Hedge funds and other alternative investment funds provide more
financing options for companies and more choice for investors, said the Hedge
Fund Standards Board in a comment letter on the European Commission’s Green
Paper on shadow banking. With
more investment choices, reasoned the Board, risk can be better managed. Thus,
alternative investment funds help
spread risks more widely, rather than allowing risk taking to be concentrated
in a small number of large banks.
While the EU is
still strongly reliant on the banking sector, noted the Board, the US provides a
fairly different picture, relying a great deal more on capital markets. The
Board emphasized that it will be important for Europe
to develop and attract more non-banking forms of financing, including asset
management, in order to attract the required investment for economic growth.
The Hedge Fund
Standards Board is the guardian of the Standards drawn up by international
investors and hedge fund managers to create a framework of discipline for the
hedge fund industry. The Board’s mission is to promote the Standards through
collaboration with managers, investors and regulators.
The Board
acknowledged that fund liquidations are not unusual and happen if investors
collectively decide to redeem. Such liquidations happen without any concern for
systemic risk. Under normal circumstances, the price formation in the market
place and for the fund provides a mechanism for balancing supply and demand
with all investors being treated fairly.
Liquidations
and closures of funds are not undesirable per se, said the Board, adding that the
crucial distinction between banks and funds is that a hedge fund does not
guarantee a repayment amount. The redemption price is determined by the
underlying market price of the assets in the fund, or in the event of a liquidation,
the liquidation value of the assets in the fund. Also, funds do not have deposit taking characteristics,
and therefore do not give rise to the type of systemic issues arising in banks
or bank-like deposit taking investment vehicles.
However,
a run on a fund can arise if investors fear unfair treatment or expect a loss
from holding on to a fund investment. This situation can arise, for example,
when parts of the underlying assets become illiquid and long term investors,
who under normal circumstances would stay invested in the fund, have an
incentive to redeem for fear of being "stuck with the bottom of the barrel."
This rational incentive for the
individual investor to redeem causing a run on a fund can be mitigated by
ensuring fair treatment of investors, said the Board, ensuring that the
redemption process is slowed down, or gates are enacted. The HFSB has developed
Standards focusing on strong liquidity risk management practices, governance
arrangements to deal with such situations, and adequate disclosure to investors
or the mechanisms available to ensure fair treatment in situations of liquidity
distress. The Board believes that a strong bottom up risk management approach,
along with adequate tools to ensure fair treatment of investors, are crucial in
mitigating concerns about runs on funds.
The concept of
leverage has been intensely debated in the context of the EU Directive on
Alternative Investment Fund Management, said the Board, and a key lesson from
this discussion is that leverage can have different meanings in different
contexts. There are many different types of leverage, ranging from balance
sheet leverage, such as in the context of a bank, to leverage in market-based
finance, which arises in the context of securities lending and the use of
derivatives.
The HFSB has often
highlighted that leverage is usually not a standalone risk measure, but needs
to be seen in the context of the respective investment strategy and portfolio.
Fixed income funds can exhibit higher and fluctuating leverage, if classical
balance sheet measures are employed, than equity funds with no relation to
actual risk. Therefore, the Board emphasized the importance of explaining and
categorizing the types of leverage properly in order to assess the risk
accordingly.