Upcoming G20 comments from ComplianceAsia

We recently sent comments to clients and contacts regarding the action plan published in advance of the G20 meeting in April 2009.

The “Progress Report on the Immediate Actions of the Washington Action Plan (“the action plan”) prepared by the UK Chair of the G20” can be found in the communiqués section of www.g20.org.

This memo to clients and contacts sets out issues ComplianceAsia thinks may be of significant relevance to those firms we work with. Ultimately any resolutions arising from the G20 meetings will find their way into regulatory notices or new legislation. Please consult your legal advisors when those details are released.

There are significant topics that we have not covered in this memo relating to accounting standards, bank liquidity, reform of multilaterals, and reform of credit ratings agencies. If you have an interest in those topics we suggest that you read the progress report.

Regulation of Hedge Funds

The action plan called for best practices already developed by private sector bodies to be unified so that Finance Ministers and regulators could assess the adequacy of these proposals.

The progress report on the action plan stated that AIMA (the Alternative Investment Management Association, see www.aima.org ) and the MFA (Managed Funds Association, see www.mfainfo.org ) along with members of the Asset Management Committee of the President’s Working Group on financial markets (see www.amaicmte.org ) “are committed to publish jointly a common set of principles by the end of April.”

Thus far the various pronouncements of these bodies can be found at www.hedgefundmatrix.com and ComplianceAsia is hosting a seminar in Hong Kong and in Singapore on what these various bodies are proposing.

The progress report goes on to state that “G20 Finance Ministers and Central Bank Governors have made recommendations to the London Summit to ensure that all systemically important financial institutions, markets and instruments are subject to appropriate degree of regulation and oversight, and that hedge funds or their managers are registered and disclose appropriate information to assess the risks they pose.”

This raises a number of very important issues. Firstly how representative are AIMA, the MFA and the PWG Asset Management Committee of the industry? Barclay’s global database (see www.barclayhedge.com ) lists some 5,700 active funds, fund of funds and managed futures firms or CTA’s. Current estimates of industry size are some US$1.2 trillion in AUM. Neither AIMA nor MFA publish full lists of members (the PWG does publish a list of its members) but it is clear that while many of the major hedge fund managers and prime brokers are active in these organizations, a substantial number of smaller managers and managers outside the USA or the UK are not represented in these organizations.

Given the extremely important input of these industry groups to this process, we recommend that all managers, advisors and service providers look carefully at the AIMA, MFA and PWG Asset Management Committee recommendations and ask whether you are satisfied that those recommendations represent your views. If you do not feel that you are getting adequate representation of your views, and you are a member of these groups, then now is a good time to set out any concerns you may have.

ComplianceAsia is considering a joint submission to both AIMA and the MFA looking at Hong Kong and Singapore specific issues so please let us know if you would like discuss individual concerns particularly if you are not a member but believe you may be impacted by these suggested policies.

Interestingly the combined weight of the global mutual fund, retirement fund and insurance industries is estimated to be 100 times larger than the alternative investment industry. Precisely why the alternatives are being singled out for so much G20 attention when the scale of losses and the social impact of the broader traditional industry is so much larger, is something that has not received much in the way of considered analysis. We suspect that the politics of going after the alternatives are easier, and the rewards for legislators and policy makers higher, when targeting alternatives. We hope that in whatever submission the industry groups make to the G20 that they highlight their relatively modest size.

The second important issue is to consider the specific language of the action points and next steps. In that respect it is noted that registration of managers and disclosure of information are the two issues that are required to be addressed. As many readers will know the typical structure in Asia involves a Hong Kong or Singapore company advising an offshore manager of an offshore fund.

In Hong Kong there is a requirement for the advisor to be licensed with the SFC and in Singapore there is a requirement to register with the MAS under a lighter regime for most professional only firms.

If these changes are enacted then in Hong Kong there will be greater focus on regulation of the fund and probably a regulatory view that the offshore manager should be essentially ignored, unless there is a clear commercial reality to its offshore business. Structures where the offshore manager is really a brass plate of the Hong Kong advisor may become obsolete from a regulatory perspective. There is an integral link between taxation issues and the offshore manager and it would not surprise us at ComplianceAsia if the current aggressive regulatory environment regarding offshore tax arrangements results in the tax advantages of offshore management also being eroded or removed.

For Hong Kong firms that are outposts of larger US organizations, then those firms are going to find that they are going to become outposts of regulated US organizations if they are not already so. Practically this will mean enhanced compliance controls and processes to meet SEC standards in the offshore offices.

For Singapore registered firms we believe the changes will be more profound. The Singapore system has thus far been a registration system with the byproduct that a number of very small, or less than optimal, managers have been able to find a home. There are of course a number of large and important advisors in Singapore. However, we believe that there are also examples of brass plate arrangements in Singapore and smaller firms with little or no compliance infrastructure to protect investors from conflicts of interest and poor back office processes. In order to remain an important global asset management center, and inside a global infrastructure being created under the G20 auspices, we believe that regulation in Singapore may evolve whereby new rules closer to those in Hong Kong are introduced, properly structured firms are grandfathered into a new system, a greater emphasis is placed on regulation of funds managed as well as managers, and sub optimal firms find they need to shut up shop.

Lastly it will be very interesting to see if Hong Kong and Singapore can maintain their current edge over the regulatory environments for alternative asset managers in India and mainland China. Both India and China are G20 members, and if new rules regarding onshore access and concessionary rates of taxation were considered by those countries, they may create a compelling argument for location of hedge fund managers within those two locations instead of Singapore and Hong Kong acting as proxies.

We would submit that if there is a harmonization of rules between Hong Kong and Singapore then consideration should be given to regulatory passports between both locations. While this may be counter intuitive to the two regulatory systems that have seen themselves in competition for many years, we have been of the view for several years now that each system could work in support of the other and thus reduce red tape and make the region as a whole more attractive to larger international firms.

Formalising the CDS and OTC derivative markets

The action plan mentions the “imminent launch of central counterparty services for credit default swaps (CDS)” and the fact that efforts should be made to reduce the risks of CDS products and over the counter derivatives.

The progress report noted that G20 Finance Ministers and Central Bank Governors agreed to greater standardization and resilience of credit derivatives markets.

Considerable progress towards new rules has been made already with ISDA’s BB Protocol for CDS trading being published on 12 March 2009. The Protocol creates a new Supplement to existing ISDA agreements which improves settlement practices, firms up the definitions of credit events and limits the time between the occurrence of a credit event and when they can be actionable. Further ISDA has rolled out a Standard North American CDS contract for single name trades which is intended to become an industry standard trade and allow the development of centralized processing of CDSs.

We expect to see more reform across the board for these products with more standardized contracts, central clearing exchanges in major financial centers and greater disclosure of gross and net positions by systemically important firms.

While in Hong Kong these products may typically be reviewed by both the HKMA and the SFC, depending on the license type of each individual firm, we expect to see greater concentration of rule making towards the HKMA and ultimately the HKMA expanding inspection powers in this area.

Of course in Singapore the MAS already has both a banking prudential supervisory role as well as a securities market and product rule making role that could accommodate greater focus on clearing and disclosure of CDS and OTC positions.

