UK's top financial services regulator has called for more transparency in the use of leverage by hedge funds.
The call by Howard Davies, Chairman of UK's Financial Services Authority, came following misleading coverage in the UK press of the FSA's stance on hedge funds. A leading financial newspaper indicated that the FSA was likely to allow the retail marketing of hedge funds.
But the FSA firmly denied this, noting it had already stated last month that it will preserve the status quo on hedge funds, limiting the marketing of these funds to sophisticated investors or via qualified financial intermediaries.
Speaking earlier last week at the annual lecture hosted by the Monetary Authority of Singapore, Chairman Davies said: "I believe we can identify some gaps in our defences against financial instability, which could be plugged, if the will were there."
After citing his unease at the undisclosed financial risk taken on by the re-insurance market, Chairman Davies went on to highlight hedge funds. He said: "Similarly, I am not sure we know enough about the hedge fund market."
"I chaired a working group on highly-leveraged institutions for the Financial Stability Forum, which reported a couple of years ago. Our conclusion then was that there needed to be better risk management by hedge fund counterparties, better risk management by highly-leveraged institutions themselves, enhanced public disclosure by those institutions, and some other related changes."
"I am not one of those who believes that hedge funds are inherently dangerous beasts in the financial jungle. Indeed in many cases hedge funds have been useful in being prepared to take positions, sometimes counter-cyclical positions, which have helped stabilise markets."
"But the sector has grown dramatically, and as the Long-Term Capital Management problem showed, if leverage is uncontrolled, even one fund alone can be a destabilising factor."
"So while I do not believe that the case for direct regulation of hedge funds is made out, I do think we need more transparency, particularly about the extent of their leverage, and the recommendations to that effect in my earlier report have not been effectively implemented as yet. It is encouraging that under its new Chairman the SEC are holding a series of roundtables on the subject in New York."
Chairman Davies also highlighted concern in the area of credit derivatives. He said: "A second, and related area is the issue of credit risk transfer and the role of derivatives. This has been the subject of some entertaining exchanges between Warren Buffett and Alan Greenspan, in the last couple of weeks.:
"To simplify grotesquely, Warren Buffett believes that credit derivatives have generated new risks for the financial system; Alan Greenspan believes they are one reason why there has not been more financial instability during a period when markets have been highly volatile."
"This is a difficult debate in which to take sides. My own view is that neither proposition is rigorously proven at this stage. So my cautious recommendation as a regulator is that we need to know more about how these derivatives are used, and where credit risk has ended up as a result. In particular, we need to know whether regulatory arbitrage is one of the causes - whether risk is migrating to sectors with inadequate capital requirements for this type of risk."
"That is a subject on which many FSF members agree that our knowledge base is inadequate. So far the international regulatory community has not been successful in getting a grip on the extent of the possible systemic problem. It is a gap which needs to be filled quickly."
Background Note: Howard Davies plans to leave the FSA at the end of September to move to the London School of Economics. The search for his successor has begun.