Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 40-59)

SIR JOHN GIEVE, MR NIGEL JENKINSON, MR JON CUNLIFFE, MR CLIVE MAXWELL, MR HECTOR SANTS AND MR DAVID STRACHAN

1 FEBRUARY 2007

  Q40  Chairman: Were you not getting carried away a bit, Sir John, because you are addressing the Hedge Fund Conference?

  Sir John Gieve: I was trying to be interesting, if that is what you mean. But actually the message I had for hedge funds, the main message of the speech, was not intended to flatter them. It was that, as hedge funds have grown as a factor in the markets, they are going to find it more and more hard to justify a claim that they can provide more than normal returns. So, if you like, the overall message on this was not one which was intended to flatter the audience and nor was this part. It was a vivid way of making the point that the growth of the capital markets, if you like, rather than traditional bank lending and the growth of funds which has come with that, is not a negative in itself for financial stability.

  Q41  Chairman: Are we getting a bit nearer to it being in your top 10?

  Sir John Gieve: No. I have agreed a top 10, or we have discussed a top 10 with the other two. Maybe you should try the others.

  Q42  Chairman: I am going to try the others. Your top 12 Hector, or, let us be modest, your top 10?

  Mr Sants: I will answer the question, but can I make a couple of introductory comments just to get the points properly framed. The first point to make is clearly the FSA thinks that the growth and development of the hedge fund industry, which has been significant over the last few years and we think will continue to be significant, is something that we as a regulator think should be significantly focused on. If the question is, which I know it was not: "Is it in the top 10 issues of areas which the wholesale group is focused on?", the answer is definitely, "Yes". If, however the question is: "Is it in the top 10 of likely drivers of current financial instability in the immediate forecast period?", which I think is the question, then we would not—

  Q43  Chairman: The question is quite simple. It is in the top 10 of what you are concerned about?

  Mr Sants: It is certainly in the top 10 of what we are concerned about, but it is not in the top 10 of likely drivers of financial instability.

  Q44  Chairman: The answer is yes then.

  Mr Sants: That is not right.

  Q45  Chairman: You have kept your line quite steady, but let us go on to the Treasury. Is it in the top 10 of what you are concerned about in terms of being a concern for the future?

  Mr Cunliffe: In terms of financial stability, I think our view is very similar to the Bank and the FSA; I have to say I do not think they are very different. Hedge funds, as a class of institutions, I do not think are one of our risks. Some of the things that happen in hedge funds and in other financial institutions are in those risks, but I do not think we have a bracket that says hedge funds as hedge funds per se

  Q46  Chairman: I understand that, but it is the complexity and the opaqueness or whatever else. Sir John, I am getting the feeling it is two against one here.

  Sir John Gieve: No, I do not think that is fair. Can I just come back on that? You have broadened this out to cover opacity in the markets, complexity of derivative instruments and you have put that under the heading of "hedge funds". I was not doing that, I was saying that the growth of hedge funds is separable from that. Coming on to your broader point: is the growing complexity of derivative markets and some opacity about where the risk lies a potential cause of concern on stability grounds? I think that that is, and in fact that was one of the three I mentioned to you.

  Q47  Chairman: That is what is involved in hedge funds.

  Sir John Gieve: Hedge funds are involved in that, but they are involved in a lot of other things as well, and it is not necessarily the hedge funds which are driving it. I think it is misleading to say this is a hedge fund problem when actually what you are talking about is a broader issue.

  Q48  Chairman: But that is the issue, and the fact is that your speech talking about hedge funds did not pay to attention to the depth of the issue. That is what I am trying to get at with you, and that is what others are trying to come out and say: the contrast with the ECB is quite stark. I take it as a nearer two to one. We want to move on. However, if you want to come back it is extra time.

  Mr Sants: Can I make one quick point. I think we need to distinguish between a loose terminology of hedge funds and recognise there is no established definition of hedge funds. Actually what you want to look at is the consequences of the types of investment techniques which hedge funds use, and they would be broadly characterised as shorting, leverage, and so forth, the use of a wide range of different instruments including derivatives, and that is the wider issue and that is the right issue, I think, for the regulatory community to be focused on, which we certainly are.

  Q49  Chairman: And that is the concern we are focused on as a committee, but there was a concern in the wider sense. Jon, how do you feel about it?

  Mr Cunliffe: I do not think there is a disagreement with the Bank actually.

  Q50  Chairman: I did not think there would be. We are in public.

  Mr Cunliffe: One of the things we are also concerned about is what you call the full herd mentality and people moving in the same direction. One of the points about hedge funds which should be remembered is that they often do provide the opposite to that. So there can be benefits in having players in the market that are prepared to take controlling positions, and the opposite. It is a kind of broader picture when you look at it.