Compensation Practices

The action plan states that financial institutions need to have internal incentives that promote stability and “avoid compensation schemes which reward excessive short-term returns or risk taking.”

The progress report noted that the Finance Ministers and Central Bank Governors have agreed to the Financial Stability Forum’s (see www.fsforum.org ) sound practice principles for compensation.

We searched the FSF website, the various sites covering the G20 and the web and could not find this document.

Further the FSA in the UK published a draft Code of Practice of Remuneration Policies in February 2009 which covers all FSA regulated firms which seeks to tie pay policies to risk management policies.

Broadly the populist sentiment on the issue is that financial firms that want the underlying guarantee, implied or direct, of government support must adhere to far more restrictive remuneration policies which are significantly lower and reflect reward for long term creation of value.

The effect of this is likely to be a transfer of both personnel and the risks that they want to trade into smaller niche practices. Large hedge funds seem to be ideally placed to assimilate this shift as they typically already have the product knowledge, legal and risk management infrastructure and mandate to required to take on the business and design their own compensation policies without significant regulatory influence.

It will be very interesting to see if the greater oversight of these funds, as contemplated by the G20 changes mentioned above, also includes an attempt to restrict compensation practices. We would hope not unless taxpayers are considering underwriting performance at the funds.

Promotion of market integrity

There are three specific initiatives dealing with market integrity in the action plan. The three action plan items relate to:

- Cross border cooperation

- Information sharing between national and regional authorities

- Reviewing business conduct rules to protect markets and investors from fraud and market manipulation.

It is notable, if not alarming, that in relation to this third action item the only comment in the progress report is “The IOSCO Task Force on Short Selling has proposed four high level principles for the effective regulation of short selling.”

While there is indeed several regulatory investigations into short selling issues and possible abuse during the market collapse last year, there were many other issues of investor protection, fraud and market integrity that were highlighted during those turbulent times. The fixation on short selling alone ignores mis-selling of financial products to retail and pension fund investors, conflicts of interest in the operation of multi disciplinary financial firms and service providers, all of the issues arising from the Madoff scandal particularly those relating to custody, due diligence, regulatory inspections and auditing, and the lack of enforcement resources globally given the sophistication and size of financial markets.

In our view the G20 is missing the wood for the trees on this topic.

Separately the report of the task force, headed by the SFC in Hong Kong, has not yet been released but according to the SFC website should be released shortly.

ComplianceAsia

March 2009

September Compliance Newsletter

Happy Halloween.

What a month its been – horror for hedge funds in India, shocks in the credit markets, ghosts of Oct 87 in the USA, booming equities in China, tricky results for those sitting exams in Hong Kong, tax treats in Singapore, the promise of regulatory treats in Hong Kong, even a phoenix in Australia.

The SFC Director of Licensing, Stephen Tisdall, gave an interesting and informative presentation on Hong Kong licensing to our breakfast meeting attendees in October. Stephen talked about the need to increase resources in his department and about a number of reforms instituted and coming up.

He said that all elements of the licensing process are currently up for review: procedures, forms, FAQ’s, circulars, even the requirement for individuals to be licensed at all.

We have been of the view for some time that the Securities and Futures Ordinance was never designed to take into account a number of major trends that have taken place in Hong Kong and the licensing regime has been problematic for many firms for the wrong reasons.

This review is to be welcomed by the industry and reflects the ongoing desire of the SFC to ensure that it remains a leading regional regulator. Those firms that wish to make submissions on any element of the licensing process should write to Stephen directly at the Commission. ComplianceAsia will also be making a submission and clients and contacts who would like to have their views incorporated into our submission should email Philippa Allen.

Stephen also discussed recent exam results at the HKSI in answering a question from one of the attendees. We were shocked to learn that only 16% of candidates passed Paper 1 at the HKSI in September and only a slightly greater number the month before. This compared to a pass rate of approximately 60% a year earlier.

The HKSI’s exams are a gateway to getting a business up and running in Hong Kong as the HKSI has a monopoly on the provision of exams for the securities industry in Hong Kong. They affect employment, investment and the ongoing relevance of Hong Kong in the financial markets. Poor questions and double negatives have been issues in the past. These horrendous results suggest there are issues again.

We call upon the HKSI and its executive to expedite the reviews of the examinations which has been discussed for some time so that the HKSI can remain an important way of developing new entrants to the industry but not stand in the way of the economic progress of Hong Kong.

The Hong Kong exams issues however are small potatoes compared to the dramas unfolding in India in relation to hedge funds investing in participatory notes or P Notes. Essentially to invest in India requires registration. Large investment banks have done this and then went about issuing derivatives to mirror the economic interests of various securities. Professional investors, particularly hedge funds (who SEBI would not allow to have direct access as FII unlike traditional managers) bought a lot of these and a large part of the inventory of securities being held by these named parties was actually bought for other, as far as the Indian regulator was concerned, unnamed parties.

About two to three weeks ago the Securities and Exchange Board of India announced that they would halt investments using this process and introduced a number of provisions to affect this. This has caused considerable disruption and discomfort in the industry despite the valiant efforts of a number of prime brokers and AIMA to resolve the situation.

Recent pronouncements by SEBI have confirmed that the new provisions are here to stay.

SEBI had made public noises that they will loosen the registration process so that those people previously using P Notes could register formally. However the devil is in the details, if you will pardon our last Halloween pun. It has always been the case that FII approval will only be given to fully regulated managers (which rules out most Singapore based hedge funds) but even with this comfort, SEBI has a backlog of about a year’s worth of applications.

While we have no view either way as to whether the old situation should have been allowed to continue or not, we do believe that if SEBI, and the RBI for that matter, are going to take a sledge hammer to an established market practice then they need to ensure that they have the capacity to efficiently process a very large number of applications that will come in from large institutional investors. We do not believe they can do this and thus the current arrangements will economically disadvantage India.

India seems like a wonderful place to invest in. An emerging economy, lots of talented people, a regulatory system that is essentially easy to understand and great international interest in its development. It would be a shame if poorly thought through regulatory action resulted in foreign investors looking elsewhere.

Elsewhere around the region we report on the changes to the Singapore tax system in relation to fund managers and for those of you who did not see it, we refer you to our earlier technical article prepared by the tax team at Ernst & Young. We also note some new licensing guidelines in Malaysia and continued announcements in Japan on the FIEL.

In Indonesia, DBS has had trouble with its dealing license registration and this highlights the ongoing problems that foreign firms can face with their businesses there.

Indian hedge fund investment issues

The big news in Asian investing over the last two weeks has been the decision by Indian authorities to halt investment in P-notes by hedge funds via their investment banks. The issue has a number of complexities but at its heart is the ability of the prime brokers to offer access to the Indian market to hedge funds.

The steps taken by the Indian Government have been justified by them saying that the large capital inflows this year were causing Indian exporters problems, that they needed to know who was investing in their stocks, that they want funds to come in via the front door not using P-notes.

Unfortunately this looks like the protectionist India of old. India has a an exciting future ahead as a huge country with a growing and educated middle class and a legal system that while far from perfect is actually considerably easier to understand and deal with than the Chinese system for most US and European firms.

