UK regulator “disappointed” by hedge funds’ market abuse controls

The programme of visits to hedge fund managers is part of its overall remit to tackle market abuse across the financial services industry as a whole, but it has been given greater urgency by the sharp growth in hedge fund assets under management and the sector’s growing public profile.

The visits to a cross-section of hedge fund managers, from very small firms to global organisations of several hundred people and representing a broad range of instruments and strategies, seek to review the controls in place to mitigate the risk of market abuse and to canvass views from within the industry on the areas where managers believe the risks of market abuse are greatest. The FSA is also talking to banks about whether the potential for market abuse has grown as a result of hedge fund activities.

The regulator found, as it expected, that the level and type of market abuse systems and controls varied considerably. While some managers have a high level of awareness and appropriate controls in place, the FSA says in the latest edition of its Market Watch newsletter, ‘others were less aware, had fewer controls and demonstrated a complacent attitude to the risks.’

The regulator adds: ‘We are disappointed by some of what we saw. We will be following up with the firms visited and also launching a programme of visits to a wider cross-section of hedge fund managers over the coming months to formally assess their market abuse systems and controls.’

Richard Burger, a senior solicitor in the regulatory team at Mills & Reeve, says: ‘Market abuse has been firmly on the FSA and City agenda for the last four years. I am not surprised that the FSA are disappointed with some of results of this study, in particular the standards of staff training.

‘With the FSA intending to undertake visits across the sector to formally access anti market abuse systems and controls, this study is the first and perhaps last shot across the sector’s bows. Now is the time to tighten up those systems and roll our appropriate training. I doubt the FSA will have any sympathy with a manager who demonstrates inadequate systems and controls at the time of a formal visit.’

Burger notes that some managers believe responsibility for tackling market abuse lies solely with the compliance function. ‘It is not acceptable for some managers to believe that the responsibility to combat market abuse lies solely with the compliance function, as the ultimate responsibility lies with senior management,’ he says. ‘This is a cultural issue and goes to the core of good governance.

‘The FSA looks to the City to, in part, police itself over the market abuse issue. Hedge fund managers play an important part in this policing, especially when it comes to inadvertently receiving inside information from target companies. Managers must have policies in place that their staff can understand and apply when dealing with these situations.’

In its report on the visits it has conducted, the FSA identifies the responsibility issue as a key one. ‘Firms should demonstrate that ultimate responsibility for compliance with the market abuse regime lies with senior management through both the culture and the controls found within the hedge fund manager,’ the regulator says. ‘This is in contrast with the impression given by some managers during our visits that responsibility lies with the compliance team, either internal staff or external consultants.

‘All staff have a role in combating market abuse and should be aware of the part that they can play. For example, risk managers regularly review the trading of their firms and should refer any identified unusual (and potentially abusive) trades for review. Likewise, those operating within a central trading function are in a position to identify trading activity which is out of line with normal practice and should also forward these identified unusual trades for review.’

To lessen the need for human intervention, the FSA encourages managers to build controls into their computer systems that restrict or identify market abuse, for example by restricting access to systems drives and indicating if a trade is about to be executed in a security on the restricted list.

It also insists on independent monitoring, whether in-house or external, of market abuse controls and procedures, but says the box-ticking type checks seen at some hedge fund managers are of limited benefit. ‘Each firm should assess the market abuse risks to which it is exposed and monitor the controls in place to manage those risks,’ it says. ‘Simple examples of monitoring include reviewing the reasons for trading securities that are being traded for the first time or are traded before an unscheduled regulatory announcement.’

Training in market abuse controls, too, is crucial but the FSA says this tends to be carried out poorly if at all. ‘We were particularly disappointed at the level and standard of training at some of the managers visited. While there are pockets of high-quality training, we found that sometimes the level of training was non-existent, low and/or of poor quality. Senior management must ensure that staff are adequately trained – we do not believe it acceptable to rely on training provided by previous employers.’

Noting that one of the major risks to which hedge funds are exposed is insider trading, the FSA says it expects managers to maintain a list of all securities – not just equities but all listed securities – on which they have received inside information and in which trading is therefore restricted.

The regulator approves two practices seen at some managers, involving the receipt of inside information via a single named individual rather than through a range of individuals, plus with the examination of causal links between different securities and additions to the list of restricted securities where a correlation exists. Where ‘Chinese walls’ are in place, robust procedures are required to demonstrate they operate effectively.

The FSA expresses its concern about the number of leaks across the marketplace about potentially price-sensitive events. ‘All firms have a part to play in the efforts to reduce the number of leaks leading to informed trading,’ it says. ‘Managers must have in place policies to ensure their staff are aware of the need to maintain the confidentiality of such information. Both culture and training have an important role to play in achieving this. We will take action in situations where we identify the deliberate leakage of information or the dissemination of rumours.’

The regulator recommends that the majority of hedge fund managers who do not record telephone conversations reconsider their policy, particularly where staff operate relatively independently and without supervision. It also praises one hedge fund manager that reviews the personal account dealing of all staff retrospectively once a year and says others might find it helpful to follow suit.

In discussions with the FSA, managers expressed concern about the quality of external compliance support for firms that feel their size does not warrant a full-time compliance officer. The regulator has some sympathy but notes that it is the responsibility of managers to ensure they receive suitable advice: ‘It is not a valid excuse to claim they are not meeting regulatory standards because of inadequate advice.’

To avoid managers inadvertently receiving inside information from companies, it recommends that they make clear before meetings that they do not wish to receive inside information, noting that one hedge fund manager ensures that investment managers visiting companies are accompanied by a representative from the compliance department. While this is not practical solution for all, managers need to be able to demonstrate their ability to manage this risk including, if such information is received, making arrangements to ensure that they do not trade on the information.