  Q51  Chairman: Is there anything that keeps you up at night and makes you rush for the Rennies?

  Mr Sants: I think we should always be focused on issues, but, as I have said, I do not think there is one thing that is particularly keeping me up at night at the moment in the context of this discussion.

  Q52  Chairman: What about you Jon?

  Mr Cunliffe: Nothing.

  Q53  Chairman: What about you, Sir John?

  Sir John Gieve: The thing that worries me most is co-ordinating an international financial crisis, but at the moment that does not seem imminent and so I am sleeping all right.

  Q54  Kerry McCarthy: At the risk of labouring the point, I have a few more questions about hedge funds. You mentioned the herd mentality and saying that at least that was not such a problem with hedge funds because they tend to be more innovative and so on. Is it not more of a trend now in the hedge fund markets that because they are using similar financial models that herd mentality is growing?

  Mr Cunliffe: I do not think so. Hector will have more information about how the models work, but I think—

  Q55  Kerry McCarthy: I think there was an IMF warning issued.

  Mr Cunliffe: There is another set of players in the market who often take contrary positions, and some of the techniques they use—. I will go back to this point. It is difficult to define what is a hedge fund; and just about everything we talk about is done by the proprietary trading desks of big banks throughout the world, so this is not exclusive to hedge funds. For example, the use of derivatives, which John mentioned, which cause concerns about understanding the instruments, value in the instruments, but of course one of things that credit derives do is they take risk and they cut it up and they parcel it out to people who are best able to bear it, and there is an argument that one of the reasons why the financial sector has been able to weather some pretty big shocks is that it has actually been able to spread risk or diversify it more efficiently through these instruments. The point I was simply making is that there is an up side and a down side here; it is quite a complex picture.

  Q56  Kerry McCarthy: There is some consolidation going on within what for the sake of this we will call the hedge funds. I think it is looking as though there may be fewer funds but they will be much larger. Is that a source of concern for anybody: because, obviously, if one institution goes over to a larger institution, it potentially can cause more damage?

  Mr Sants: As I said earlier, we certainly expect the hedge fund sector (recognising the difficulties of precise terminology here, but loosely the hedge fund sector) to continue to grow, reflecting the popularity of that investment technique. What, of course, you would expect as the sector grows and matures is it does change in structure, and there are various changes in structure taking place which do, in fact, further increase the complexity of the financial landscape. One thing, of course, that has happened and is likely to continue to happen if it is a growing sector, is that you will always have a steady stream of new start-ups, smaller funds starting up, which will carry some risk inherent in any start-up situation. History tells us that that is clearly the case. Where you have a larger number of start-ups you have some failures—I think that is part of a healthy market place—and we would expect that trend to continue. The second thing, of course, that happens, which I think is what you are touching on, is that as funds grow they do clearly drive to scale because there are then operational efficiencies and economies and from their point of view to owners the returns can be higher. So a drive to scale can at times lead to consolidation, and that we would also expect to continue, but then there is the third trend which we have seen of late, which is if you have got an entrepreneurial community which has start-ups, there comes a point when the owners of that community may want to monetise some of the return they have made and either sell, or float, or in some way or other change the structure, and that, I think, clearly is what you would expect to see and we have already begun to see in the sector as it matures. The final point, which I do think is critical to an understanding of the way the market place will develop in the future and the sort of risks we need to be focused on, is, of course, that as you see the success of the (if I can use it loosely) absolute return strategies in attracting new money, then, of course, other more conventional (if I can use the phrase) "long only fund managers", institutional fund managers, clearly get a look at that space and say, "Should we be offering that type of investment technique off our platform?" So the other and final trend that one would clearly identify and is already apparent in the market is effectively a convergence occurring in the larger firms between the hedge funds and the more conventional long only managers who are now seeking to set up platforms and offer a variety of different investment strategies to their actual or potential clients. So that trend is one of convergence at the larger end and sits alongside the further complexity already mentioned, that the investment banks, of course, increase their amount of proprietary risk over the years in terms of their revenue mix, and those type of strategies that they employ are effectively hedge fund like strategies. So it is a general convergence occurring across the market place, and that, again, is increased complexity for us to address.

  Q57  Kerry McCarthy: Can I just be clear what you are saying. You are saying that conventional funds that are only allowed to do long trading, because they can see the advantage of doing short trades, will be setting up some sort of relationship with hedge fund type institutions?

  Mr Sants: No, it is a commercial choice by individual fund managers of what investment strategies they wish to offer.

  Q58  Kerry McCarthy: If they are regulated to the extent they are not allowed to do short trades. That is my understanding.

  Mr Sants: They can obviously set up a hedge fund if they choose to utilise the structures which hedge funds utilise.

  Q59  Kerry McCarthy: So you can set up that sort of business by the back door.

  Mr Sants: It is not by the back door.


 
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