All of the public statements thus far have tried to calm foreign investor nerves - and the announcements last night were important due to the way they seemed to put a final position on a number of issues - but actually SEBI has done little thus far to open the door to the fastest growing segment of the global asset pie, hedge funds.

Large foreign inflows will greatly benefit the Indian economy. Indian executives will be required to run and staff local operations. Firms will need premises, IT and all of the other basics needed to support a sophisticated investor. They say that for every job on Wall St two others are created to support it in Manhattan. I would suggest the ratio will be much larger in India.

The losers of course, if SEBI, the RBI and the politicians do truly open up their markets are going to be the entrenched owners of business enterprises be they old families that refuse to reform or government enterprises that are in need of new investment and technologies.

Right now the investing community loves India. It is up to the Indian government and its regulatory bodies to recognise and cultivate the relationship. Open the door to all types of foreign investment in listed firms.

August newsletter comments

As our newsletter goes to print regional markets are calming down but the news relating to problems inside a variety of financial intermediaries continues. The good news has got to be that Asia remains a place where high returns can still be generated and we continue to see strong interest from established funds and institutional investors looking to increase their presence in the region.

In Hong Kong there continue to be positive moves at easing the entry of new participants into the Hong Kong financial industry while maintaining established standards. We are experiencing speedier processing time and a focus on more material issues than has been the case. This is to be welcomed and hopefully is part of the process of tidying up the entire licensing regime particularly the forms and the exams.

The forms are not well drafted and can cause some of the larger institutions considerable difficulty in answering fully. The Hong Kong Securities Institute, not part of the SFC, sets and administers the exams. There has been much criticism of the exams in the past and while they are marginally better than they were they are still an unnecessary hindrance to the entry into the market of otherwise experienced personnel.

We are of the view that there is a role for ensuring basic market knowledge of incoming market participants, a role for a competent educational body training and developing local talent, and a role for an industry body offering high level ongoing training. However the HKSI seems to be focussed on developing its educational status rather than ensuring that persons who want to come to Hong Kong can do so quickly and appropriately to the benefit of the economy as a whole. The pass rate for some of the exams remains too low, the questions appear to be poorly structured and the nature of the subject matter that will be examined remains opaque.

We believe that the HKSI needs to separate out its role as a filter for market entry from its role as an educational body. The two roles are currently conflicting.

While on the subject of training in Hong Kong, licensed firms should remember that the obligation to attend continuous professional training accumulates on a calendar year basis and all licensed personnel and their companies need to ensure that hours are completed by year end. Our clients can access our online calendar of all upcoming training to assist with planning attendance.

In Singapore there has been a number of long outstanding Capital Markets Services Licence applications which have now been processed; however there remain issues with the requirements that the MAS is imposing as part of the process of issuing licences. In some instances, MAS is requesting additional reporting to MAS from firms beyond what is required in the regulations; in others it is requiring the appointment of dedicated compliance officers. In the latter case the industry generally feels that for small operations, this is an unrealistic requirement (particularly when MAS is critical of individual employees wearing dual hats) and that it would be easier if MAS took the approach of allowing them to nominate a business person to be responsible for compliance rather than requiring an additional person to be hired who is an expensive and under-utilised resource. Our fear is that this requirement is leading to firms hiring inexperienced and inappropriate persons to execute the compliance function which surely not the result MAS desires.

Concurrent with the revised fit and proper criteria published recently by the MAS, we are aware that firms who are exempt fund managers are now being inspected by the MAS. While these firms are exempt from the licensing regime they are not exempt from Singapore law (such as market manipulation, insider dealing, anti money laundering) nor from the requirement to have proper internal controls in place and to meet statutory filing requirements. These inspections and the resulting comment sheets serve as timely reminders of this.

In India there were recent positive comments from SEBI about the entry of hedge funds into Indian capital markets. Readers may recall that we have been sceptical about how quickly hedge funds will be able to register in their own right. The recent announcements are positive and may be an indication that Indian regulators are realising the enormous potential advantages of capital markets liberalisation in such a large and growing economy.

July ComplianceAsia newsletter comments

On July 19, the US SEC announced that it had adopted Rule 206(4) – 8 under the Investment Advisors Act of 1940. The new rule makes it a fraudulent, deceptive or manipulative act, practice or course of business for an investment adviser to a pooled investment vehicle to disseminate false or misleading information to investors or prospective investors or otherwise defraud any investor or prospective investor in a fund. Further information can be found at the Sidley website at the following link- US SEC rule.

Sidley’s asset management practice in Hong Kong is headed by Effie Vasilopoulos who can be reached at evasilopoulos@sidley.com. For those in the USA we recommend you contact Michael Schmidtberger on mschmidtberger@sidley.com who leads the US asset management practice.

So much for a nice quiet summer with the considerable market volatility in August producing a number of high profile problems at hedge funds, mortgage arrangers and banks. With noted economic bears like Simon Ogus (www.dsgasia.com) in Hong Kong and Nouriel Roubini (www.rgemonitor.com) in the US calling the credit crunch for some time, it will be interesting to see how far the fallout goes – they were right about the crunch, scary to think that they may be right about how far it will go.

These events always produce some surprising corporate failures and we expect to see more of this in the months to come. Seeing how fast a highly leveraged hedge fund can completely implode is certainly sobering – we have a chart on our blog at www.complianceasia.blogspot.com that illustrates the sequence of events. We expect to see retail fallout and lawsuits in Australia resulting from the collapse of a Basis fund, considerable legal discussion on the implications of a US bankruptcy judge essentially ignoring the Cayman Islands jurisdiction relating to the Bear hedge fund collapse, interesting consequences of the SIV / Cheyne issues and prosecutors getting very interested in the Sentinel issues.

The fallout in the Asian alternative industry has thankfully been a lot lighter than in the US and UK. Asian banks probably have more to worry about than many Asian funds. However smaller funds will find this environment very challenging as capital moves towards quality and track record.

On the flip side, this volatility has produced some big winners by all accounts with some intermediaries and funds benefiting from increased turnover or taking advantage of the volatility. Seems like Risk does equal Return after all.

In Singapore there have been some important regulatory developments in August and September with new tax rules regarding funds managed in Singapore and the MAS issuing new directions on competence for exempt fund managers and exempt financial advisors.

We are delighted that Ernst & Young will be preparing a paper on the tax issues for our subscribers which we will publish shortly and Philippa will be writing up her thoughts on the new competence provisions.

June ComplianceAsia newsletter comments

June, while it now seems a little distant, was another interesting month around the region.

Further developments regarding foreign investor participation in the Chinese markets is to be
welcomed but our sense is that now is the time when those who have had joint venture relationships or a foothold in this market are turning their attention to establishing a more robust, internationally consistent compliance regime. The super profits generated in the China market in 2007 will not be coming without risk. We expect to see all sorts of shenanigans come out when the market corrects or, as is often the case in China, when someone who wanted to be part of the scheme, but was left out, decides to blow the whistle.

We have previously reported on the Hong Kong SFC steps in relation to streamlining the registration process for hedge fund managers and advisors already registered offshore. We can report that our own experience with the new system is positive and we continue to see enhancements in regulatory practice at the micro level in Hong Kong.

