Examination of Witnesses (Question Numbers
420-439)
Dr Patrik Edsparr, Miss Rebecca Fuller and Mr Adam
Cooper
24 NOVEMBER 2009
Q420 Chairman: I suppose that the thing
about the alternative investment community is that it has grown
so much in the last 20 years and we have had some anecdotal evidence
to suggest that the hedge fund community is now so big that, in
the ordinary course of business without doing a single thing you
could frown on, they are big enough to destabilise some of the
big investment banks if they all withdrew funds at once as I believe
happened.
Dr Edsparr: I think the causality goes the other
way. The reason that there was some strain on the hedge fund community
was that the big banks withdrew the funding, because obviously
the whole financial system is based on the central bank providing
emergency liquidity to the major banks, and when the banks do
not intermediate in that liquidity extension then the people who
are beholden to the banks as intermediaries are exposed. That
may be a separate subject matter, but I think that there is a
legitimate question about how the liquidity provision in today's
marketplace should take place and it may not be optimal that it
always just goes through the window and through the major commercial
banks. I think that the hedge funds are at some level dependent
on the financing arrangements that largely happen through the
banks. If the banks have access to liquidity from the Bank of
England or the ECB or the Fed but the banks start to hoard cash
and start to cut all the financing lines, it does not matter whether
you are a hedge fund or if you are a corporation or if you are
an individual because, if those financing lines disappear, most
of those participants have no other source of financing. It is
absolutely correct that that would cause some strain for some
people including us but I think that systemically the demise,
because of that withdrawal of liquidity and withdrawal of financing,
actually did not any cause any systemic threat.
Q421 Chairman: I think that we were reasonably
convinced that the banks had not suffered, but the banks had,
on the whole, got their money back from hedge funds and hedge
funds have gone down. Are hedge funds in a position of holding
large deposits with banks that they withdraw or can withdraw or
might have withdrawn?
Dr Edsparr: I think that this ties to the prime
brokerage issue. I think that any well-managed hedge fund will
have a very significant proportion of their assets in an extremely
liquid form and, for a number of hedge funds, that means holding
cash on deposit with their prime broker. I think that the demise
of Lehman Brothers was disturbing to a number of people because
they could not access that cash/liquidity reserve. It is absolutely
part of prudent risk management to keep a very substantial portion
of your assets in cash or cash equivalence to be able to meet
short-term troubles.
Chairman: Indeed.
Q422 Baroness Northover: Picking up on
My Lord Chairman's first question which was, had they grown to
such a size that they could have a systemic effect, you then turned
that around and said that actually they were affected by what
happened. If they do indeed hold large deposits in the way that
you say, if funds were to decide to withdraw these deposits, that
could have a systemic effect, could it not?
Dr Edsparr: I do not think that hedge funds
represent any significant portion of the deposit base for the
banks. That is very, very marginal. The hedge funds are net recipients
of financing. On average, hedge funds own more assets than they
have equity, so they need financing on some of those assets, and
that is where the banks typically play a role. The only area where
hedge funds can significantly contribute to systemic risk is if
one particular position, let us say the insured Bank A versus
Bank B, if it just happens to be that a lot of hedge funds at
the same time as many of the banks and as maybe many of the traditional
players, assets managers, insurance companies and so on, if they
all end up having the same position, maybe out of coincidence
or for whatever reason, I think you can argue that that can create
technical pressures in the market.
Q423 Baroness Northover: Of course that
was something which was seen and addressed, was it not, that short
selling seemed to be undermining institutions where there was
some sort of a question mark?
Dr Edsparr: My view, and speaking as a trained
economist I guess, is that short selling is actually one of the
few safety valves we have against bubbles. I find it intellectually
very disingenuous, on the one hand, to say that we want to prevent
bubbles, we want to prevent excessive speculation and risk taking,
which are largely driven by long positions, borrowing to buy more
and keeping the asset values going up and, on the other hand,
to say that when those bubbles correct the short sellers are the
damaging force. Short sellers keep those asset bubbles within
some rhyme and reason when you have a bubbly market.
Q424 Baroness Northover: What pops the
bubble?
