By James Williams – One thing is certain: hedge fund regulation in the US is tightening and is here to stay. What remains uncertain is the long-term impact it will have on the industry. Recent high-profile insider trading cases involving Galleon Group LLC and, this summer, SAC Capital Advisors, have put a spring in the step of its national regulator, the Securities & Exchange Commission.
As reported by Reuters, the SEC filed 735 enforcement actions in 2011 and collected USD928million in penalties: a fourfold increase on 2008.
With the introduction of Form PF last year, and the establishment of the Office of the Whistleblower as part of the Dodd-Frank Act, the SEC is getting access to more data on how hedge funds work than ever before.
One criticism of Form PF, however, is that the SEC is unlikely to ever prevent potential systemic blow-ups because the sheer volume of data coming from hedge funds is too large. What are they expecting to do with it all?
“I think the sceptics are on the right side of history in terms of doubting the regulators to use the data effectively in limiting systemic risk. On the other hand I do think the technologies and tools today are far greater than they were in the past and the SEC have done a good job of bringing on people that have pragmatic industry experience. They have a better chance of utilising this data effectively today than they did 20 years,” says Adam Sussman, Director of Research at TABB Group, a financial markets research and advisory firm.
On top of this SEC staff have shown a commitment to improve compliance and monitor firm-wide and systemic risk by establishing the National Examination Program. All new Dodd-Frank registrants have to comply with provisions on record keeping, marketing, portfolio management, custody, conflicts of interest, valuation and must make themselves available for examination by SEC staff.
The SEC spoke to Hedgeweek but declined to go on record.
US hedge fund managers no doubt feel overwhelmed by all of this. Factor in changes to the way OTC swaps are traded under CFTC regulations, the ominous cloud that is FATCA looming on the horizon, and the transposition of the AIFM Directive into EU law this July, and it seems that no matter which direction managers’ look, another piece of regulation stares back at them.
Michael Tannenbaum and Ricardo Davidovich are partners at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP. This year, the firm has had a tremendous amount of regulatory work, signalling the SEC’s greater intent to police hedge funds. Whereas pre-2008 requests for voluntary production of information would be sent to managers to better understand their trading strategies, the gentle touch has been replaced by the issuance of subpoenas.
“We have a handful of subpoenas in our office from the SEC as well as New York’s Attorney General. These subpoenas reflect that regulators are more focused and conducting themselves in a more formal way. You could call it the Madoff effect. Post-scandal, it is clear that regulators are being far more aggressive in gathering information,” comments Davidovich.
Voluntary cooperation, it seems, is being replaced by forced cooperation.
But Tannenbaum adds: “When a regulator calls requesting information the client can’t simply ignore it. So for many requests, even though “voluntary” and without a subpoena, the result is the same – increased oversight. That often involves lawyers. That’s our new reality.”
Davidovich says that the focus is on technical rule violations that result in enforcement proceedings or settlements.
“One of our clients, for example, has been subpoenaed because the SEC wants information relating to one of their portfolio companies. They want to get information directly from a professional shareholder rather than from the company. It puts managers in a difficult position because responding to a subpoena requires significant resources and time when the manager is not even the focus of the investigation: they have been deputised.”
One important aspect to Dodd-Frank is the move towards centralised clearing of OTC swaps. The Commodity Futures Trading Commission (CFTC) has identified no less than 38 areas for which rules will apply, and has this year commenced a three-phase cycle of compliance for swap clearing. Swap dealers and major swap participants registered in March 2013, followed by Category 2 entities that include private funds. Commercial end-users and ERISA pension plans must register this September.
At its heart, swap clearing regulation aims to bring greater transparency and price discovery to the market. This is a big deal because it means that overnight hedge funds who trade interest-rate swaps and credit default swaps will have to post initial and variation margin, as well as comply with stricter rules imposed by the clearing houses on eligibility of collateral. Ultimately, the move away from OTC bilateral arrangements into centralised clearing is going to become a more complex, costly, and, potentially, less precise activity.