While there are many arguments for and against changes to the regulatory infrastructure in Hong Kong, most market participants would agree that change has been needed in the way regulation is conducted on a day to day basis. The hedge fund changes set out in this report are really just a process of reform of several areas where small changes can make a lot of difference for those regulated by the SFC.

The Hong Kong Monetary Authority has recently been making noises about systemic risk with hedge funds and other capital flows. Readers may wish to check out the Chief Executive’s blog .

India continues to be a challenging environment for hedge funds with the Government thus far refusing to let hedge funds trade directly. While SEBI seems to be softening its views, the Reserve Bank of India does not. In our view the RBI is the key player here and we don’t yet see major political interest in changing the status quo. In the interim funds will continue to pay higher fees and transaction costs.

For those of your north of the equator, enjoy your summer months and hopefully not too many
typhoons, for those south, enjoy the winter and the footy, and for those of us in the middle, well its just more of the same.

Darth Vader?? Interesting comments on black pools

Last year we spoke about the rise of black pools and we found an article in on Market Watch that discusses it.

Here is an extract of former SEC Commissioner Pitt's comments - may the force be with you:

Regulation

Mistrust of hedge funds is also the product of a landscape that is relatively lawless. SEC rules governing dark pools went into effect in 1998. Most agree that those measures, which allowed dark pools to become exchanges or broker-dealers, or neither by keeping their volumes low, is already outdated.

"Regulators have enormous problems," said Pitt, the former SEC chief. By the time regulators enact new rules, "the world has passed the statute by."

Pitt maintains that the dark pool name has hurt what is essentially a wholesale stock-trading industry.

"When I think of dark pools I think of the dark side and Darth Vader," Pitt said, adding that their lack of transparency does run counter to the regulatory emphasis on disclosure.

New rules for public exchange trading emphasize that customers should get the best price available, regardless of whether they're posted at the NYSE, Instinet or any other public market,

Unlike other markets, in dark pools "a level of transparency can lead to manipulation," Pitt said. On the contrary, the proliferation of dark pools also presents a problem: too many anonymous players and that "can produce disproportionately bad pricing."

Historically, the SEC didn't know how to regulate a market that looked like an exchange but wasn't an exchange.

For instance, brokers trade on their networks but also act as police, creating a conflict. Hedge funds are controversial players. Some systems exclude them and when Liquidnet offered to include them to boost its market share in a competitive market, some existing customers threatened to pull out.

Different venues have different rules. Pipeline doesn't force clients out of the system altogether, according to founder Fred Federspiel. When a violation is found, Pipeline rebuilds the platform to prevent abuse. "We have had to kick a few people out until we got a fix deployed," he said.

The discord over rules may change with the SEC's appointment of Erik R. Sirri, a Babson College economist, as the agency's chief market regulator in 2006. Sirri has said the commission is reviewing, not acting, on the issues presented by dark pools.

Hedge fund article by Pillsbury Winthrop Shaw Pittman

The US law firm of Pillsbury Winthrop Shaw Pittman recently had an article published in Institutional Investor talking about regulatory trends relating to hedge funds.

Jay Gould from that firm authored the piece.

Entitled "The Secret Life of Hedge Funds May be Over" it covers some of the history of the SEC registration debacle and some of the fundamental shifts in the industry over the last two years.

We share Mr Gould's view that this is an area that the market can look after itself as the serious professional investors are able to make informed choices about the risks they want and what they are prepared to pay for exposure to the funds.

A full copy of the article can be found at the following link.

March newsletter comments

Here is the comments section from our March newsletter:

March was an interesting month on the regulatory front.

In Australia, ASIC began a public awareness campaign on financial scams. It never ceases to amaze us how many members of the public still get caught up in advance fee frauds, boiler room operations and other illegal predatory activities. This is an area that deserves continued regulatory focus as those who lose money are often least able to absorb the loss.

Also in Australia a number of court actions were published involving prosecutions or investigations relating to fraud, dishonest behaviour, conducting a regulated activity without a license and even and insider dealing case.

In Hong Kong we noted the SFC alerting market participants on the need for sound hedge fund valuation practices. Hedge fund valuation is an ongoing concern of the SFC and even though the issue is a fund, rather than a manager issue, those firms who do not have third party valuations for all of their fund should be looking at how they can document their existing valuation procedures and what conflicts may arise from those procedures.

On the enforcement side we noted a number of prosecutions of firms and individuals who were found to be conducting regulated activities without a license. Licensing is a critical part of the financial landscape in Hong Kong and the SFC has repeatedly warned participants to ensure that they are properly licensed for the activities they conduct while physically present in Hong Kong.

We welcome the Hong Kong SFC clarification regarding the use of serviced offices by licensed entities and firms applying for a license in Hong Kong. The clarification was issued in March and follows on from several specific instances in 2006 where the Commission was refusing or objecting to license applications where a firm selected short term office space, typically serviced. This despite the fact that a number of reputable firms in Hong Kong were already licensed and operating from such locations. The previous ‘informal policy’ position of the Commission caused not only delays in licensing applications but significant extra costs associated with establishing a permanent office and then awaiting approval to get the license – something which is of itself very time consuming in Hong Kong.

We have felt all along that the appropriate concern of the Commission should not be whether an office is short or long term but rather the actual controls in place at the office as per the internal control guidelines so this develop is positive.

We see this clarification as part of a general improvement in the commerciality of a number of decisions being made on licensing issues and part of the recognition by the Commission that new market participants are by and large good for Hong Kong.

All firms should note the Commission’s requirements regarding licensed premises which we set out in the main body of this newsletter.

Various rumours are circulating in Singapore that the financial regulators are considering a tightening of the rules that have allowed a major influx of niche asset managers, including hedge funds, into the country. There has been no statement to this effect from the MAS.

While the rapid growth of the sector is bound to have attracted a couple of less scrupulous operators and the sheer number of funds suggests that not all will succeed, there are a number of major firms who have established or who want to establish a presence in Singapore to take advantage of a lighter regulatory touch. We expect that the MAS will want to be very careful to ensure that it continues to attract serious hedge funds to Singapore as well as providing a venue for Asian start ups to flourish. Institutional investors are aware of the lighter regulatory regime and tailor their due diligence accordingly. The real concern, in our view, should be the micro funds that establish without any industry experience and drag into their operation family and friend investors.

We mention continued fallout in Thailand from last year’s coup and the investigations into the business interests of former PM Thaksin. Singapore’s purchase of a stake in Shin Corp from Thaksin’s family immediately prior to the coup continues to be a hot button political issue that is effecting investor confidence across a number of sectors in Thailand. Consistent enforcement of securities regulation has never typically been a Thai strong point. Further politicisation of the process due to the coup is going to make the regulatory environment even less predictable.

Comments from February Newsletter

Here is the comments section from our February regulatory newsletter:

In February, AUSTRAC in Australia released new rules for discussion in relation to AML and CTF. The 57 page draft can be found by clicking on this link.

For firms in Australia the rules set out proposed AML and CTF programs including minimum information collection requirements to support KYC, a requirement to conduct prospective employee due diligence, a requirement to provide AML / CTF training and a requirement to have your AML / CTF program reviewed by an independent party.

For firms who conduct business with Australian firms in the financial industry you should expect to have to provide more details about the nature of the foreign company including names of directors and beneficial owners.

