There are several forms of risk here, but the primary risk must rest with a regulator who, having undertaken due diligence, then confers regulated status to a firm and individuals. In the event that it transpires that the firm and individuals undertake criminal conduct, the primary risk rests with the regulator. Whilst there are some important issues, such as the use of dealing commissions softing still to be settled we expect further detail from ESMA and the FCA in due course , the overall picture is becoming clearer.
Current FCA rules allow for discretionary investment managers to dis-apply the recording requirement where a conversation or communication is with another firm itself subject to the obligation e. So the recording obligation is getting broader and the retention period longer. If adopted, this will impose significant new technology requirements on many investment managers who currently do not need to record such communications.
At first sight, this points to a total ban on all dealing commission arrangements to pay for company research. This type of account will have to be operated under strict conditions, including a research budget, based on a reasonable assessment of need, to be pre-agreed with, and funded by, the client, and a regular assessment of the quality of research purchased.
Above all, there must be no link between execution volumes and research spend. There are difficulties around the objective measurement of best execution in nearly all asset classes save liquid shares where, by definition, poor execution is unlikely.
Hedge fund managers also struggled to see why their performance in this narrow area should be under the microscope when they have every incentive to achieve the best possible returns for their clients. MiFID II should enhance this regime in two ways: first, in the new transparency and publication requirements across a wide range of instruments. The execution venues themselves will have to publish annually the quality of execution provided, assessed by factors such as price, costs, speed and likelihood of execution, giving investment managers hard data on which to base their execution venue decisions.
Firms themselves including investment managers will also have to justify these decisions by publishing annually their top five execution venues in terms of volume and information on the quality of execution actually obtained, thus adding another layer of transparency to underlying investors. The number of data field increases from the original 23 to These include short sale flags and the ID of either the individual trader or the algorithm responsible for the decision to trade.
Delegation of transaction reporting will still be permitted, but this is likely to be harder, particularly in view of the ID requirement. Many investment managers are expected to conclude that taking transaction reporting back in-house is a cleaner solution. At the very least an investment manager will need to understand how its counterparties will comply with the new reporting requirements.
MiFID II greatly expands the scope of financial instruments caught by pre- and post-trade transparency requirements. Equity-like instruments such as depositary receipts, exchange traded funds ETF and certificates are included for the first time, as are bonds, structured finance products, emission allowances and derivatives traded on a trading venue.
Trading a UK government bond, for example, post January , will look much more like trading a UK share does now in terms of a visible order book and trade tape.
There will still be exemptions for the publishing and reporting of illiquid shares, large orders and transactions similar to the current MiFID regime for equities. Where this gets interesting and controversial is in the calibration of thresholds for such waivers, and particularly the definition of what is liquid. If they go too far in either direction, investors could end up paying more, not less, for executing their strategies.
We know well, from previous experience, that the devil is in the detail and European legislative packages in their final implemented form can look vastly different from what was originally proposed.
There is scope for further evolution between now and and there are unlikely to be prizes for first movers. However, the broad structure is now largely fixed and the direction of travel is clear. When MiFID came into force in November , its impact was quickly lost in the travails of and the protections it sought to implement looked outdated very quickly. However, MiFID II is not just about updating legislation to reflect market developments - the opportunity has also been taken to reflect on the financial crisis and so to address two areas that were seen lacking: transparency both for the client and regulators and protecting the interests of clients.
The growth in importance of hedge funds has led to an increase in regulation. Hedge fund managers may now find themselves on the wrong end of a personal enforcement action from the FCA pour encourager les autres. Investing some effort in managing this personal risk is time well spent.
However, dealing with regulation requires a demystification of the industry. For the trusted answers that help you anticipate, mitigate and act on risk with confidence. Manage enterprise risk, corporate governance, customer and third party risk, regulatory compliance and financial risk effectively, and accelerate business performance. White Paper. Executive summary Executive summary 1. The FCA: Personal liability for hedge fund managers 2.
