Examination of Witnesses (Questions 60-79)|
1 FEBRUARY 2007
Q60 Kerry McCarthy: But in a less
Mr Sants: They are presented in
the market place in the same way as hedge funds are, and they
can introduce variants around that whereby they can look at the
components of the investment strategy and, as appropriate, introduce
it into their other funds. The restrictions, just to remind you
(and so we do not get confused), are on the marketing of products
to UK consumers. There is no restriction on a company setting
up a hedge fund utilising the various legal structures which hedge
funds themselves utilise and, indeed, vice versa, a hedge fund
could set up a conventional asset manager, indeed, some have done.
Q61 Kerry McCarthy: That has made
it clearer. Is the move into credit markets from equities significant
or, again, is that just an example of their innovation?
Mr Sants: I think there have always
been different types of hedge funds in different spaces. As you
rightly point out, when hedge funds started to develop they tended,
in terms of their marketing strategies, to be focused on a particular
area of which the most common classes, as you rightly identify,
would tend to be equities (long and short equities), fixed income
and credit, but there have always been operators in all these
different segments. What, however, we have seen is growth in all
these segments and we have also seen the development, as I have
mentioned. As hedge fund managers develop into scale they tend
to offer greater choice off their platform, and so you will see
groups who previously maybe were only offering equity funds develop
a credit product to sit alongside. We also see, and we have highlighted
this as a potential risk, there is always the risk of what one
might loosely describe as mission creep whereby a fund, which
may be telling its investors it is primarily focused in a particular
area because it might be concerned about maybe not achieving the
returns that it is expected to or it hopes it will in that area,
might be tempted to move into another area to seek to supplement
its returns, and obviously that then raises issues of transparency
with the investors as to whether they are fully informed as to
the underlying strategy about the fund, and that is a transparency
issue between the funds and the investors. We have highlighted
the importance of the hedge fund community being clear with its
investment communities about exactly the strategies that they
are pursuing in the various product offerings that they have.
Q62 Kerry McCarthy: It touches on
the question of regulation. You say you have highlighted the importance
of them being open with their investors, but to what extent do
you have any regulatory powers over hedge funds?
Mr Sants: I think it is important
to be clear about this. We do regulate the fund managers who are
based here in the UK. You tend to get odd comments around saying
that hedge funds are not regulated. To be absolutely clear, the
fund managers who are based here in the UK are regulated, and
that includes our overall conduct regime. Our overall conduct
regime obviously requires them to treat their customers fairly
and act with integrity and honesty, and so forth. That conduct
regime does apply to the managers based here in the UK.
Q63 Kerry McCarthy: Amaranth was
mentioned earlier, and this is again a question for the FSA but
possibly for the Bank and the Treasury as well. What did you learn
from the failure of Amaranth? What assessment did you make at
the time whether it would pose a financial stability threat?
Mr Sants: To be clear, the specific
Amaranth fund which got itself into difficulty was not regulated
by the FSA. We would not have direct insight, as a regulator,
into the particular circumstances that occurred there. Any comments
we make you have to look against the background that we were not
actually the regulator for that specific fund. Having said that,
as you rightly point out, you would expect us to properly consider
the events there and to give consideration as to whether any lessons
could be applied here in the UK as a result of what we understand
happened in the Amaranth circumstances. When we look at what we
understand happened there, we can reasonably say that our regulatory
regime here is structured to take into account the type of issues
which appear to underlie the problems which Amaranth got itself
into. Of course having a regulatory regime which does focus on
those particular risks does not always guarantee, and is not designed
to guarantee because it is not a no fail regime, that individual
fund managers will not get themselves into difficulty. It is certainly
the case here in the UK, which is different to many other regulators
around the world, which you will note from our various public
pronouncements in response to the fact that it is a growing area
which we rightly should be focused, on we have set up a dedicated
supervisory group and have increased our supervisory engagement
with the larger fund managers we do regulate who are based here
in the UK. We now have an active supervisory programme in place
with sematic visits with that group of larger funds. Of course
in that visit programme we do focus on the control environment
and the efficiency of stress testing and the types of mitigants
that we would expect a well run fund to have in place to address
the types of risks that we could envisage in the market-place.