As mentioned in a previous comment about the Australian legislation, AUSTRAC has the power to visit a business in Australia and inspect its AML records without a warrant. It may also fine a business that does not comply with the act in addition to other general prosecutorial powers. These new rules set out the type of AML / CTF program that AUSTRAC wants to see and hence the type of program that must be in place to avoid either a fine or a name and shame action.

The proposed rules and the legislation are likely to be an added compliance burden on both Australian firms and firms wanting to transact business in Australia.

In practical terms the act and its rules are more likely to be quite effective tax collection and anti avoidance measures rather than simply anti money laundering provisions.

At the time of going to print with this newsletter, the Hong Kong SFC has clarified that it does not specify the precise type of premises that a licensed entity can use in Hong Kong. In 2006, the SFC had informed a number of license applicants that it would not accept a serviced office address, this despite the fact that a number of previously licensed firms were operating quite properly from these locations.

Reason has prevailed however, with the SFC clarifying that in fact they are only concerned with the internal control implications of any premises used by a licensed entity, serviced, leased or otherwise. This is a welcome change of policy and means that firms can indeed apply to commence smaller scale operations in Hong Kong provided they have appropriate internal controls in place relating to whatever they choose as premises.

There are other continued indications from the Hong Kong regulator that they are becoming more receptive to new applicants entering the Hong Kong market and we hope this trend continues.

The last month has seen new budgets released by both Singapore and Hong Kong. In broad terms company taxes are coming down and both locations continue to compete to lure regional head offices. Investment management and advisory companies will find that the budgets, and associated tax policy, continue to encourage the location of these firms in Hong Kong or Singapore.

The Nikko Cordial drama continued to unfold in Japan with Citigroup making a tender offer for all of the company’s shares at the time of going to print. The bid is interesting as it appears to us to be indicative of the opening up of the Japanese financial sector to much greater foreign involvement.

Firms with investment advisory operations in Japan should note the upcoming implementation of parts of the new Financial Instruments and Exchange Law that may affect their business. We understand from Japanese counsel that provisions relating to the registration of a number of firms previously unregistered will come into force in the second half of 2007.

Unlike Hong Kong and Singapore, Japanese tax authorities appear to be strengthening a number of provisions that may have the effect of taxing financial businesses previously exempt or largely exempt from Japanese taxes. Firms with operations in Japan may wish to get advice on this topic if they have already done so.

Managed Funds Association testimony to congress

A link to the MFA testimony to congress about hedge fund regulation can be found here.

An extract of the testimony is below:

MFA agrees with the SEC’s conclusion that it is no longer appropriate for hedge funds to be sold to natural persons who fall within today’s definition of Accredited Investors. MFA has long endorsed raising the financial standards in Regulation D as a means to address the SEC’s concerns about the “retailization” of hedge funds and the effect of inflation on income and net worth standards as they relate to the “accredited investor” definition.19 We have, however, some specific concerns about the proposed new Accredited Natural Person Rule, including its high degree of complexity and the potential for confusion on the part of investors, as well as added costs. MFA has explored these issues fully in our comment letter, dated March 9, 2007, to the SEC on the proposed rule. We ask Congress to consider ways to encourage greater consistency among financial sophistication standards across all regulatory agencies over which it has oversight for the benefit of investors and fund managers alike.

Regulators have also linked investor protection issues to regulations that require investment adviser registration with the SEC. With respect to the registration of hedge fund advisers, we believe the current statutory regime is sound. The vast majority of the top 100 hedge funds in the world are managed by SEC-registered advisers. In the past, mindful of the need of the SEC to gather data on the industry, we have proposed to the SEC that unregistered hedge fund advisers could be required to notify the SEC of its intention to operate as a hedge fund adviser in reliance on the relevant exemptions. Our proposal provided for a notice that could include certain basic census information about the hedge fund adviser determined to be necessary or appropriate. In the future, regulators may wish to re-visit our proposal.

Comments from our January Newsletter

Here is the Comments section of our January Asian regulatory newsletter:

January was a quiet month from a regulatory viewpoint in both Hong Kong and Singapore.

In December in Hong Kong there seemed to be a regulatory bottleneck in getting various applications processed. We noted that this eased in January. 2006 saw a large increase in the number of licensed entities in Hong Kong and we did not detect any decrease in activity as the year came to an end. A major regulatory challenge in 2007 will be ensuring that regulators can attract and retain sufficient expertise to handle both the new entrants and the new products and processes emerging from established firms.

As Hong Kong is still a great place to build and develop financial services, getting new entrants to the market quickly can only be good for the economy in general and the slow speed of application turn around in 2006 was by and large a drag on investment in Hong Kong.

We believe that there will be a temptation to tighten the Singapore regulatory environment in 2007 as such a buoyant economy breeds a little complacency on the business development side of the MAS. This is already being seen in the greater emphasis placed by the MAS on timely notification of changes at both licensed and exempt institutions.

MAS is sending warning letters to licensed individuals who fail to notify them of changes in personal details so internal education campaigns about the importance of these requirements should be commenced.

We believe that taxation on the activities of financial firms in both Singapore and Hong Kong will remain a policy focus in 2007 and proper planning and advice remains critical in this area.

2007 will be the year that many of the new changes in Japanese financial law come into effect. Coupled with the resurgence of the Japanese financial industry and the move towards greater integration of the Tokyo Stock Exchange with the NYSE, this year should be a challenging and exciting year for financial firms in Japan.

China and India are both predicting strong economic growth again in 2007. We expect to see a measured opening up of the Indian regulatory system and further liberalization and internationalization of the Chinese system.

In news outside the Asia Pacific Region, the Guernsey Financial Services Commission (“GFSC”) with regard to closed end funds has introduced a new regime. The process of gaining consent has now been streamlined to 3 days and the closed end funds that have received such consent will be known as “registered” funds.

In order to streamline this process the GFSC has placed reliance on the administration of the fund, requiring some certifications from the promoter and administrator of the fund.

Lastly this newsletter goes out just prior to Chinese New Year. We wish all of our readers a prosperous and healthy year of the pig. For those of you in Hong Kong – Kung Hei Fat Choi, and if you are in Singapore – Gong Xi Fai Cai.

Deloitte survey on hedge fund risk issues

Deloitte Cayman have published the results of an interesting survey of some 60 hedge funds entitled "Risk Management and Valuation Practices in the Global Hedge Fund Industry".

The full report can be downloaded from this link.

The report discusses risk management, compliance and fund valuation trends and issues.

December 2006 Newsletter Comment

Here is the comment from our December 2006 newsletter. If you would like to subscribe please visit our website at complianceasia.com

Comment

Welcome to our first newsletter in 2007 with a summary of Asia Pacific regulatory issues in December 2006.

An interesting breaking story over the Christmas holidays in Australia involved the resignation of the Chairman and senior executives of Alinta Gas following an offer to purchase the company by those individuals. We are expecting to see more about conflicts of interest, directors duties and stewardship issues in 2007 in Australia and this case highlights that some high profile firms still have a long way to go to meet international best practice.