Do you know the modern day hedge fund? Closing thoughts. Chapter One. They would be required to report on a confidential basis certain portfolio information of interest to the Federal Reserve or other systemic risk authorities. The bill provides exemptions for advisers to venture capital funds and small business investment corporations.
The Restoring American Financial Stability Act, as ordered reported by the Senate Banking Committee on March 22, , includes similar provisions regarding registration and reporting of systemic risk data. The Senate version exempts venture capital funds and private equity funds. Advisers below that figure would be regulated by the states. In an echo of the Robber Baron Era, the late 20 th century saw the rise of a new elite class, who made their fortunes not in steel, oil, or railroads, but in financial speculation.
Intervention was thought necessary because the fund's failure might have caused widespread disruption in financial markets—the feared scenario then closely resembled what actually occurred in except that large, regulated financial institutions took the place of hedge funds.
They are, however, widely viewed as part of the "shadow" financial system that includes over-the-counter derivatives, non-bank lending, and other lightly regulated or non-regulated financial sectors. Hedge funds are essentially unregulated mutual funds. They are pools of invested money that buy and sell stocks and bonds and many other assets, including foreign currencies, precious metals, commodities, and derivatives.
Some funds follow narrowly defined investment strategies e. Hedge funds are structured to avoid SEC regulation. Hedge funds also avail themselves of statutory exemptions in the Investment Company Act of , which governs public mutual funds. Mutual funds must comply with a comprehensive set of regulations designed to protect small, unsophisticated investors.
These regulations include limits on the use of borrowed money, strict record keeping and reporting rules, capital structure requirements, mandated adherence to specified investment goals and strategies, bonding requirements, and a requirement that shareholder approval be obtained through proxy solicitation for certain fund business. An investment company becomes subject to this regulation only if it has or more shareholders; hedge funds therefore generally limit themselves to 99 investors.
Most hedge funds are structured as limited partnerships, with a few general partners who also serve as investment managers. Hedge fund managers are often ex-employees of large securities firms, who strike out on their own in search perhaps of greater entrepreneurial freedom and certainly in search of greater financial rewards. Those rewards, even by Wall Street standards, can be extremely high. Data on hedge funds are available from several private sources, but estimates as to the size of the hedge fund universe vary considerably.
Starting a hedge fund is relatively simple, and, with a few quarters of good results, new hedge fund managers can attract capital and thrive on performance and management fees. Because many of them make risky investments in search of high returns, hedge funds also have a high mortality rate.
Estimates of the average annual return earned by hedge funds differ. The short life span of many funds creates obvious difficulties for measurement, including a strong survivorship bias: the many funds that shut down each year are not included in return calculations.
Annual return figures of course conceal a wide variation from year to year and from fund to fund. In any period, the law of averages dictates that at least a few funds will do extremely well.
Views were therefore sought on the Double Volume Cap and its impact on transparency in equities trading. Spot foreign exchange — the consultation paper also questions whether NCAs ought to hold additional supervisory powers over spot foreign exchange, which does not currently fall within the scope of MiFID II. Whilst the consultation does not suggest that spot foreign exchange will necessarily fall within the scope of MiFID II in the future, the European Commission does note that it has been asked by stakeholders to analyse whether policy action in this area is needed.
Notably for hedge fund managers, ESMA, in this report: agrees with stakeholder input that the calculation of position limits favours the most liquid market with the highest open interest in that commodity derivative. Considerations for hedge fund Senior management responsibilities — UK regulated firms, such as many hedge fund managers, are not required to have a single senior manager responsible for their Covid response but senior managers should consider the risks arising from the current situation and the current crisis affects existing risks to the firm.
Statements of responsibilities and significant changes to senior manager responsibilities — the FCA notes that it does not intend to enforce the requirement to submit updated statements of responsibilities if there is a temporary change to responsibilities as a result of Covid and the firm expects to revert to its previous arrangements. The FCA however stresses that regulated firms are required to keep accurate records of any such changes and should notify them of changes made. Furlough and reallocating prescribed responsibilities — senior managers who have been furloughed will retain their regulatory approval during their absence and will not need to be re-approved by the FCA when they return.