Dr Edsparr: There is a combination of technical
factors and fundamentals that pop bubbles. I cannot say that I
have any secret insight as to when that happens, whether it is
tulips in Holland or real estate in the US suburbs or, as a Swede,
I guess I have a little bit of perspective from the Swedish real
estate prices in the early 1990s. I do believe that short sellers
play an extremely valuable function in forming efficient prices
in the marketplace and I think that there is a crucial difference
between saying that, in one particular name and at one particular
time, the number of positions add up to too much, so that it is
justifiable for a regulator to say, "Well, let's stop now
in this name" as opposed to any kind of blanket restrictions.
Q425 Lord Haskins: The logic of what
you said about the hedge fund reliance on the banks for their
cash would suggest, if you regulate the banks properly, that is
where the systemic risk arises and, if you do that properly, then
the banks themselves would be the regulator of the hedge funds
because they are the ones who provide the money and, if they are
providing money in an irresponsible way, then it is the banks
who pay the price. You could argue that there are other reasons
for regulating hedge funds but systemic risk does not appear to
be one.
Dr Edsparr: I would largely agree with that.
I think that the key in this equation is the capital structure
and the regulatory regime around banks and obviously that filters
through to the access to leverage and financing for other participants.
I would say that it is the regulatory regime around banks on the
one hand and the access to emergency liquidity from the central
banks which are the two macro-levers that, as regulators for setting
the stage for the financial market, I believe are the two key
features.
Q426 Chairman: I was trying to establish
whether hedge funds are now large enough that if, in the normal
course of business and perfectly legitimately, they remove all
their cash deposits from the banks because they are worried about
the banks, they would be large enough to destabilise the bank?
I think you thought not, Dr Edsparr.
Dr Edsparr: I do not believe so. Also, remember
that, if you do not keep any cash on hold, you will not be able
to borrow anything against your assets. Effectively, if you want
to do that on a bigger scale, you would basically just collapse
your business.
Mr Cooper: If I might add in response, the US
regulators in particular are looking at enhancing the capital
requirements applicable to banks so that they are required to
post more capital, maintain more equity against their balances.
What I think we found in the fourth quarter was that the system
was under-capitalised and the banks had not reserved sufficient
equity capital against their obligations and certainly great scrutiny
is being put into that right now.
Q427 Chairman: They were, in short, relying
too much on their depositors?
Mr Cooper: Yes.
Q428 Lord Trimble: There are US proposals
as well as the EU proposals which we are looking at. I wonder
if you could give us an indication of how the two sets of proposals
differ.
Mr Cooper: Broadly speaking, I think they have
similar goals of enhancing investor protection and guarding against
systemic risk. The approach that the EU takes vis-a"-vis
these issues as compared with the US approach is, however, slightly
different. The US approach—and again these are all just
proposals now that are being considered—is based more on
transparency, information and disclosure. I believe that the EU
proposals are more prescriptive and rule based in nature.
Q429 Lord Trimble: If the EU proposals
are more prescriptive rather than just being on the questions
of transparency and disclosure, could this then result in a situation
of these two regulatory structures developing in the way you have
said, which is actually then going to be a commercial advantage
for New York based businesses and, consequently, EU businesses
might suffer as a result?
Mr Cooper: You may be getting at the notion
of, should there be some form of equivalency among regulatory
regimes? I am not aware and I am not privy to the inner thinking
of the regulators in this. I do not think there is any notion
that they are trying to create a regime that would encourage regulatory
arbitrage. I think what we saw more than anything in the fourth
quarter of last year was the absence of harmonisation in communication
among international regulators exacerbated. I think that there
is a great drive now to harmonise the approach. You do not want
to have the culture of a prudential regulator in jurisdiction
A impacting a decision of where a participant goes if the culture
of a prudential regulator in jurisdiction B is different.
Q430 Lord Trimble: If we are going to
harmonise the regulatory structures and we have US proposals that
are concentrating on transparency and EU proposals that are a
little more rigid in terms of their operation, how is one then
going to harmonise?
Mr Cooper: I think that there is a process in
place where the regulators speak to each other. It is an aspiration;
it is not necessarily something that can be achieved. I think
that the best outcome though is an outcome that permits alternative
investment fund managers to operate efficiently and smoothly in
multiple jurisdictions. We are an international institution, we
operate all over the globe, and it is important for us to be able
to continue to keep doing so rather than to be arbitrarily precluded
from one particular jurisdiction because of the absence, for example,
of equivalency.