In Hong Kong the Stephane Hug case involving alleged offences on the Tokyo Stock Exchange was an interesting interpretation of the Hong Kong fit and proper rules. Compliance personnel in Hong Kong should read the information available on this case if they are not familiar with it.

The Hong Kong SFC reported that there were 73 companies in 2006 applying for asset management licenses. We believe that this is close to a 25% increase in the number of licensed asset management firms in Hong Kong, if all end up with a license.

In a speech just recently given Ms Alexa Lam from the Hong Kong SFC has highlighted side letters, valuations and sub standard offering documents as issues that the SFC is most concerned about in relation to hedge funds in Hong Kong. We note that these are all fund issues and, in a number of earlier statements made by the SFC at industry functions, they downplayed their role regulating funds versus regulating advisors and managers to funds.

During 2006 we had already noted that a large number of questions directed to asset managers by the SFC were in fact fund issues and this recent speech may be a confirmation that fund issues, rather than issues concerning the Hong Kong regulated entity are an increasing focus of the regulator in Hong Kong. The full text of Ms Lam’s speech can be found on our blog (http://complianceasia.blogspot.com ) and on the SFC website.

In India, SEBI announced that the next IOSCO conference will be held in India in April 2007.

In Thailand, December was of course the month that Thai investments went though a volatile period with on again, off again statements regarding exchange controls. The outlook for 2007 remains uncertain in Thailand with lingering political issues and only marginal improvements in the financial system and legal infrastructure that melted down in 1997.

Alexa Lam from the HK SFC speaks on asset management regulation

On 18 January, Ms Alexa Lam from the HK SFC spoke about asset management regulation in Hong Kong to the Investment Company Institutes 2007 conference.

The full text of her speech which can also be found at www.sfc.hk (minus the footnotes) is reproduced below.

Of particular note is Ms Lam's commentary on hedge funds contained within the body of her speech and we have highlighted the heading for this section in bold.

The Outlook and Regulatory Challenges for the
Fund Management Industry in Hong Kong
18 January 2007
Speech by Alexa Lam
Executive Director
Intermediaries and Investment Products

Ladies and gentlemen,

Thank you for inviting me to speak to you today.

When I was asked to give this presentation, I was wondering how to make talking about the fund management industry from a regulator’s viewpoint interesting. It’s a challenge but then I realised that in at least one respect regulators actually share the same objective with the industry, which is to ensure that our markets compete successfully in the face of global competition.

As regulators, we constantly ask ourselves whether our regulatory framework is doing what it needs to do to continue to attract liquidity to our markets.

We believe it is a given that we should not over-regulate, nor should we be, or even appear to be, heavy-handed, or funds will be put off by the high cost of compliance, and investors will also suffer by having far fewer products to choose from.

On the other hand, we take our role as gate-keepers very seriously by firmly and fairly enforcing the relevant codes and guidelines. Another prerequisite for attracting liquidity is that the investors are treated fairly, and rules are properly enforced.

Regulatory objectives The Hong Kong Government and regulators are committed towards developing a quality market with both breadth and depth.

Recent industry-friendly measures include abolishing estate duty and exempting offshore funds from profits tax in late 2005 and early 2006 respectively. These measures are meant to strengthen our competitiveness as an international financial centre and attract international investors to hold assets in Hong Kong and to use our asset management services. During this period, we saw 73 corporations coming in to apply for an asset management license.

We also provide a robust regulatory framework to ensure that market players have a level playing field and sufficient market transparency for investors to make informed investment decisions. I will say more about this later but the important lesson is that this obviously cannot be achieved by working in a vacuum. As regulators we always try to work with the industry when we formulate regulatory policy or facilitate the development of new investment products. This also gives us the feedback we need to remove obsolete policies that hinder innovation and change.

Hong Kong as a major international financial centre

Hong Kong is widely recognised as a major fund management centre. We are ranked 2nd (after the Mainland) as the most preferred destination for foreign direct investment in Asia.

The fund management industry in Hong Kong is thriving. It has enjoyed substantial growth in assets under management over the past few years. The combined fund management business grew by 25% in 2005 and over 22% in 2004. The size of Hong Kong’s combined fund management business at the end of 2005 was more than half (55%) of Hong Kong’s stock market capitalisation at that time.

Opportunities in China

No talk about Hong Kong’s financial markets would be complete without mentioning Mainland China. The Mainland is an important focus point in the financial world today or good reason as the Mainland’s economy is expanding rapidly, with the world’s biggest saving pools (US$2 trillion according to market sources) and the world’s largest foreign currency reserve of over US$1 trillion2. Such liquidity brings significant opportunities for both investors and asset managers.

In 2006, the Mainland’s domestic A-share market surged 130% and domestic mutual funds topped US$100 billion. This increase of the size of the domestic mutual funds was largely driven by two factors – a big shift in investments from money market funds (investing in short-dated bonds) to equity products as well as the sizeable jump in China’s domestic Ashare market.

The asset management industry in China is also enjoying rapid growth – there has been a 10 times increase in total assets under management within six years between 2001 and 2006.

In one year alone, total AUM jumped by 84% (from US$59 billion in 2005 to
US$107 billion at the end of December 2006).

The sheer volume of Mainland investor money hungry for investing opportunities is a well documented phenomenon. As an example, a new Mainland joint venture fund management company between Harvest Fund Management Co. Ltd. and Deutsche Bank saw a bumper fund launch in the final quarter of 2006. One of their new funds was able to receive US$5 billion in subscription money in just one day.

So, the question now, is how does one tap into the lucrative Mainland market? Although the market is opening up at an unprecedented rate, restrictions abound. The most significant measures introduced by the Central Government to date to open up the Mainland’s financial markets are the QFII (Qualified Foreign Institutional Investors which are allowed to invest in Mainland securities) and QDII (Qualified Domestic Institutional Investors which allow Mainland investors to invest in overseas equity markets through qualified institutional investors e.g. fund management companies) schemes. By obtaining QFII status, Hong Kong asset management companies can directly play the China securities market. There are currently 52 approved QFII with a total quota of US$9 billion for investing in the Mainland securities market. We have seen some of these QFII quotas used to package retail fund products in Hong Kong.

As for QDII, although they offer notable investment opportunities for Mainland investors, the take up rate has been slow. At the end of December 2006, SAFE (State Administration of Foreign Exchange) granted a US$13.6 billion quota to approved QDIIs, of which US$13.1 was granted to 15 bank QDIIs. However, the actual investment in QDII products totalled less than US$400 million, a rather low utilisation amount. The remaining US$0.5bn was granted to for Hua An (a Mainland based asset management company).

Bank QDII products are not doing as well probably due to (i) lack of product diversification and low return from fixed income due to restrictions in the current bank QDII rules to bonds and fixed income products; (ii) anticipated continued appreciation of RMB exchange rate; and (iii) pick up of China’s stock market which made buying A shares more attractive.

To address these issues, the first joint working group meeting of CBRC (China Bank
Regulatory Commission), SAFE, SFC and HKMA concerning QDII was held in November
2006 in Hong Kong. The working group recognized the importance of widening the scope
of permissible investment of QDII banks and discussed the possibility of expanding the scope to include products that are familiar to Mainland investors (e.g. SFC authorized funds that invest in H shares listed in Hong Kong).

