Interview with FSA's Hector Sants: Warm Reception
As the FSA's chief hedge fund watchdog, Hector Sants embodies the U.K.'s firm but friendly style of regulation.
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By Loch Adamson
For Hector Sants, who runs the Financial Services Authority’s wholesale and institutional markets division, the first rule of regulating hedge funds is engagement. Although the FSA already has a variety of regulatory tools in place that enable it to work with the hedge fund industry, Sants is trying to modernize the agency’s data collection strategies and interact more closely with fund managers. Last fall the FSA created a new supervisory group to focus on high-impact hedge funds and carry out risk assessments, helping the managers develop customized, confidential risk mitigation plans.
Under Sants, the FSA has also begun to gather data from the industry’s prime brokerages, which are voluntarily providing periodic snapshots of leverage in the hedge fund industry (and making sure that they have sufficient information to assess their own exposures). Given all the points of contact between investment banks and hedge funds, the FSA is looking closely at information flows, checking for areas of vulnerability and potential abuse.
Despite this ambitious project, Sants sounds remarkably tranquil when discussing the phenomenal growth of the hedge fund industry, unlike many of his regulatory peers in the U.S. and Europe. Although he speaks in the determined first-person plural of a regulatory watchdog — forever saying “we” — the affable former financier is clearly proud of the FSA’s growing rapport with the U.K.’s hedge fund industry, which now numbers 668 single-manager funds running a total $108 billion in assets, according to Chicago-based Hedge Fund Research. Although those numbers pale in comparison to the U.S.’s 5,391 single-manager hedge funds running $935 billion in assets, the U.K. hedge fund industry is getting bigger all the time.
“Hedge funds are here to stay,” Sants says with a wry smile. “And their asset management techniques are here to stay. We believe that, in aggregate, hedge funds are actually beneficial to the health of the financial markets because they provide a very, very useful function with regard to risk mitigation and dispersal.”
At a time when many regulators seem almost panicked about their lack of control over hedge funds, the FSA recently concluded, after an 18-month review, that it already has sufficient powers to supervise managers and that no further laws are needed. Radical as that may sound coming from a regulator, the FSA has considerable insight into the hearts and minds of the managers in its midst: To practice their trade, hedge fund managers must register with and be authorized by the FSA. Only their actual hedge funds are considered unregulated because they are domiciled offshore, and the FSA has no powers outside its jurisdiction.
That legal mandate means the FSA has the power to engage closely with the hedge fund community, collect data and conduct periodic inspections of managers’ businesses. The agency flexed those powers recently when it investigated star convertible-bond trader Philippe Jabre and his (now former) employer, London-based hedge fund GLG Partners. The investigation focused on whether Jabre had misused premarketing information he had received about a convertible bond being issued; the FSA concluded that he had. In August the agency levied fines of £750,000 ($1.42 million) against both Jabre and GLG for market misconduct — the first-ever fines imposed on London’s hedge fund industry.
“The British attitude toward hedge funds has always been to let the flowers bloom where they may, but if there is a problem, the FSA will go and fence them in,” says American-born derivatives expert Gay Huey Evans, president of multistrategy hedge fund Tribeca Global Management (Europe). Evans, who spent seven years as a top regulator with the FSA before joining Tribeca last fall, adds, “It is really a much more liberal approach to the industry than other jurisdictions take, and it works quite well here.”
The same cannot be said of regulatory efforts in the U.S. The Securities and Exchange Commission suffered a humiliating blow this summer when the U.S. Court of Appeals for the District of Columbia Circuit unanimously struck down its five-month-old hedge fund registration rule. SEC chairman Christopher Cox has chosen not to appeal; the agency is now looking for new ways to police hedge funds without requiring them to register.
The FSA, by contrast, has taken a more risk-based approach to oversight. In 2005 the agency published a discussion paper on risk and regulatory engagement, inviting responses from industry participants. The FSA published a follow-up paper this March, reflecting the firms’ responses and detailing actions the FSA proposed to take with the industry’s full support, including steps to further assess hedge fund managers’ impact on the capital markets and better understand trends within the industry, such as the convergence between private equity and hedge funds.
Sants, 50, who joined the FSA in May 2004, has been at the forefront of that process in his role as overseer of the U.K.’s wholesale and institutional markets. Although he strongly believes that the agency’s existing regulatory powers are sufficient for the challenge of supervising hedge funds, he wants the FSA to become more effective in gathering and interpreting data. In that regard, his background will likely prove useful. Before joining the FSA, Sants was CEO of Credit Suisse First Boston’s businesses in Europe, the Middle East and Africa; he is also a former board member of the London Stock Exchange, where he strongly supported the introduction of electronic trading.
An alumnus of the University of Oxford, Sants began his career as an analyst at Phillips & Drew in London and remained there after UBS bought the firm in 1987. A decade later he moved to Donaldson, Lufkin & Jenrette, where he virtually built the firm’s international equity research business before DLJ’s acquisition by CSFB (now Credit Suisse). Sants’ experience gives him a visceral understanding of what it is that most hedge fund managers do — and what they might be tempted to do, were it not for the FSA’s strict code of market conduct and its surveillance capabilities.
Sants is keen to work across international jurisdictions to address what he believes are a number of key risks for the industry as a whole as it becomes more global, not least the potential for abuse of asset valuations. In some instances, hedge fund managers provide their fund administrators with valuations of illiquid, complex financial instruments; the FSA is concerned that those administrators may not have sufficient data to challenge managers’ valuations. As a result, the FSA is working closely with the International Organization of Securities Commissions to help that group develop international guidelines for sound valuation practices.
