BAI: IOSCO Final Report: Hedge Funds Oversight

Hedge Funds Oversight Final Report TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS June 2009 CONTENTS Executive summary 3 Background 4 The six high level principles on the regulation of hedge funds 7 IOSCO recommendations Annex 1: Feedback statement on the public comments received on the 17 Consultation Report on Hedge Funds Oversight Annex 2: List of respondents to the Consultation Report on Hedge Funds 24 Oversight Annex 3: List of contributors to the report 26 2 EXECUTIVE SUMMARY 1. The IOSCO Technical Committee published its Consultation Report, entitled Hedge Funds Oversight on 18 March 2009 (the Consultation Report). 1 The purpose of the Consultation Report was to describe the operating environment of hedge funds, highlight the associated regulatory risks (Chapter 1), review and illustrate the work and recommendations issued by IOSCO and other international organizations and regulators in this area (Chapter 2) and to make preliminary recommendations of possible principles and actions that may serve to mitigate these risks (Chapter 3). 2. The aim of this Final Report is to recommend the following six high level principles on the regulation of hedge funds, taking into account the outcome of the public consultation and the hearing held in Madrid on 20 April 2009: i. Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration. ii. Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to: a. Organisational and operational standards; b. Conflicts of interest and other conduct of business rules; c. Disclosure to investors; and d. Prudential regulation. iii. Prime Brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds. iv. Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks). v. Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate. vi. Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders. 1 Available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD288.pdf. 3 BACKGROUND 3. The Task Force on Unregulated Financial Entities (the Task Force), co-chaired by the CONSOB of Italy and the FSA of the United Kingdom, was established by the IOSCO Technical Committee on 24 November 2008 2 in order to support the initiatives undertaken by the G-20 to restore global growth and achieve needed reforms in the world’s financial systems following the recent financial crisis. 4. The Task Force was requested to examine issues surrounding unregulated financial entities. Given the G-20’s particular interest in hedge funds, the Task Force decided to focus its work on hedge funds 3 , rather than deal with other potentially ‘unregulated’ entities such as private equity funds (which have very recently been reviewed by IOSCO 4 ) or Special Investment Vehicles (which could as easily be described as ‘products’ rather than ‘entities’). However, many of the observations and conclusions described in the Consultation Report and in this Final Report may be applicable to other market participant entities that hold and/or control large pools of capital. 5. The IOSCO Technical Committee acknowledges in its Consultation Report that there is no consistent or agreed-upon definition of the term hedge fund. Previous IOSCO works recognised that an approach for identifying these types of entities is to look at the kinds of characteristics of and strategies employed by institutions that would consider themselves to be hedge funds. On this basis, IOSCO has considered as “hedge funds” all those investment schemes displaying a combination of some of the following characteristics: • borrowing and leverage restrictions, which are typically included in collective investment schemes related regulation, are not applied, and many (but not all) hedge funds use high levels of leverage; • significant performance fees (often in the form of a percentage of profits) are paid to the manager in addition to an annual management fee; • investors are typically permitted to redeem their interests periodically, e.g., quarterly, semi-annually or annually; • often significant ‘own’ funds are invested by the manager 5 ; • derivatives are used, often for speculative purposes, and there is an ability to short sell securities; and 2 http://www.iosco.org/news/pdf/IOSCONEWS134.pdf. 3 In some recent documents, international groupings such as the G-20 and the G-30 have used the term of “private fund” and/or “private pools of capital” for the purposes of this Report we treat such terms as referring to hedge funds. It should also be noted that hedge funds are not actually ‘unregulated’ in the strict sense of the word in many jurisdictions – as often the hedge fund managers are subject to registration/authorisation and on-going supervision/monitoring. In addition, in some countries the underlying funds themselves are subject to direct regulation. 4 Private Equity - Final Report, Report of the Technical Committee of IOSCO, May 2008, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD274.pdf. 5 We use the terms “hedge fund manager” and “manager” to refer to the entity that establishes the investment profile and strategies for the hedge fund and makes the investment decisions on its behalf. 4 • more diverse risks or complex underlying products are involved 6 . 6. Despite the broad characteristics described above, it is difficult to define hedge funds on a universal basis, given their different legal and business structures – not only across different jurisdictions but even within a single jurisdiction. 7. The conclusions and recommendations of the Consultation Report were provided as input into the G-20 summit in April 2009. 8. The G20 favoured increasing regulatory oversight over hedge funds/hedge fund managers, as stated in its declaration of 2 April 2009: 7 “hedge funds or their managers will be registered and will be required to disclose appropriate information on an ongoing basis to supervisors or regulators, including on their leverage, necessary for assessment of the systemic risks that they pose individually or collectively. Where appropriate, registration should be subject to a minimum size. They will be subject to oversight to ensure that they have adequate risk management. We ask the FSB [Financial Stability Board] to develop mechanisms for cooperation and information sharing between relevant authorities in order to ensure that effective oversight is maintained where a fund is located in a different jurisdiction from the manager.” 9. The IOSCO Technical Committee is aware of the European Commission’s proposed Directive on Alternative Investment Fund Managers (AIFMs) 8 which has the objective of creating a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level. Although there may be potential overlaps, the scope of this proposed Directive is broader than the scope of the work of the IOSCO Task Force. In the United States, the US Treasury Department has proposed the following approach with respect to hedge funds: required registration of all advisors to hedge funds whose assets under management exceed a certain threshold; mandatory requirements for disclosure to investors and counterparties and for regulatory reporting; regulatory reporting requirements regarding information necessary to determine whether any hedge funds could pose a systemic threat and should be subjected to prudential standards. 9 While it is anticipated that Congress will consider legislation in 2009 regarding these proposals, it is unclear what the ultimate regulation will be. 6 See the definition of hedge funds in Regulatory and Investor Protection Issues Arising from the Participation by Retail Investors in (Funds-of) Hedge Funds — Final Report, Report of the Technical Committee of IOSCO, February 2003, p.