We do have a programme which is looking at those types of risk.
As you would expect me to say, this is not a no fail regime. We
are alert to these issues but individual firms would not get themselves
Sir John Gieve: As I said in this
speech the Chairman has been commenting on, it was a very interesting
episode because, in gross terms, the losses were almost as big,
or even bigger in some ways, than LTCM which did cause real troubles
in the financial markets. This did not create a crisis although
it was very painful for Amaranth and the investors in it. The
question is what comfort do we draw from that. I think you can
draw a bit of comfort in that they were able to liquidate their
positions smoothly within working markets, that the leverage turned
out to be not as great as it was in LTCM, and so on. Does that
mean all is well and we do not need to worry about big price changes,
in this case in the gas futures market or other markets? There
were a few special features of the Amaranth case which meant that
it had a few things going for it which might not always be true,
one of which was it was in a special market, and the other of
which was the change that hit it was a positive change for the
world economy, namely a reduction in prices. If you go back to
1998, you had some big negative shocks to the world economy, the
default of Russia and so, which were associated with LTCM. I thought
it was very interesting.
Q64 Kerry McCarthy: If Amaranth had
happened in the economic circumstance of 1998, potentially the
fall-out would have been much greater and vice versa?
Sir John Gieve: My conclusion
is that it is positive because a lot of things worked well which
allowed this big loss to be swallowed by the market. I do not
think it should lead us relax our guard completely.
Q65 Kerry McCarthy: It was a particular
combination of factors.
Sir John Gieve: Yes, there were
some special factors.
Mr Cunliffe: I will just make
the obvious point. Hector has talked about lessons learnt and
comparing the system of regulation to which Amaranth was subject
to our own system. As far as the Standing Committee on risks is
concerned, as it became quite quickly apparent that Amaranth was
not going to pose a financial stability risk, either in its home
market or internationally, we did not discuss the financial stability
risk because it did not occur. That is the sort of thing, had
a risk started, we would have picked up. On why was it different
to LTCM, John is right that 1998 was a particularly stressed time
in the world economy because of the Asian crisis and the Russian
default, et cetera. The other point I make is its leverage was
less. One of the things that is different now in relation to hedge
funds and the way they are regulated, because they are regulated,
is that a lot of the prudential regulators focus on this question
of where leverage is coming from in the financial system. Of course
LTCM was very highly leveraged.
Sir John Gieve: One other thing
about Amaranth is the fact that this was supposed to be a multi-strategy
firm but it actually bet the whole fund, as it turned out, on
one particular strategy. I think that has sent messages through
the industry, to both the investors in hedge funds and to hedge
fund managers themselves in terms of risk controls, transparency,
and so on.
Q66 Kerry McCarthy: In some ways
that is more powerful than any attempts at heavy-handed regulation.
Sir John Gieve: Market restraints
are very important.
Q67 Chairman: Could I just finish
this? Sir Andrew Large, your predecessor, made a speech in Hong
Kong a number of years ago, "Where is the Risk?" I was
not able to get it before I came here. I tried the Bank of England
website but failed this morning in that. On this issue of hedge
funds, he gave the impression that we do not know where the risk
is. You have discussed how hedge funds and complex derivatives
parcel out risk and this can lessen the concentration of risk.
I accept the liquidity brings the markets and the positive aspects
but does it not also mean that you cannot see where the risks
currently lie and, along with complex financial instruments, this
opaqueness poses a risk in itself?
Mr Sants: I would agree with you
that one of the challenges, or arguably the biggest challenge,
we face from the financial stability perspective is the fact that
it is almost axiomatic that markets are getting ever more complex.