Hong Kong as a gateway for Mainland investors

Hong Kong is ideally positioned to act as a bridge between the Mainland and the rest of the world. We enjoy close relations and proximity to the Mainland, and are also familiar with the languages, cultures, practices and systems of the Mainland.

As a leading asset management centre in Asia, our fund management industry has an
international and offshore flavour. Around 60% of investment funds available are sourced overseas and the majority of assets are invested outside Hong Kong.

In terms of human resources and services, Hong Kong possesses a rich pool of talent and can offer a comprehensive set of skills, experience and advisory services for Mainland institutions seeking to invest overseas. With a broad range of authorized investment products that can cater to all levels of investors with different risk appetites, Hong Kong provides a one-stop shop for Mainland investors who are enthusiastically seeking to diversify their investment opportunity overseas. This complementary and highly synergistic situation benefits the Mainland and Hong Kong fund management industry.

I suggest that Hong Kong based fund managers take this opportunity to explore the
possibility of how they could contribute to, and benefit from, the opportunities that QDII opens up. For instance, they may wish to conduct market research to determine what type of fund products, or what kinds of underlying investments, would be of interest to Mainland investors.

Global issues for the fund industry

Let me now turn to some of the global issues regarding the fund industry faced by regulators in major markets around the world.

(i) Regulation of hedge funds

The first issue is the regulation of hedge funds.

We in Hong Kong feel that hedge funds are an exciting product and should not be altogether barred from the retail public. Indeed, we were one of the first jurisdictions in the world to introduce guidelines to facilitate the offering of hedge fund products to the retail market.

However, bearing in mind that retail investors may have less resources available to them to demand adequate risk transparency and structural safeguards, we have imposed stringent requirements on the structure, fund managers’ competence, performance fees disclosure, etc.

As you all know, retail hedge funds are only a very small part of the hedge fund universe.

The vast majority of hedge fund managers who are in Hong Kong manage or advise private hedge funds. We conducted theme inspections in 2005 on a sample of hedge fund managers. Last November, we carried out joint inspections with the US Securities Exchange Commission on a sample of hedge fund managers licensed/registered with both regulators.

From these inspections we have uncovered some key areas of concern, which include:

(1) Side letters

Some fund managers give preferential treatments to certain investors through side letters without adequate disclosure to other investors, which can lead to unfairness and conflicts of interest.

Disclosure could be one of the solutions to this problem, e.g. AIMA issued guidance on side letters in September 2006. Fund managers should disclose to investors the existence of side letters and their material terms, such as preferential redemption rights, portfolio transparency rights, etc.

(2) Valuation

Some managers were found not to have clear valuation policies, such as the valuation
methods for complex and illiquid products.

(3) Substandard offering documents

Some of the terms in the offering documents of hedge funds were ambiguous.

We are working closely with the industry, other regulators and IOSCO to look into these issues and how best to address them. For example, we actively participate in the IOSCO Task Force on hedge fund valuation from which IOSCO expects to receive comments from the public on this topic in the summer of 2007.

(ii) Mis-selling of products

The investing trend nowadays sees Hong Kong investors demanding yield enhancement,
capital preservation and diversification away from the traditional asset classes such as property, shares and foreign exchange. In addition, as the population ages, there is increasing demand for sound retirement planning.

With these objectives in mind, investors are attracted to the wide range of traditional unit trusts and mutual funds, hedge funds and other collective investment schemes, structured products as well as investment-linked insurance policies (ILAS) on offer in Hong Kong. In this competitive environment, there is also plenty of aggressive marketing and product pushing to attract retail investors.

Given this situation, the typical retail investor faces a bewildering and possibly confusing range of choices due to product complexity, difficulty in understanding offering documentation and possible conflicts of interest on the part of the intermediary selling the product. These factors make it difficult for the typical retail investor to make a reasonably informed investment decision. Because of this, more and more investors turn to their investment advisors for objective and appropriate advice. The onus, therefore, is on fund managers to provide suitable training to distributors and investment advisors to ensure that they provide professional and objective investment advice to their clients, including all
necessary information about the features and risks of the products, and most importantly, unsuitable products are not sold, or “pushed” to investors.

Ongoing investor education plays an important role in helping investors know their rights, responsibilities and risks when seeking advice from investment advisors. In this regard, the SFC will continue to educate investors through different channels via the media, workshops, publications and our comprehensive online investor education portal - “InvestEd”. The aim is to help investors develop the right attitude towards personal financial management. Once investors understand the features and risks of the product they are thinking of investing in and learn to ask the right questions, they will be better equipped to make informed decisions.

Regulators are generally in agreement that investors should have the opportunity to base their investment decisions on solid information when considering their investment options. Whether an investor is guided by a salesman's recommendations, disclosure in the CIS operator’s prospectus or is largely self-directed, the investor should have, before buying, the information necessary to understand what he or she is buying, its cost and its risk/performance profile, as well as a market intermediary's associated conflicts of interest.

In Hong Kong, it is current market practice for investment advisors not to disclose to clients the quantum of their remuneration or commission which they receive from product providers. This creates conflicts of interest issues in that investment advisors may put their own interests ahead of those of their clients.

A new IOSCO project will consider the kinds of meaningful and effective information
that ought to be disclosed to investors at the point of sale. The SFC has volunteered to be part of the drafting committee. Already such types of disclosure are mandatory in Australia, UK and Singapore.

(iii) Use of soft commission

Soft commission arrangements is another area of concern for regulators as they give rise to conflicts of interest issues between the fund manager (who receive benefits) and the fund and its investors’ interest (in paying the lowest commission rate available and obtaining best execution of the funds’ transactions).

The SFC’s Code of Conduct requires a licensed person to disclose soft dollars received from a broker and their approximate value to the client. A licensed person is also required to ensure that the transactions undertaken or services acquired are in the best interests of the client.

IOSCO issued a consultation paper on soft commissions in November 2006 to examine any
issues of concern and regulatory responses among its member jurisdictions. The UK
Financial Services Authority has taken the initiative to require investment managers to disclose to their clients how much they are paying for execution and research services, i.e. to unbundle the commission.

We are keeping a close eye on further international developments in this area.

Conclusion

Hong Kong already has a robust regulatory framework in place, which is bolstered by a
large pool of talent, experience and world-class financial services and legal system and a deep, broad pool of well-managed investment products. We are well poised to provide value to Mainland investors looking for better choices and services, and to benefit from the synergy and opportunities that the opening of the Mainland market offers. This is a historic moment, and we live in an interesting time. We should all work together to make the road ahead meaningful and beneficial to all investors and market players.

Thank you.

Speech to International Compliance Association

On 29 November, Alex Duperouzel spoke to a group attending an International Compliance Association networking event on the role of compliance in 2007. Here is the text of that talk:

Good evening.

ComplianceAsia is an organization that provides consulting services to financial industry participants on issues that affect their regulatory profile, or their ability to work within their own international standards.

We work for a large number of firms who have operations in the Asian region including investment banks, trading banks, traditional asset managers, alternative asset managers, financial advisors, trust companies, institutional investors and government owned corporations. Geographically we cover not only Hong Kong and Singapore, where we have offices, but Japan, Korea, Taiwan, China, India, Thailand, Indonesia, Malaysia, Australia, Vietnam, Pakistan, the Caribbean and even Europe and North America from time to time.