Dr Edsparr: I would add, also, that the ultimate
decision makers obviously are investors. It is the investors,
whether they sit in Asia, the Middle East, Europe or the United
States, in terms of tax treatment and in terms of legal treatment.
There are all kinds of reasons why you can only operate efficiently
in one environment and I think that, in all these proposals, the
devil is in the detail.
Q431 Lord Haskins: If we go into a little
more detail on the two approaches to regulation, basically the
proposal that the EU are putting forward and, you know much better
than we do, the proposal being discussed in America. It seems
to us that there seem to be three or four areas where they differ
and I would like to get your comment. One of them is possibly
different leverage requirements of the two regimes; the second
one appears to be very important and is a moving scene and that
is third-country investment and even the EU will tell you it is
changing its position day by day on that; and the third one is
a little related to that and that is marketing and scope of hedge
fund activities.
Mr Cooper: I will speak briefly and then turn
it over to my colleague, Miss Fuller. The EU proposal, as you
suggest, would prescribe leverage, marketing and third party services
in third countries as well as depository and marketing limitations.
The US provisions that have been proposed do not prescribe or
address any of those issues in the same way that the EU does.
There are no mandated leverage limits or restrictions under any
US proposal. There are some slight proposals with respect to marketing
but, by and large, EU managers can market freely in the US their
investment products provided that they become registered as investment
advisers as US managers must.
Q432 Lord Haskins: Is that easy to achieve?
Mr Cooper: Yes, I believe it is. These are just
proposals, but I am confident that the US will pass legislation
requiring investment advisers to register and I think that the
rules and the way in which they are satisfied will be equally
convenient or applicable to US and non-US managers, and then we
permit them to freely market within the US provided that they
maintain compliance with various marketing and private placement
rules that exist. These are all private investment funds, so it
is not a public offering to retail.
Q433 Lord Haskins: Do you think that,
if the proposal goes through, the gap in approach between the
two regimes is widening or narrowing? We keep hearing that it
is important that hedge funds can trade freely across the world.
Is the gap in approach widening between the two regimes or narrowing?
Mr Cooper: I would like to defer again to Miss
Fuller with respect to the EU Directive, but some of the prescriptions
of the EU Directive I think would make it very challenging for
an international institution to freely deploy capital throughout
markets in the EU.
Q434 Lord Haskins: Including the recent
Swedish compromise on third country private placement?
Miss Fuller: I think that the third country
private placement under the Swedish compromise text is definitely
a step in the right direction. What remains unclear though is
the ability of offshore managers to continue to market through
the private placement regime into the EU and, just standing back,
conceptually, nevertheless it is still going to be more difficult
for third-country funds to be marketed in the EU. The Swedish
text is definitely a step in the right direction but it is still
a move away from the status quo which relies purely on the national
private placement rules.
Mr Cooper: If it is harder to market, I think
it is ultimately the investors in the EU who suffer the consequences
of that with the absence of alternatives in deploying their capital.
Q435 Lord Woolmer of Leeds: Picking up
that point, 80 per cent of funds managed by alternative investment
fund managers are outside of Europe, overwhelming through the
United States. I suppose that one could say that United States
fund managers can do without Europe but European fund managers
might find it not quite as easy to do without the United States
and the rest of the world. In other words, if Europe has a regime
that is tighter and much tougher and more regulatory than the
United States, that could result in relative damage to investors
in Europe compared with elsewhere in the world. First of all,
is that a fair assessment of the way in which things could be
going in Europe compared with the United States? It would be helpful
to know that. Secondly, coming back to the point of arbitrage,
if there are real differences, taking up Lord Haskins's point,
will the result be arbitrage or simply less business and less
opportunities and choice for European investors, pension funds
and so on?
Dr Edsparr: I believe that there are two aspects
to this and you touched on both of them. I think there is one
question of where you can conduct business as a hedge fund and
the second issue is where you can attract capital from. If I may
start with the latter one, I think it is clearly one of the issues
in the current draft EU Directive to what extent international
funds can market and engage European investors. Ultimately, the
concern that I have as a European is that sophisticated institutional
investors in Europe will not have access to some of the state
of the art investment products. Obviously, 2008 and early 2009
created an enormous strain on the system and hedge funds, along
with a lot of assets, went through some extreme gyrations, but
I think the basic premise that they provide value-added returns
with relatively low correlation with the other major asset classes
is still the outcome and it is the common conclusion based on
any kind of statistical econometric analysis. I think it would
be very unfortunate if the European investors, the pension funds
and the rather larger more sophisticated investors, were not to
have access to those products because of the regulatory regime.
