Examination of Witnesses (Questions 40-59)|
1 FEBRUARY 2007
Q40 Chairman: Were you not getting
carried away a bit, Sir John, because you are addressing the Hedge
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
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
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
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
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
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
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 failuresI think that is part
of a healthy market placeand 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
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