As you yourself have said, recent historical experience suggests
that one of the positives of the increased complexity of markets
has been increased risk dispersion. It is really important to
recognise the hedge funds have been a primary agent in that increased
risk dispersion. Our point about the benefits hedge funds bring
to the system is to indicate, on historical records to date, that
ability to disperse risk has been a very major benefit to the
market-place. I do not want, in any way, to underestimate the
point you are making, which is as markets get more complex the
available transparency to the regulatory community overseeing
those market places is diminished. I would make the point that
even if we could see all those risks and those trading positionsI
think that is where you are coming fromat a given point
of time, it is not in any way clearand Callum McCarthy
made this comment in a recent speech in December on hedge fundsthat
we could either do anything with that information or, given the
moral hazard point, should want to have that information. Whilst
it is reasonable to say that visibility of risk is on a declining
trend due to complexity, it is not totally clear that increased
visibility of risk would necessarily help regulate.
Q68 Chairman: Surely that is a debate
for more disclosure and more transparency.
Mr Sants: What is reasonable to
look atand we have some initiatives in this space and we
are working at doing moreis focusing particularly on counterparty
risk. As you will be aware, we have increased transparency of
that through a voluntary reporting scheme with the prime broking
and investment banks. If you mean specifically transparency of
individual trading positions in something approaching real time,
I am not sure that would help the regulatory community.
Q69 Chairman: Are there any areas
of hedge fund operations you would prefer to know more about?
Mr Sants: We are seeking to operate
a proportionate regime and we do think our degree of oversight
of the fund managers based in the UK within our FSA remit is currently
broadly appropriate and proportionate.
Q70 Chairman: You do not need to
know more about most of them. Sir John, do you agree with that?
Sir John Gieve: I would like to
know quite a lot more about markets, particularly how new instruments
will behave under different stress conditions. The opacity that
worries me is not so much that there is not a database people
can access to find out whether hedge fund A has a position or
does not have a position, it is the opacity that is inevitable
because we have a lot of new instruments and new players. We do
not know, for example, coming back to one of Hector's points,
quite whether the patterns of correlation which people are trusting
and that have held up over the last five years will continue to
hold up in the future. In a way, what I think is the most worrying
point in this development is not that there is not a super database
where people can check positions but that people cannot know exactly
what risks they have taken on because they have not seen these
products through a full cycle.
Q71 Chairman: That answers the question.
We are at one, at the end of this session, on that. Could I ask
this final question very quickly? There has been a suggestion
from the ECB for an international highly-leveraged institutions'
credit register. Do you support such an idea and do you think
it will happen?
Mr Sants: As we currently understand
the idea, I do not think we would currently support it. We would
have to understand more about it.
Sir John Gieve: This is an FSA
lead but I agree.
Mr Cunliffe: I think one needs
to know more about it. Some of the problems that Hector mentioned,
about trying to have a real time picture and what would you do
with it, would be very tricky. We prefer to focus on this question
of leverage and counterparty.
Q72 Mr Love: Can I turn to private
equity? Mr Sants, you have been quoted as saying "The default
of a large private equity-backed company is increasingly inevitable."
What would be the consequences of such a failure for stability?
Mr Sants: I did say that but I
think increasingly inevitable does not necessarily make it inevitable
but highly likely. I also said, at the same time and which is
still my view, that such an event, in our view, does not pose
a particular risk to financial stability. In other words, what
I was highlighting there is reflecting where we are in the cycle.
It is clear that private equity deals are tending, quite understandably,
to get larger, the degree of leverage is increasing and the terms
of financing on which it is being achieved are getting more aggressive.
It seems likely, at some point, either you have a failure of the
syndication process around that funding in a particular deal,
or the subsequent underlying investment gets itself into difficulty,
and is not necessarily able to fund the funding structure that
is being set up to support that investment. That happening could
then lead to losses being incurred by the investors in that particular
fund or the syndicating bank. We were highlighting the importance
of being focused on that point and trying to maintain the appropriate
disciplines. The fact that some individual deals may fail, either
in syndication or subsequently, in no way necessarily poses a
threat to overall financial stability. Obviously it is theoretically
possible the set of circumstances could arise but that is not
our central message.
