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  1. 1. PRESIDENT’S STATEMENT MFA President John G. Gaine’s Remarks on “Approaches towards Alternative Investments” at the IOSCO Technical Committee Conference November 9, 2007—Tokyo, Japan It is a great pleasure to join you in Tokyo for this fourth meeting in which IOSCO brings together the private sector and the international regulatory community in a major financial center for high level discussions and interchange of ideas. I. Hedge Funds: The Current Debate It is particularly appropriate to consider the question of approaches to alternative investments in this forum where currently a breathtaking amount of change is underway. Not only is the Financial Services Agency (Japan FSA) in the midst of multiple changes to its regulatory system to modernize the financial infrastructure and to spearhead interoperability with the international financial community, but also probably the largest privatization in history here is in the process of running its course. The Postal privatization will permit new modalities of investment of funds now held in more than 20,000 branch office locations within Japan. Further, as stated recently in The Economist, the vast household savings here, estimated at more than 12.5 trillion US dollars, and the many Japanese companies that can be characterized as champions, promise an increasingly invigorated financial sector and new opportunities for global financial sector businesses as Japan accelerates its current reforms. Mr. Michel Prada, chairman of the IOSCO Technical Committee and chairman of the Autorité des Marchés Financiers, France, has asked me to express my opinion on the appropriate approach of regulators to hedge funds. I come to this question with the perspective of 15 years’ experience leading Managed Funds Association (MFA), founded in 1991. MFA is the only US-based, global membership organization dedicated to enhancing understanding of the hedge fund industry, fostering communication with regulatory authorities and otherwise improving the profile of the alternative investment sector of the capital markets, including hedge funds, funds-of-funds and managed futures funds. MFA early on demonstrated its status as a good financial citizen by pioneering the development of standards of excellence for alternative investment managers. In 2000, the very first core set of sound practices, Sound Practices for Hedge Fund Managers (Sound Practices), was published in response to a 1999 call by the President’s Working Group on Financial Markets (PWG) (a group comprised of the Chairs of the CFTC, SEC and the Board of Governors of the Federal Reserve and Chaired by the Secretary of Treasury) to the industry to articulate sound practices of risk management and internal controls. MFA updated the document in 2003 and 2005, and it has recently released a new, improved 2007 version on Monday of this week. The iterative improvements address myriad issues, including: • risk management • valuation policies and procedures • responsibilities to investors Washington, DC | New York |
  2. 2. • ethics (conflicts of interest) • documentation policies and controls • counterparty relationships • AML policies In addition, MFA has included in its new version of Sound Practices a Due Diligence Questionnaire for investors. MFA’s experience and leadership role in bringing experienced practitioners together to identify and shape the components of a code of sound practices has made it acutely aware of the speed and breadth of the evolutions taking place in this sector and of the worth of ongoing dialogue. With respect to the notion of regulation of hedge fund vehicles, the following remarks constitute generally my philosophy and advice: 1. Let the burden of creating and fostering market discipline fall directly on the market participants themselves, rather than imposing governmental regulations, unless absolutely necessary. 2. Seek high level flexible and interoperable approaches to benchmarking sound practices to facilitate global access and management of global risks rather than commoditized consensus across cultures and markets. 3. Design any regulatory structure to maintain a wholesale market. That is to say, retain public awareness that these products are sophisticated, complex, and risky vehicles to be used by knowledgeable investors with sufficient bargaining power and technical capacity to assure appropriate investor protection consistent with investor “risk appetites.” Permit me to address each point briefly in turn: Market Self-Discipline When last I spoke with IOSCO on this topic in Mumbai, the most recent word on hedge funds was that of the PWG. I indicated at that time MFA’s support for the PWG’s approach. The PWG acted to reinforce market discipline by enjoining market participants at every level: creditors, counterparties, investors, and fiduciaries, as well as fund managers, to raise the bar of their existing due diligence and investment risk management policies. Among other things, the guidance advised the commitment of sufficient resources to maintain, keep under review, and document the execution of risk management practices (including those related to the size, collateralization and suitability of investment exposures). The PWG’s statement was the first advice directed specifically to fiduciaries. It was also the first market- oriented advice to shore up the will (and vigilance) of the industry to use appropriate tactics and measures, particularly if information needed from alternative investment managers was not forthcoming. MFA believes that the PWG guidance remains relevant today. But, as all of you well know, the markets are continuing to expand, and investment strategies are increasing in complexity and volume. Technology, innovation and the expansion of cross-border trading have forced a tsunami of change. Even the means of access to a number of markets is changing, with direct access in some cases testing the traditional safeguards employed by intermediaries and counterparties. During the credit crunch in August, hedge funds withstood the turmoil relatively well, leading the U.S. Secretary of Treasury to note, with some irony, that the material problems were in regulated institutions. Nonetheless, in August and September, it became starkly evident that all the interconnections between market participants are not yet well understood. Both Washington, DC | New York |