“Swap regulation is certainly a drag for the hedge fund community. It doesn’t mean that people will stop trading strategies that use swaps, but the amount of money they can make from those trades will to some extent be diminished in the near-term.
“In the long-term, if the regulation has the desired effect of making the markets more transparent, and spreads narrow, then managers may get some of that expense that gets paid out to cover margin costs back in the form of transactional savings. But right now, the only thing managers know is that it’s going to be more expensive,” explains Sussman.
Hybrid products like swap futures are being developed to help the buy-side deal with the margining costs; two-day margining compared to five-day margining for cleared OTC trades and 10-day margining for non-cleared OTC trades.
James Bibbings is President of Chicago-based regulatory advisory firm Turnkey Trading Partners. Bibbings does not think that centralised clearing will necessarily change the systemic risk structure of the industry. Taking OTC trades out of the shadows into CCPs is a positive step, naturally, “but if we don’t have a definite idea of how swap clearing is going to work, or how it’s going to be back-stopped, then globally we’ll just end up building another too big to fail entity with centralised counterparty risk,” says Bibbings.
Whilst they might be cheaper, hybrid solutions like swap futures or Market-agreed Coupon (Mac) products are unable to provide the precise hedging that multinationals – true hedgers – require with respect to contract size and/or duration. Over time the range of maturities will grow but standardised contracts do not allow for bespoke hedging: how does one hedge 50-day interest rate risk if only 30- or 60-day contracts are available?
“It becomes an inefficient hedging exercise: companies are forced to make the unenviable choice of being either under-hedged or over-hedged due to standardised contracts. That just adds risk to those least able to accept it,” says Bibbings.
Sussman fears that the increased capital ratio requirements under Basel III might well disincentivise the banks (swap dealers) to accommodate non-cleared OTC contracts.
“They will have to set aside even more of their balance sheet meaning they may seriously pull back on the size of their uncleared swap book.”
Bibbings makes an astute observation with respect to the 87 or so registered swap dealers in the US. Among all the usual broker/dealer names there are a few anomalies; FOREX firms like Forex Capital Markets (FXCM) appear. Why?
Because OTC swap regulation is set to include retail FX in the US.
This, says Bibbings, will be a major game changer.
“Companies like FXCM are being proactive and registering as swap firms. That’s because standardised spot FX contracts are poised to no longer be regarded as OTC FX trades but will instead be viewed as swaps or contracts for difference (CFDs). The potential disruption to global markets could be significant. It’s almost crazy to start redefining FX trading in the US as swap dealing.
“Going down this route could easily isolate the US forex marketplace from the rest of the world if we’re not careful.”
Tannenbaum thinks that the nature of the hedge fund industry is undeniably changing in the face of widespread regulation and the influx of capital from institutional investors:
“Managers aren’t taking the same level of risk they were taking 10 years ago. With all this regulatory oversight and with risk aversion that many institutions have these days, fund strategies are becoming less volatile, and therefore, one could argue, less profitable to the investor. Perhaps some managers are shifting to an asset accumulation model as opposed to a leveraged, more risky model.
“I think that’s unfortunate. The hedge fund industry was never designed to be like that.”
Not that all regulation should be viewed negatively. On the flip side, the introduction of the JOBS Act could prove a useful fillip to smaller US managers struggling to raise assets. At a time when hedge funds are being more tightly regulated it does seem slightly odd that managers will now be able to target retail investors.
Then again, greater risk controls for trading OTC derivatives, the use of CCPs, and improved transparency, not to mention having to register with the SEC, are creating a safer environment for hedge fund investment.
“On the whole, I would say regulation has been a negative but the JOBS Act is creating opportunities for smaller managers,” says Sussman.
Davidovich agrees that the JOBS Act presents a new capital raising avenue:
“There’s a whole segment of the US population whose interest has been piqued by hedge funds but until now they’ve never been invited to the party. This JOBS Act will allow hedge funds to get their names out there in a way that was previously impermissible.”