Q73 Mr Love: If I could go on to
further quote you, and you can tell me whether this is accurate
or not, and I am paraphrasing. Such defaults have negative implications
for lenders, purchasers of the debt, which you have mentioned,
orderly markets and conceivably, in extreme circumstances, financial
stability and elements of the UK economy. We have already touched
upon excessive leverage, which I think is a concern here especially
with interest rates rising. Someone in the American market suggested
that private equity groups were attempting crazy deals. Is there
not a concern that the direction in which private equity is going
could well lead to some of the difficulties that you expressed
in that comment?
Mr Sants: As I am sure you appreciate,
we need to distinguish, and this is a bit akin to the hedge fund
discussion a moment ago, between the general concept of private
equity and the terms under which private equity deals are being
done. Certainly the concern of the FSA, rightly given our remit
over the financial sector, is particularly to focus on the issue
of the terms and basis under which the financing is occurring.
We absolutely have said that, as I have just re-capped. We do
recognise that leverage is rising and that risk is increasing
around the financing terms of individual private equity deals
and that some of those may, in consequence, fail. As I have just
said, and as you rightly quote me there, clearly theoreticallyand
we are now into the business of risk and probability and impactif
the deals were to be large enough and there were to be interconnecting
ramifications with the funding institutions, for example if the
investment banks themselves were not properly anticipating the
consequences of such a failure, that could be a transmission mechanism
for an impact on the wider financial system. Our judgment clearly,
not wishing to repeat myself, is currently that does not look
that likely, not least because the deals are not yet at a size
that in any way looks like it would threaten the overall UK financial
stability. It is interesting that in the States, which may be
the point you are trying to draw out here, deal sizes have been
rising. We have had commentators talk about deals moving more
into the US$50-100 billion size, which is significantly bigger
than deals we have seen here in Europe to date. It seems reasonable
to assume, as we tend to see conversions over time in markets,
that we will see deal sizes getting ever larger here in the UK.
Possibly over the very long term some of these risks you are talking
about will come further up the risk map, if you will, or there
will be areas that undoubtedly the FSA should be focused on. Again,
that is my earlier point about hedge funds. In response to the
fact that we absolutely do think it is part of our obligation
to keep an eye on developing trends and changing structures in
the financial market, we have set up a dedicated group with specialisms
in private equity, particularly in these large leveraged transactions,
to make sure that we can properly monitor developments. As a long-term
trend that we need to be very focused on, I completely agree with
you. As a short-term driver for financial stability, we do not
see that as a current major risk.
Q74 Mr Love: There has been this
drift upwards in the American market in particular. We are told
constantly in the newspapers that the Americans are sniffing around
Europe for similar types of deals. Is that something you, at this
point in time, are concerned about?
Mr Sants: From the FSA standpoint,
addressing the financial stability mandate, that is not something
we would currently be concerned about. Do we think, which is reflected
in the comments I have already made, that individual investors
and individual banks should be focused under the terms under which
they are doing their current deals? The answer to that is yes.
Q75 Mr Love: Can I move on to a term
which has been used on a number of occasions so far in this discussion,
the "search for yield". I want to ask each of you what
you mean or understand by the term "search for yield"
and what your concerns are arising from it.
Sir John Gieve: The search for
yield is shorthand for the position in which the premium offered
for taking risk is reducing in a number of respects. Interest
rates, especially long-term interest rates, are fairly low. People
want to get a better return. They are willing to take on extra
risk, for example, by buying a debt which is of a lower than investment
grade. You have seen a narrowing of the gap between the AAA investment-rated
bonds and other bonds. Why is this a matter of concern? The potential
is there will be a snap back to more normal historical levels
which will change asset prices and some people may find themselves
exposed to losses. That is the fundamental worry.
Q76 Mr Love: There were a lot of
people going around saying it is the benign macroeconomic environment
created by central banks, the low interest environment you talked
about. Do you accept some responsibility for this narrowing of
Sir John Gieve: I have only been
there a year so I am not going to claim credit for macroeconomic
stability, although I suppose I was partly in the Treasury when
this great stability started. I think the macroeconomic stability
has been a factor in this and it has been a very successful period
in the West. I suppose our worry is that people may be refining
a little bit too much on that, and what Mervyn King calls the
"nice decade" may actually be unusual even in a world
in which the macroeconomic policy is being well run.