  3. 3. the value and the costs associated with risk dispersion continue to be evaluated by the market as well as by regulators. MFA concurs that we must continuously test market practices against current developments to see that change and innovation remain forces for good. Such testing cannot be done in a vacuum by the authorities. Observing how trends impact various market practices and whether self-directed market discipline evolves concurrently and satisfactorily are key. The regulator needs to be kept informed by the market of the types of products in circulation and the types of issues that cause the industry concern. Open dialogue between market participants and regulators, either directly or through channels such as MFA, is not just an option, it is a necessity. Why ongoing dialogue is essential seems widely recognized. For example, MFA is following the many ongoing initiatives to keep the lines of communication open and to examine how current industry risk practices and alerts can be refined. In particular I note: • The work within IOSCO’s Working Party 5 and the attendant public consultation, some of which was before you during this meeting • The work within the Committee of European Securities Regulators (CESR) and its expert groups • The convening of blue ribbon panels to refine regulation here in Japan • The work of the UK-based Hedge Fund Working Group, led by Sir Andrew Large, released for comment this October, proposing a voluntary model code of conduct that uses the “comply or explain” technique to address conflicts or governance issues, and companion work of AIMA • Initiatives in Dubai • The initiative announced this September by the U.S. Treasury of the formation of two private sector working groups comprised of asset managers and investors (but no trade associations) to provide market response to the PWG advice In commenting on some of these ongoing initiatives, Ben Bernanke, Chairman of the U.S. Federal Reserve affirmed that he favored more self-discipline and disclosure by hedge funds, rather than more regulation. All this activity demonstrates that alternative investment strategies raise issues that are likely to remain under constant review and perhaps permanently on the agenda of forums as diverse as the G-8, the Financial Stability Forum, the IMF and elsewhere where governments and regulators seek to assure themselves as to the vigor of their approaches. MFA believes that it is important to maintain an open dialogue to examine, and if possible dispel, the issues that are causing market participants concern. But at the same time, as the Japanese saying goes, “One Step Forward is Darkness.” We should be careful not to set in stone insufficiently flexible responses or quell innovation and freeze the design of the market itself by unnecessary regulation. Tailored but Interoperable Approaches to Sound Practices It is now almost a cliché to say that we should not attempt to make “one-size-fit-all.” Market users generally prefer that neither industry associations nor regulators adopt disparate processes, procedures, practices or standards, the substance of which differ so materially that they cannot be harmonized at the “enterprise level,” leaving gaps that permit bad conduct to go unchecked. Reputational risk affects the whole sector as well as the isolated bad actors. Washington, DC | New York |
  4. 4. For this reason I reiterate the value of multiple open consultations while we strive to discover the best path to provide high level guidance on some of the most perplexing issues. Such consultation will help to ensure that there are sufficient inputs into the process and that any end result can flexibly accommodate the rate of evolution in the marketplace. At the same time, regulators (and practitioners) should, where possible, avoid redundancy or needless inconsistency. Further as we discussed in Mumbai, any such global work should not prescribe structure, determine the merit of particular investments, or unduly constrain strategies or business processes. The Wholesale Approach Regulators should not seek to disguise the risk in alternative investment products. Remember, alternative investments are just that: “alternative.” While it may be true that in search of returns, fiduciaries for retail beneficiaries, through institutions such as pension funds, are investing in hedge fund products, these entities are serviced with the most professional and expert advisers who are remunerated to keep the best interests of the beneficiaries and who bear liability (often personal liability) if they do not. Managers of investment vehicles and fiduciaries who are currently in the process of informing the ongoing dialogues can take advantage of the current inquiries, as well as take steps in specific transactions, to tell the market what they need in the way of transparency to make appropriate investment decisions. MFA supports not opening the alternative investment market to the retail public because it believes that these products are inappropriate for the financially unsophisticated and for those who cannot determine how either to measure or mitigate their likely investment risk to keep that risk consistent with their investment objectives or who lack advisers (or filters such as funds-of-funds) to help them do so. Further, sophisticated investors can influence more readily the behavior of hedge funds by virtue of their knowledge of the marketplace; the retail participant typically cannot. MFA believes that the wholesale market—which is designedly not a risk free market or product—should not be encumbered with protections intended for the protection of retail participants. MFA generally supports the move in the United States to ensure that accredited investors have the wherewithal, in today’s money, to be treated as non-retail. Additionally, MFA looks forward to the continuing dialogue on what market discipline should be enhanced. MFA is proud of its role in improving sound practices and the information available to counterparties and the investing public to date. II. Valuation and the Challenges of Valuing Illiquid and Complex Instruments The issues related to valuation of illiquid instruments relate directly to the risks created by of lack of, or withdrawal of, liquidity and the concomitant risks related to wholesale redemptions. As a preface to my thoughts, it is useful to recall that liquidity relates both to the design of the financial instrument and the circumstances at any given point of time of the market in which it is traded. Similarly valuation can be viewed as both a process and a methodology. First, while I believe that we (including the markets) have not fully digested the events of the past two months and that it may be premature to draw lessons from these events now, I equally believe that concern about proper valuation practices (not just to deliver returns, but also to measure risks) are at the heart of unease about hedge fund and other strategies where there is no ready market for the instruments being held or traded. Washington, DC | New York |
