11 JULY 2006

CHALLENGES FOR REGULATORY AUTHORITIES,POLICY REFORM PRIORITES AND FUTURE CO-OPERATION

Why the debate?

– There exists no legal definition for "hedge fund" under U.S. securities laws and regulations

– Hedge funds aggressively manage portfolios of investments

Leverage

Long/Short

Derivative positions

Domestic and international markets

Historical Role of Hedge Funds

– Hedge funds were developed often seek to offset potential losses in the principal markets they invested in by hedging their investments using a variety of methods, most notably short selling

– The term "hedge fund“applies to many funds today that do not actually hedge their investments, importantly thise using short-selling

– Hedge funds that act as institutional investors (only with more gearing) do exist

– It is normally institutional investors who want to enjoy the hedge hund’s advantages

Are long-term hedge funds possible?

Why the debate? (cont.)

– That said, the positive contributions of the hedge fund industry are evident:

They contribute to correcting mis-pricings in the market

They provide liquidity

They improve capital market depth

They are an important source of risk sharing and diversification

Why the debate? (cont.)

– For regulators worldwide, hedge funds exhibit two main causes for concern:

The possibility of introducing systemic risk to international and domestic financial markets

and

inadequate consumer protection.

Areas of concern include the following:

– Transparency

– Indebtedness/leverage

– Herd behaviour

Sub-prime crisis

Commodites boom

Dot Com bubble of 2001

How best to achieve Investor Protection

– The focus amongst regulators is how to best achieve investor protection

Two regulatory approaches exist

– The regulated product approach

Hedge funds are defined in legislation

Need to register with the relevant regulatory authority

Registration requirements can be placed on

– Liquidity

– Pricing disclosure

– Trading cycle

– Trading strategies

– Net asset value of the fund

– Leverage exposure.

Two regulatory approaches exist cont…

– The regulated marketing approach

Does not apply product restrictions

Aims to limit marketing to specific investors

Pension funds require explicit reference to hedge funds in their asset allocation rules

For retailisation, requirements can restrict the minimum investment size

Requirements can also be placed on the intermediaries’ qualifications and experience, while disclosure of the risk; trading strategy; previous performance; corporate structure; directors; tax consequences; objectives; and expenses to the client could be made compulsory

Two regulatory approaches exist cont…

– International precedence suggests preference for the regulation of marketing approach

– Most countries restrict this to institution and top-end investors

Which is the preferred approach to regulation?

– Largely dependant on choice

– Focus should be on market discipline

A balanced regulatory approach required

This approach calls for middle ground between disclosure that allows authorities to assess risk positions and at the same time allow the innovative nature of hedge funds to continue

South Africa: the big divide

– The regulatory debate in South Africa has focussed on investor protection.

Hedge fund supervision

– No legislation regulating the establishment and operation of hedge funds in South Africa

– Current legislation pertaining to collective investment schemes, the Collective Investment Schemes Control Act (CISCA) has been developed to accommodate alternative types of collective investment schemes like hedge funds, as well as the traditional types

It has enhanced consumer protection and disclosure for most CISs Eased the investment limits under which fund managers operate. The limits have

been eased to allow fund managers to improve their fund's performance without compromising the protection that these limits the investor.

Collective investment schemes are prohibited from using leverage and short selling strategies

Enough liquid assets to ensure there are sufficient resources to continue the operation of a scheme for three months in the event of the winding up of a manager

– Despite CISCA, the South African legislation does not make provision for a regulated product structure with the freedom necessary to follow a typical hedge fund strategy

– Creation and regulation of Funds of Hedge Funds (FOHF) is therefore also a challenge

Current areas of disagreement between the FSB and the industry include

Pricing: Prices of hedge funds are traditionally priced every three months. The FSB would prefer a daily pricing system

The trading cycle: The norm for hedge funds is a three-month trading cycle. The FSB proposes a 1-month trading cycle

Capital adequacy: If the trading cycle is shortened, the investment manager should provide sufficient liquidity

Investment managers and the marketing of hedge funds in South Africa

– Hedge fund managers are regulated as investment managers under the Financial Advisory and Intermediary Services (FAIS) Act in terms of which investment managers must be licensed by the FSB

– The registrar has the power to prescribe additional requirements, allowing hedge fund managers to be in a class separate to other traditional managers, on the basis that they require more intensive supervision relative to standard CISs

– Although hedge fund products are not outright prohibited, the FSB offers no protection to clients in these investments. The FSB is therefore attempting to put structures into place that will allow for a competent supervisory framework for leveraged hedge funds.

ConclusionNational Treasury’s positionNational Treasury is still refining its policy position to hedge funds, and therefore these proposals must be viewed in the context of being a work in progress:

Systemic risk

– The benefits of product regulation to mitigating systemic risk is limited

– A preferred approach is to follow the Financial Services Authority approach and register hedge funds (possibly only those above a certain size) and have ongoing communication and data submission.

– Feeding into this surveillance, the FSB could interact directly with hedge funds in getting qualitative information on their investment strategies, as well as to engage with the SARB (who would in turn engage with the banks, as the lenders), on credit and liquidity risk issues in the hedge fund environment.

– Offshore developments should be monitored and engaged on, as any global systemic risk will spill over to the SA market

Conclusion Cont…

Investor protection

– National Treasury is in agreement with the FSB on their views of marketing regulation, and strongly supports the idea that a balanced approach needs to be taken between marketing and product regulation so as not to stifle the innovation Hedge Funds foster.

Conclusion

– Regulators and supervisors should foster an environment in which market discipline, in particular counterparty risk management, constrains excessive leverage and risk-taking.

– Effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients' risk profiles

– Placing the onus on market participants to provide discipline can make good economic sense; private agents generally have strong incentives to monitor counterparties as well as the best access to the information needed to do so effectively.

– For various reasons, however, creditors may not fully internalize the costs of systemic financial problems, and time and competition may dull memory and undermine risk-management discipline.

– Accordingly, supervisors and regulators should ensure that banks and broker-dealers implement the systems and policies necessary to strengthen and maintain market discipline, making several specific recommendations to that effect.

Conclusion cont…

– An alternative policy response, being advocated by some in the international policy arena, is the direct regulation of hedge funds.

– Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking.

– So far the majority of international authorities have put their weight behind the claim that in the case of hedge funds, market discipline can work.

– Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risk-taking.

– Direct regulation runs the risk of imposing costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.

– In focusing on counterparty risk management, these recommendations are not intended to prevent failures in the hedge fund industry.

– An appropriate regulatory response should aim at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.