I think that there is a second discussion obviously where you
can conduct that business and, yes, in order to protect your investors,
you have to find a reasonable regime to operate under.
Q436 Chairman: May I ask again about
the latest Swedish draft. If the private placement regime remains
in place—and I appreciate that in the present version private
placement, as in the Swedish Presidency's draft, remains in place—accepting
that it is not as good for American investors as the existing
regime, will it drive away hedge funds provided the private placement
regime remains in place? I think it is the general European assumption
that while the Commission would rather have a proper equivalency
regime, if that is not possible the maintenance of national state
private placement regimes will enable hedge funds to go on operating.
Miss Fuller: My view is that the maintenance
of national private placement regime is the pragmatic solution
on the table with respect to the marketing issue. However, I do
think that we need to be somewhat careful with respect to what
the Swedish draft has and has not achieved, though certainly a
number of steps in the right direction. However, it remains unclear
whether managers who are based outside of the EU managing funds
outside of the EU will, going forward, be able to avail themselves
of the private placement regimes. Certainly for managers who are
based within the EU managing off-shore funds, the private placement
regime will be maintained to an extent, although I note that the
Commission is due to review that three years into the operation
of the Directive. So, I think, yes, as an outcome, maintaining
private placement regimes is a good result, but we have to be
somewhat careful with respect to the detail.
Q437 Lord Woolmer of Leeds: The latest
Swedish draft of the Directive suggests or proposes certain restrictions
and conditions on the payment of bonuses in the alternative investment
fund management field. What is your understanding of the current
position as proposed by the Swedish Presidency and would you care
to comment on the proposal as you understand it?
Dr Edsparr: My belief is that this is something
that is very much at the heart of the discussions between investors
and fund managers and I think that fee structures for different
products are intensely debated between investors and managers
on an ongoing basis, along with a range of other issues, and are
very much negotiated in the context of that relationship. There
is a huge difference between privately held institutions dealing
with sophisticated international investors determining what is
fair compensation for different services and, let us say, the
remuneration debate around institutions that received explicit
government aid. I feel that there is a legitimate desire from
investors to have a tight link between the timing of realisation
of profits with the timing of the remuneration. I think that is
something that permeates the hedge funds and private equity communities
and I believe that all the events of the last couple of years
have made those links tighter and much more precisely defined.
What I am referring to is, obviously, that if you make an investment
today and the realisation happens three years from now, people
should primarily get compensated on the ultimate resolution of
that, not on some intermediate mark. Personally, I believe that
most of the excesses which took place in the system were when
that close link between realised profits and remuneration was
broken because positions were kept on the books for a very long
time. I do not see that it is appropriate for a regulator to dictate
that. It is a very dynamic environment and it is, as I say, negotiated
on a daily basis.
Q438 Lord Woolmer of Leeds: You know
that the public are greatly concerned about the issue of reward
and excessive reward which is apparently related to excessive
risk taking. What is your answer from the point of view the alternative
investment fund industry because they would say, "We hear
what you say, nevertheless these are tough times and there should
be seen to be some restraint"?
Dr Edsparr: My answer would be that, unlike
banks and large public institutions, most of the principals in
major hedge funds have very significant amounts of, if not most
of, their net worth tied up in exactly the same product as their
investors. There is no misalignment of interest between the investors
for whom you work and your own remuneration. It is not as if,
I can book things in a non market-to-market bank book (available
for sale—AFS) that sits on the books, for ten years while
I will get my bonus in a year or two. Most senior principals in
the hedge funds community have a total alignment with their investors
through their own pocket books. It is a simple discussion between
serious experienced investors and serious investment professionals
to determine what is a fair compensation structure for different
services/different products and it is very much at the heart of
these discussions.
Q439 Lord Woolmer of Leeds: Are there
any proposals in the United States to cap, restrict or regulate
payments of bonuses in the alternative investment fund industry?
Mr Cooper: There are none.
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