  5. 5. Second, it is important to state up front that hedge funds operate many strategies, and not all, indeed not most, strategies involve complex valuation issues. The recent concern that where there is no market (either by design of the instrument or by virtue of market events) one “marks to myth or models to myth” stems from situations where no independent benchmark is available or where the assumption of market liquidity fails. Indeed, in the latter case there is likely a market at some “fire-sale” price. The question of valuation then really becomes one of proper management of when to liquidate an illiquid position to avoid a premature close out at what might be an aberrational discount to value. A companion issue is whether liquidations necessary to satisfy short-term cash or financing needs might precipitate correlated losses that would have corrected in the short term had there been the financial leeway to wait. Therefore the issues of lock up provisions that permit holding positions and the issue of liquidity provisioning are fundamentally also valuation issues as they may permit the hedge fund to avoid valuation in extreme scenarios. Of course, a further complication is the perception (or actuality) of conflicts of interest in the application of any valuation model. MFA believes, as reflected in the IOSCO paper, that the process of valuation is critical —to have one, to disclose it and to follow it. Comfort as to it fairness is provided in part by documenting the process and making it transparent. This includes documenting that procedures are applied on a consistent basis, documenting any exceptions and the reasons for these, and insulation of the process from improper meddling. Like IOSCO, MFA has spoken extensively on best practices for valuation. IOSCO posed nine basic principles, focusing on the transparency of procedures to investors, consistency, equity, documentation, and model validation. MFA makes fourteen core recommendations in its Sound Practices with respect to valuation: 1. A hedge fund manager should establish procedures to independently verify the existence of financial assets and liabilities. 2. A hedge fund manager should establish policies and procedures for the control and processing of purchases and sales of financial assets and liabilities. 3. A hedge fund manager should establish policies and procedures for the periodic reconciliation of its recorded financial assets and liabilities to statements produced by independent sources. 4. A hedge fund manager should establish procedures for obtaining confirmations and periodic reconciliations of OTC derivatives with its respective counterparties. 5. A hedge fund manager should establish policies for maintaining sufficient internal documentation of transactions involving non-publicly traded financial investments (other that OTC derivatives) for the purpose of facilitating and ensuring the verification of the hedge fund’s financial assets and liabilities. 6. A hedge fund manager should adopt an appropriate accounting standard that incorporates the concept of “fair value.” 7. A hedge fund manager, in consultation with its governing body, should determine the party who bears ultimate responsibility for the valuation of investments and disclose this information to hedge fund investors. 8. A hedge fund manager’s pricing policies and procedures should be fair, consistent and verifiable. Washington, DC | New York |
  6. 6. 9. A hedge fund manager should establish pricing policies and procedures that ensure that NAV is marked at fair value. 10. A hedge fund manager should establish policies for the frequency of determining a hedge fund’s NAV. 11. A hedge fund manager should establish policies and procedures for periodic closing of books and records consistent with appropriate accounting principles. 12. As part of the financial statement close process, a hedge fund manager should incorporate procedures for the review and recordation of all financial and non-financial assets and liabilities (including accruals of interest, dividends and recordation of all non-financial assets and liabilities, including management fees, incentive fees, and other liabilities). 13. A hedge fund manager should review the allocation of income and expense to hedge fund investors. 14. In relation to reporting to hedge fund investors, a hedge fund manager should incorporate procedures that seek consistency between periodic reports and annual audited financial statements. Without question, recent events highlighted once again the vital role of valuation in proper fund management. For example, the U.K. document specifically cites the difficulties in valuing assets in the credit markets. It also poses questions as to whether managers can adequately mitigate potential conflicts of interest and provide sufficient information to investors about the valuation process. In this connection it advocates that managers quantify the proportion of assets that are hard to value. In fact it may be the case that valuation will always be on the table. But this complexity does have its bright side. Valuation questions may create new business opportunities. No one really has yet determined how best to address the observation that it is the black swans or “fat tails” that plague financial markets, not the routine day-to-day risks. Here is an issue not unique to hedge funds where more ideas may be forthcoming. I, therefore, return to my original premises: Ongoing dialogue among the industry, the regulators and with experts and a policy of avoidance of retailization are paramount. This will assure necessary continued vigilance, adaptation of sound practices to market evolutions and containment of risks of alternative investments to those most able to understand and bear them. Thank you for the opportunity to be here to participate in this important discussion. Washington, DC | New York |