In late August, Sants sat down with Alpha Senior Editor Loch Adamson at the FSA’s headquarters in London’s Canary Wharf to discuss the growth of the hedge fund industry and how his agency is tackling the risks associated with it.
Alpha: From a regulatory standpoint, is it more important to deter market abuse or to crack down on infractions?
Sants: We are more interested in deterring than we are in enforcing per se; ultimately, what we want to do is to improve market quality, not per se the number of cases we bring. And improving market quality is about effective deterrence. We think that pro-active surveillance is a very effective tool, and we have various initiatives, including looking at certain investment strategies where we feel there might be greater opportunity for managers to misbehave. Trading on premarketing information about convertible bonds, for example, was certainly one area of focus, but there are others. We have recently been looking at information flows between loan credit desks and loan trading desks.
What does the new hedge fund supervisory team’s risk-based approach mean in practical terms?
We now have a team of six supervisors, which is providing pro-active, close supervision of the largest hedge fund managers based in the U.K. — we’re up to about 30 firms now. We can also use the team as a resource to do more thematic investigation of smaller funds if we think we need to, but our supervisory approach is, as you say, risk-based, and we are concentrating our resources on those firms that might potentially pose a hazard to the markets by virtue of their size.
How is the FSA tackling those market-based risks?
First, we’ve begun implementing a new initiative to overhaul, modernize and improve the quality of the fund manager data we collect. Broadly speaking, we came up with two handfuls of additional questions that we need to ask, which are designed to identify whether the asset management firm is really a hedge fund manager. If it is, we want a little more data on the amount of risk and the size of its portfolios.
Second, we’ve also begun collecting data from a number of investment banks’ prime brokerage units here in London. That is a relatively new, voluntary program designed to give us a reasonable picture of the overall amount of leverage in the marketplace every few months. While we are clearly aware of the hazard of having intermittent snapshots of an industry — market disruptions could still happen — we think that getting that snapshot is helpful, partly because the exercise itself has sharpened up data collection and self-management of risks by the investment banks and their hedge fund clients.
Are you concerned by the cumulative effect of leverage in the financial markets?
We certainly recognize the potential risk of layers of leverage in the system — and there are a lot of layers. High-net-worth individuals, who may themselves be geared, are investing in funds of funds, which will then gear their own products, which in turn invest in the single-strategy hedge funds, who are leveraged themselves. So clearly, hedge funds are part of leverage chains, which are not fully transparent to any one participant or investor in that chain. However, there is relatively little that a national regulator, or indeed the global community, can do about that because those chains often spread across international jurisdictions. But we do need to be aware of them and encourage increased industry self-awareness.
Is the amount of leverage employed at the individual fund level rising?
Our current data doesn’t suggest that individual fund leverage is rising; it’s actually a lot lower than it was just a few years ago. So no, I don’t think that, in aggregate, the amount of leverage in the larger single-strategy hedge funds is at an unreasonable level.
The FSA has recently been cracking down on insider trading. Are hedge funds more likely to be caught misbehaving than other market participants?
Well, hedge funds have certain operational characteristics, such as the speed with which they can act on information, that provide scope for opportunity — and, arguably, incentive — for managers to misbehave, maybe more than conventional long-only managers. But we’ve also made the point that it is not just hedge funds that share these characteristics; so do the proprietary desks of the investment banks. We have somewhat changed our approach from being reactive to being more pro-active and identifying particular areas where information could be being inappropriately used, such as wall-crossing prior to convertible-bond issuances. That is a legitimate practice, but hedge funds and other asset managers must not misuse that information.
Given their fee structures, hedge fund managers have a lot to gain by being able to manipulate the net asset valuations of their portfolios. Is that an area of concern at the FSA?
Yes, that is another area of risk that we have been highlighting. It’s actually a subset of a general area of concern across the industry: How do we ensure good-quality valuations, particularly in illiquid products? We have been a prime mover of the International Organization of Securities Commissions’ initiative on valuations. And that should provide a valuation code of practice to be finished sometime in 2007. Here in the U.K. we have been concerned about the issuance of material side letters, which result in some investors receiving more information and preferential redemption terms compared with other investors in the same share class. We think investors should be informed when a material side letter is granted. They should know whether all investors are being treated equally.
A lot of hedge fund managers are moving into other strategies, particularly private-equity-style deals, seeking higher returns. Do you see those diversification techniques as another potential source of risk?
We are seeing an increasing blurring, or overlap, between private equity funds and hedge funds. But here in the U.K., it is a minor activity; by far the vast majority of hedge funds continue to stick to their knitting. So yes, it is an issue, but it is by far a more emerging issue than a current issue. But we are mindful of it.
How well are hedge funds managing and controlling their risk right now?
Broadly speaking, the industry’s risk management techniques have significantly improved over the past few years. Here at the FSA we have been emphasizing the importance of having good-quality stress-testing tools in place, particularly since we have to take a view going forward that markets are likely to be less benign than they have been. That is a point that we have been making to the whole of the financial sector: We feel people should be focused on the likelihood of markets getting more difficult and making sure that they are properly set up to manage increased volatility and increased risk.
If the markets do become choppy, do you expect to see greater attrition in the hedge fund industry?
Well, it’s worth recognizing that the FSA is not a zero-failure regulator. We fully expect that some individual funds will fail and do fail, and that in a market downturn, the number of funds failing will probably increase. That is just a characteristic of the financial marketplace. But having said that, we do think in general, particularly among the larger hedge funds and those that we supervise in a close and continuous fashion, that risk management techniques have definitely improved.