The SEC was vociferous in its views on the JOBS Act. And this could, potentially, adversely affect managers who choose to exploit it. Continues Davidovich: “The SEC was clear in its objection to the provision of the JOBS Act allowing general solicitations. As a result, you might find the SEC scrutinising fund managers that choose to advertise.”
What it does do is remove the veil of secrecy under which hedge funds previously operated as non-regulated entities. It’s up to managers how they choose to market themselves.
40 Act funds: a growing trend
One interesting trend emerging in the US is the rising number of hedge fund managers looking to launch long-only 40 Act funds. Cliff Asness’s AQR Capital Management, Highbridge and Ramius have all launched new products to attract a wider investor base. This, says Tannenbaum, is one of the benefits to regulation as virtually all US managers are now registered with the SEC as investment advisers.
“Before the law, most were not. As a result, they weren’t allowed under the law to manage assets for US mutual funds under the Investment Company Act. Those funds can only be managed by registered investment advisers, so one of the intentional (or unintentional) consequences of registration of hedge fund managers is that they can now manage money for investment companies.
“We are seeing growth of registered funds and a demand for these funds (many closed-ended) by managers who under the prior law wouldn’t have had to be registered. There are restrictions but all in all it’s a positive development,” states Tannenbaum.
Indeed, as Bloomberg reported on 12th August 2013, Fidelity’s Portfolio Advisory Service has invested USD1billion in BlackStone’s alternative mutual fund, the BlackStone Alternative Multi-Manager Fund. Clearly, there seems to be a convergence at the upper echelons of fund management where the biggest managers and asset management houses, like Fidelity, are trying to tap in to the same institutional investor base.
“I think larger hedge fund groups are going to continue to roll out 40 Act funds. They are becoming more asset gatherers than they are alpha generators,” adds Sussman.
FATCA is yet another piece of legislation facing US hedge fund managers. The IRS has its online portal within which clients can familiarise themselves with the registration process, although official registration will not commence until 1 January 2014 (ahead of the 1 July 2014 implementation date).
US Bancorp Fund Services has been quick to support its clients ahead of FATCA by developing a solution called Finomial. Finomial brings automation to the investor onboarding process, where key investor information is gathered from tax and fund subscription documents to provide a clear window into the tax status of a manager’s investor base. Any red flags can be easily addressed to ensure that the manager, when filing to the IRS, is fully compliant with the regulations and not at risk of getting hit with 30 per cent withholding tax.
“In addition to keeping our staff up-to-date, we’re also hosting webinars and distributing newsletters to our clients, to keep them informed,” says Beth Mueller, Managing Director, Investor Services in US Bancorp’s Alternative Investment Solutions group. She advises that managers should begin conducting a preliminary review of their existing investor base well ahead of the July implementation date.
“Hedge fund managers face an overwhelming amount of regulation. They have a lot on their plate. Assistance from a good service provider can help managers stay focused on investing.
“With Finomial, managers can view every subscription, all of its documentation, and any potential compliance issues. They have a real-time snapshot of their fund’s FATCA status; identifying any potentially recalcitrant investors and the necessary steps to remediate.”
Lonnie Macdonald, President of JD Clark & Company, the hedge fund administration division of UMB Fund Services, takes the 40 ACT fund scenario further forward when asked how the US hedge fund industry might look in 20 years time by referencing the global success of the UCITS brand.
“It’s an amazing structure because of its passporting capability and because of its acceptance in 75 countries worldwide. Right now, if you want to operate in the US regulated market you can’t do it with a UCITS fund, you have to start a 40 Act fund or a Reg D 3(c)1 or 3(c)7 fund. What I see potentially happening is US managers looking to access mutual fund assets outside the US increasingly think to themselves, ‘Why do I need to set up a new legal structure to do that? Why can’t there be one global legal structure that allows me to target US as well as global investors?’
“Maybe the UCITS brand will eventually become that. In 20 years we might see the 40 Act replaced.”