. We have worked on an important piece of work on valuations. The valuation of a fund is critical to its investors and to the fund manager. So, the idea is to create an important set of principles for people to agree to, which the international regulatory committee will sign on. And we developed the standards through this working group that had regulators, but also there were hedge-fund managers, fund of fund managers, administrators, auditors, third party pricing providers etc. So you can shine a different light on the same issue and you can see its different facets. Involving the whole community will put pressure on those who are not complying and it will be a vote of confidence for those who are.