Q77 Mr Love: Without creating turbulence,
how do we deal with this flattening of risk, not pricing risk
properly, which we see emerging?
Mr Cunliffe: The first thing I
would say is low interest rates globally and low yields look very
low by historic standards but of course one does not know, there
is no certainty, that interest rates should be at a certain position.
There could be all sorts of reasons why interest rates are low,
and there are benefits to having global rates low as far as firms
and investment are concerned. Part of that issue is not just to
do with central banks and how central banks happen to be operating
at present. It is noticeable that even those central banks who
have gone in a tightening cycle across the world raising interest
rates, generally low long rates have persisted more than you might
think. A lot of it is to do with excess of savings over investment
opportunities in the world economy. It is to do with large reserve
accumulations in Asia and now in oil producers. You have a lot
of money looking for an investment home, looking for opportunity,
and that pushes yields down. One does not deal so much with the
problem, one deals with ensuring that the people who are taking
these risks, who are looking for high yields and who have changed
the pricing of risk in the investments they take, regularly stress
test and examine what they would do if rates were to snap back
so that they are proofed against it. There are lots of trades,
for example the carry trade which is often talked about, where
people need to do those tests to be sure they are robust to those
Q78 Mr Love: What about carry trades?
What about some of these riskier investments that everybody accepts
in principle are risky but do not seem to be priced in that way
by the market at the present time? What is the FSA doing to alert
those involved in this activity to do better?
Mr Sants: You rightly identify
it is not our role to directly manage individual firm's trading
strategies. What is critical, and clearly the focus of our attentions
as a regulator, is to seek to ensure they have proper systems
and controls and proper risk management systems. There are two
key components I would like to re-emphasise which have both been
mentioned before, and one is a comment which we made in the FRO
today. One of the features of the shorthand term "search
for yield" is also people looking to utilise a greater variety
of trading instruments than they did before and that does push
them into illiquid and, in many cases, OTC markets. One particular
risk we do want people to be focused on is the valuation point
and the importance of having good valuation systems which seek
to, as best they can, make sure that these portfolios of illiquids
are properly valued. Secondly, and most criticallyand I
know you have heard this a lot already today but it is an absolutely
essential mitigant for firms to be focused on hereis the
ability to scenario test stress tests. It is tied back to our
capital regime but it is critical that people stress test effectively.
We do believe stress testing in the industry is much improved.
We believe the introduction of the CRD regime is further increasing
the focus in that area. Having said that, as we said before, and
we have had some special papers on this topic, we think there
is still more work to be done. It is drawing the extension between
stress testing, to give you a layman's feel, maybe looking back
at historical events and saying "If that happened, what would
happen to our set of positions at the current time", but
also overlaying that type of analysis with the more extreme question,
which we think senior management should be properly focused on,
which is under what conceivable circumstances would this financial
institution get itself into difficulty. That type of stress testing
is a somewhat different one to running historical scenarios. We
do think more work can be done in this area so we recognise progress.
Q79 Mr Love: Can I ask all three
of you one final question about these new and complex financial
instruments? A lot of this is done by computer and so the old
heard instinct we have talked about in financial markets has been
replaced by this thing they call black box investing when it is
all done through computers. You are in the market and out of the
market not based on whatever sentiment there is in the market
but based on whatever the programme tells you about these complex
instruments. Does that have ramifications? We have talked, in
previous declines in the stock market, about this and the influence
of computer programmes. Is that a worry for you? What should we
be doing about it if it is a worry?
Mr Sants: There are two types
of automated risk here: one is about modelling, which we have
covered already; and the second point, which is maybe what you
are principally alluding to, is more to do with exchange-traded
instruments and the ability of automated systems to execute large
volumes of trades in very short periods of time. That is a risk
we do believe exchanges and intermediaries should be focused on
and we clearly believe they should have proper systems and controls
in place to manage that risk.