To the extent that a furloughed senior manager held any prescribed responsibilities, these prescribed responsibilities ought to be re-allocated to another senior manager. Firms will have to notify the FCA in order to make use of this temporary extension of the regime. Notably, where the absent senior manager held prescribed responsibilities, firms are able to allocate these prescribed responsibilities to the replacement where the replacement is an employee of the firm. Share issuances The FCA has released a statement of policy on companies raising capital in response to the Covid pandemic.
Best execution — the FCA has stressed that it expects regulated firms, including hedge fund managers, to meet their applicable best execution obligations. However, this is on the condition that: prior information is provided by the firm to the client that it is impossible to record the call and that written minutes or notes of the call will be taken; and the firm ensures enhanced monitoring and ex-post review of relevant orders and transactions. Authors Andrew Henderson Partner.
Samuel Brooks Partner. Christopher Acton Partner. Ned Twigger Solicitor. Investment management Financial services regulation Derivatives and trading. Sign up to receive our publications. This website uses cookies We use cookies to offer you a better browsing experience. Accept all cookies Show settings. Your choices regarding cookies on this site. Your privacy When you visit any website, it may store or retrieve information on your browser, mostly in the form of cookies.
Strictly necessary cookies These cookies are necessary for the website to function and cannot be switched off in our systems. Performance cookies These cookies allow us to count visits and traffic sources so we can measure and improve the performance of our site. Information is identified that regulators should have the power to obtain, to monitor manager remuneration structures and manage conflict of interest issues between investors and fund managers.
Analysis of the reform proposals In the past the FSA has taken the policy position that counterparty prudential risk that may arise through hedge fund leveraged and derivative trading was best addressed by gathering sufficient information to understand the nature of these hedge fund counterparty exposures of banks and primebrokers to ensure such banks and primebrokers properly managed this exposure and held adequate capital in this regard.
It is unclear whether or not the regulatory reform proposals represent, as far as the UK is concerned, a significant policy change. Authorisation of hedge fund managers established in the UK has been required since and proposals for greater regulatory powers to gather information may just reinforce the current FSA fund manager and prime broker information surveys.
Unfortunately the discussion of the issue in the Turner Report is brief and provides little basis for any reliable conclusion as to what may have been intended. No attempt is made to consider or explain why prior FSA policy with respect to hedge funds was unsatisfactory in circumstances where there is no evidence of a failure of that policy despite the worst global banking crisis in more than 75 years.
The Turner Report also does not address the legal jurisdictional issue with respect to the exercise of regulatory prudential powers over hedge funds which arises because hedge funds, as opposed to hedge fund managers, are usually established in off-shore tax havens.
The pragmatic regulatory response to this characteristic of hedge funds is to focus on hedge fund managers rather than the underlying fund, as was the FSA policy prior to the Turner Report. The FSA considers that the potential for hedge funds to generate systemic risk would emerge through distress at the regulated counterparties to hedge funds rather than at the hedge funds themselves. We address this risk through our supervision of the counterparties by ensuring that we understand their exposure to, and management of, risks posed by dealing with hedge funds.
This involves close monitoring of counterparty and liquidity risk management systems. Each of the other reports take differing positions on the question of imposing prudential requirements on hedge funds. The Larosiere Report recommends the imposition of prudential requirements only in the case of hedge funds owned by banks. The IOSCO Report notes a divergence between its members but recommends certain measures to control the management of risk by hedge fund managers. It was stated that whether a hedge fund will be deemed to pose a systemic risk would be based on characteristics that include its size, its interdependence with the financial system, its leverage and how much it relies on short term funding.
Other criteria include whether the firm is a critical source of credit for households, business and governments or whether it provides a source of liquidity for the financial system. The IOSCO Report also proposes reform regarding investor protection matters management of conflicts of interest and investor disclosures.
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