Monday, March 12, 2012

Hong Kong Hedge Fund Regulation Strikes Right Balance Says Senior SFC Official

The regulation of hedge funds in Hong Kong is longstanding and balanced, in the view of Alexa Lam, Executive Director of the Securities and Futures Commission, but more transparency would be helpful. In remarks at a recent AIMA forum, Ms. Lam said that Hong Kong has always regulated hedge fund managers who operate in its markets. Whether the funds manage assets for institutional clients or offer their products to the public, without exception they are required to be licensed with, and supervised by, the SFC. Hong Kong also requires hedge fund and other asset managers to adhere to a Code of Conduct, under which they must act prudently and professionally, avoid and manage conflicts of interests, adhere to stringent internal controls, and put the interests of their investors first.

That said, the Executive Director urged hedge funds to do more in the area of transparency. The Commission is seeing a gradual expansion of the hedge funds’ investor base from the super rich and endowments to pension funds and funds of funds. The high profile successes, or failures of hedge funds and their star managers reported in the media have forever changed the way the public looks at this sector

While the senior official is aware that some hedge fund managers believe that greater transparency could reveal their trading strategies or proprietary technologies, she noted that these issues are not confined to hedge funds. Players from other financial and non-financial industries face, and successfully manage, such challenges. The Executive Director emphasized that communication fosters trust. Investors who hand over their money would understandably want to know more about how it is used and safeguarded, and that their hedge fund managers are completely upfront with them.

The Executive Director is also aware that regulators need to monitor financial stability and systemic risk as well. Even though no hedge fund has yet been designated by the Financial Stability Board as a global systemically important financial institution, the hedge fund industry is increasingly attracting regulators’ attention. The industry has metamorphosed from a collection of boutique, specialist firms into a matrix having within it some very large players.

The largest hedge fund manager now has over USD70 billion under management. In addition to their size, continued the senior official, there is also the prospect of substantial connectivity between hedge funds and the major players in the financial industry: prime brokers, banks, securities lenders and other counterparties who write or trade derivatives with hedge funds. In times of extreme market stress, if a big hedge fund were to fail, that could bring down the whole network.

To regulators, observed the Executive Director, the missing piece of the puzzle is exactly how connected a big hedge fund is in the system and how it could affect the market. There is no reliable data on hedge funds’ exact size, the level of leverage that they employ, the volume of derivative transactions that they are involved in and their counterparties. The lack of reliable information on such a crucial and highly interconnected segment of the market is inhibiting regulators’ ability to chart the nexuses that link up the financial world, said the Director, thus making it difficult to assess impact and map out contingencies.

In the view of the Executive Director, the proper way forward in this area is to seek domestic and global solutions to aggregate and share information, minimize systemic risks, and strengthen macro-prudential regulation and international co-operation. Conducting and publishing regular surveys on hedge fund managers has been a regulatory tool that the SFC adopted as early as 2006 to improve the transparency of the Hong Kong hedge fund industry. In the surveys, the Commission asked for information concerning background of manager, size of asset under management, source of funds, and geographical breakdown of investments.

In addition, an IOSCO task force has developed a survey template which adopted parameters broadly similar to those used in the SFC hedge fund manager survey, but goes further to seek from hedge funds with larger assets under management more granular information on trading, clearing, leverage and exposures. In September 2010, in parallel with other IOSCO members, the SFC conducted the first IOSCO co-ordinated survey.

Not every jurisdiction was able to require all their hedge fund managers to complete the survey questionnaire, noted the SDC official, and thus the aggregate data was not as complete as the Commission would have liked, but the exercise overall was useful. The Commission is currently revising the survey template to take in lessons learned in the first survey to improve its comparability. The next survey will be conducted in September 2012.

Finally, the Director noted that short selling is highly relevant to the hedge fund industry since it is a strategy that many funds employ. Many jurisdictions banned short selling during the financial crisis in the hope of ensuring the stability of their markets and protecting their systemically important financial institutions.

In Hong Kong, the SFC recognized the role that short selling could potentially play in enhancing market liquidity and efficiency. In 2009, the SFC commenced a review on ways to enhance transparency of short selling information to give regulators a fuller picture of short selling activities. The key measure that the SFC is introducing is to require the reporting, weekly at the close of market, of a net short position when it reaches 0.02 percent of the issued share capital of certain listed companies, or HK$30 million in value, whichever is lower. The new rules are now going through the legislative stage, and the Commission expects that they will be implemented this summer.