To regulate or not to regulate?

We live in a brave new world. The Madoff scam and the many other similar Ponzi schemes that inevitably will be uncovered over the coming months, have led to a chorus of demands from governments and pundits for increasing regulation. But regulation of what? Hedge fund and hedge fund manager regulation have taken centre stage. Where does the alternative management industry go from here? What place will it hold in the financial services industry of tomorrow?

There are a few obvious points to make. This crisis has its origins in governmental failure to properly police and regulate the banking industry. However, hedge funds have not been innocent bystanders and many have benefited from the financial turmoil. But the industry as a whole is a massive loser, with 40% to 60% of assets having departed one way or another - and they are not coming back anytime soon. The recent G20 preliminary report into the current crisis finds no evidence to suggest that hedge funds were at the heart of our current problems. Secondly, hedge funds are an easy target for politicians to aim at, as they seek to deflect attention from their own starring role in this crisis. I am not the only one to be disgusted by recent Congressional and Parliamentary interrogations of bankers, industrialists and fund managers, where our elected representatives seek to demonise the very behaviour their policies actively encouraged. Compelling television that tells us more about the ignorance and arrogance of politicians, than it does about the events that have led us into this mess.

The alternative industry itself is confused as to how to deal effectively with the pressure it is under. AIMA (the Alternative Investment Management Association) has come out in support of regulation for managers and funds, and better disclosure of aggregated securities position level information to regulators and exchanges; more transparency. To my mind it has been too quick to offer up these hostages to fortune. I have written before in these pages that there is an increasing disconnect between the larger hedge funds (US$1bn and above) and the majority of the hedge fund community who manage, on average, less than US$250m. The big boys want to play in the big leagues and develop their businesses into mainstream asset management concerns. They have the infrastructure, strategy and the ambition to place themselves within the regulators’ embrace. The rest of the industry, the majority of AIMA’s membership, sees the world differently.

The alternative community is roughly 100^th the size of the mutual fund industry and has, on average, lost far less a percentage of its clients’ assets over the last year than its traditional long-only brethren have. Because is it is much smaller, the alternative fund community advertises less in the mainstream newspaper media. The result is that almost nothing is written about the multi-year underperformance of traditional asset management and how it, and the associated elements of the insurance industry, have decimated the retirement savings of a generation.

I recently received my statement from a well known UK insurance company on an endowment policy I took out 20 years ago and, thankfully, stopped paying into 15 years ago when I emigrated from the UK. The size of my pot of gold today is exactly, almost to the penny, what it was when I left the country. Who says some things never change? Surely this will be one of the bigger ramifications of this crisis? A whole generation unable to retire and having to work for 10 years longer than their parents did and a new generation of savers with absolutely no faith in the pension and insurance system’s ability to deliver the long term growth they will need to retire comfortably at a reasonable age. A little bit of regulatory scrutiny here wouldn’t go a miss.

So where will the demand for hedge fund regulation lead? Personally I believe AIMA has made a mistake in committing itself far too swiftly to increasing regulation. The G20 and IOSCO have far more pressing problems. Hedge fund regulation and its fellow bad boy offshore tax domiciles are financial services segments that will require global fiscal and regulatory co-ordination to control. I find it hard to imagine that this will be forthcoming in a world that is turning to some extent to protectionism and retreating within national boundaries. The mood in the US under their new President is one of international co-operation and consultation rather than extra territoriality and coercion. It would be better to wait for the new global power structures to settle down before committing oneself to a position.  I suspect  there will be less new regulation of the alternative industry in the event than people expect from reading recent media reporting. In the meantime the industry is transforming itself under the intense pressure of market forces. Most of what the regulators want to see will happen whether they will it or not over the coming few years.

The biggest change of all is in the behavior of investors - the best regulator I know of hedge fund managers. Investors always remember the thing that last bit them. It will be a long time before funds that mismatch the liquidity of their underlying investments with the liquidity preferences of their investors are able to raise cash. Just as highly levered funds died the death after LTCM, so will hybrid funds that mix semi public and private market investments with public market investments.

Other changes happening are that the standards of Investor due diligence on the managers they select are improving. A manager that uses a broker dealer, owned by himself, to settle and hold stock for underlying clients is unlikely to raise much money in future. Asset managers will need to demonstrate proper segregation of duties between back office functions, risk management and asset management. They will also need to demonstrate that portfolios are properly custodised and priced by third parties. All of this will be brought about by market pressure.

On this last point, investors must focus on custody and not on administration. The value of your investment is of less importance than its safe keeping. The presence of a third party administrator will not help you if your assets are under the control of an asset manager who steals them. An administrator keeps score only, it has no duty of care over the physical whereabouts of your property. Make sure your assets are held by a solid, genuinely independent financial institution whose custody contract places the financial responsibility for their safe-keeping squarely on their shoulders. Some regulatory assistance in this area would not be out of place. Current UCITS regulation and all offshore fund regulatory regimes need to be substantially updated and improved in this area.

Where would I focus, above all other areas, if I were a regulator? The derivatives markets; these markets lie at the centre of our problems today. Anyone who has ever had the pleasure of having to read derivative contracts or prime broking contracts, is fully aware that banks and their counterparties cannot possibly understand the risks, operational and financial, that their organizations are exposed to. It is only in times of market dislocation (post the collapse of Lehmans) that these risks are uncovered. Until the greater percentage of derivative contracts are standardized and brought onto exchanges for price and settlement control we shall not have corrected the systemic problems that have created this crisis. This is where governments, regulators and the financial services industry must concentrate as a priority. The future of our industry depends upon it.