We think that gives us an interesting perspective on what is going on in the financial industry in the Asian region, and so tonight I am going to talk about a few issues that we believe are going to be important to compliance officers in 2007 and beyond.

We are also here tonight to learn more about the International Compliance Association and many of you are compliance officers who will need to meet the challenges of 2007. Furthering your own technical knowledge will be a key part in your organization’s success and may be the difference between success and failure at your company.

The role of compliance in 2007 will be meeting these challenges while facilitating progress in the underlying business. Your role is to solve the challenges so you can say yes more often.

We believe there are six big compliance issues to consider in 2007:

1. Getting to grips with new products;
2. Conquering new jurisdictions;
3. Addressing the trend away from exchanges;
4. Working with regulators;
5. Dealing with the explosion in new market participants, particularly hedge funds; and
6. Learning to be vigilant in an ongoing bull market.

New Products, New Locations

Now lets talk about the first two, new products and new locations.

As the financial industry in Asia deepens there are many new products that compliance officers need to come to grips with.

Hedge funds who do quasi private equity deals, sophisticated bond funds that slice and dice illiquid debt products, banks that are really technology suppliers, prime brokers who are looking at how they can give a fund a competitive edge by leveraging off their private banking clientele, hedge funds using aggressive bottom up investing while chasing alpha, investment mandates that pretty much let a manager do anything, forex, options, indexes available online, on your phone and ultimately targeted at the retail level, these are just some of the new products.

These new products are being transacted into a resurgent Japanese market - the sleeping gorilla of the Asian scene - a rapidly developing India, an evolving and hot China, and the too big to be ignored markets of Korea and Taiwan. These markets are not all the same, they are developing at different speeds with different national priorities and legacies.

There has also been an explosion in new market entrants to both Hong Kong and Singapore. A lot of that has been in asset management, and I will cover that issue shortly. But in addition to those asset managers, we have seen a number of new administrators, trustees, prime brokers, and market makers and specialists all piling into the world’s fastest growing economic region.

Never has education and training been so important for compliance officers in Hong Kong. It is incumbent upon you to understand not only your own business as it grows, as it evolves with technology, but also you need to understand your counterparties.

The law of probability says that not every product, not every location will be a success. A good compliance officer will be able to assist in quickly recognizing failure and mitigating loss, as well as enabling great ideas to flourish.

You will only have the confidence to say yes when you understand the real implications of saying no.

The trend away from exchanges

Many of you may be familiar with the term ‘black pools’. Those of you who are not, will be in 2007.

Many years ago stock markets were formed by participants to set common rules and level playing fields to facilitate efficient capital distribution. Sharp practices in the lead up to the great depression resulted in a government intervention on those exchanges.

More recently those exchanges demutualised and became businesses in their own right.

During the last two years we have seen unprecedented activity in the exchange space as large exchanges look at taking over smaller or complementary exchanges, buyout firms invest in niche exchanges and or look at driving consolidation, and now we have a number of financial firms setting up their own facilities to attract client business and keep it in house either en masse, as a group of big players, or individually as a trading platform for specific clients.

These are the black pools that we believe are going to radically reshape the work of compliance officers in Asia.

The black pools are popular because they offer reduced transaction fees. There is certainly a perception that the big exchanges have grown fat on the trading volumes of their clients and the public. But black pools also present substantial compliance risks.

Just what goes on inside the pool and how that information is handled by the firm running the pool is going to be a key compliance issue as these products become more popular. With the cost of setting up such a facility dropping, as technology costs drop, you can expect to see a fragmentation of the business that goes through an exchange.

How compliance officers police their traders, their technology folks, the programmers, the vendors, the support teams and others with a stake in the system will be a great challenge.

To put this simply when you work through an exchange you are outsourcing the exchange compliance and IT security issues to that exchange. If you run the exchange in house then all of the issues you never considered before are now additional issues.

Just how regulators will get involved, or indeed whether they should get involved, in these platforms will also be an interesting question in 2007.

The challenge of working with regulators

Regulators are facing significant challenges in 2007. The greatest challenge in our view is education. Regulators are in the same market for talent in Asia as the firms they regulate. There is a shortage of talent in Asia. This shortage is made more acute by the emergence of new products and the expansion of new entities into different geographic locations.

By and large we remain critical of the level of industry acumen that regulatory staff have in this region. There are indeed a number of clever people in regulatory positions. But are those bodies as up to date as they can be, do they understand what is going on inside the industry, do they have a clear perception of the role that a market regulator provides in a capitalist system?

There is no shortage of regulatory staff who can read a section of the law or the code back to you, but there is a genuine shortage of clear thinking personnel who can look at an issue from both a wider industry viewpoint and an individual risk assessment.

This is manifesting itself into inconsistent regulatory approaches, long delays in processing new business applications and, as in Korea right now, fundamental market distortions.

For the regulator my comments should be seen as a constructive challenge. Policy makers need to realize that a well trained and well funded regulator helps in the efficient development of the capital markets. The industry should support requests by the regulator for increased funding and staff development. Staff rotation amongst regulators in Asia, Europe and North America should be encouraged and facilitated. The firms run a global or multi regional operation, the regulators need to.

For the compliance officer, 2007 will be a challenge in this respect. Regulatory decisions will need to be considered carefully – the regulator could be right, they could be wrong. The uncertainty will add to existing workloads.

Will there be a hedge fund shakeout?

In Hong Kong there are currently some 499 Type 9 licensees and of those about 40 % are niche asset managers who by one definition or another could be generically termed hedge funds.

In Singapore there are over 300 firms falling into the broad definition of a hedge fund.

In our view this is too many. Too many firms chasing a large but limited number of investment dollars. Too many firms chasing experienced portfolio managers, back office personnel and compliance staff. Is there enough AUM to keep everybody in business?

The short answer has got to be no. There will be a shakeout.

However the nature of the shakeout will be varied. The good firms are going to become takeover targets, some of those will be consumed, others will remain independent but will close themselves off from new subscriptions.

Some mid tier firms will also be acquired.

Many small firms will fold. Hopefully most of them will return some portion of their AUM to their investors and they will shut down in an orderly fashion.

The danger is that with any large number of financial participants involved in a race for new volatility, and with the lure of amazing rewards for those that get it right, there are going to be massive trading miscalculations and, from time to time, just plain old fraud.

It would not surprise us if we saw one blowup a quarter during 2007 as the industry begins to mature and some funds go chasing larger and larger returns.

I am yet to meet any economist or financier who has convinced me that risk and return are not related, and so while this remains a law of nature, then you all should be wary of return and seek to understand the risk.

The Current Bull Market

I arrived in Hong Kong in 1991 and worked through the great bull run of 1992-1997 and the dot com boom that came after it. Before coming to Hong Kong I worked in the time leading up to the October 87 crash.

Those bullish days are back. Whether it be the enthusiasm for all things China related, the boom in India, the resurgence of technology and web 2.0, or the boom in private equity acquisitions and leveraged buyouts, this is one big bull market.

There are many dangers in a bull market for a compliance officer.

Firstly its very hard to say no to the guys and gals in the front office. The more deals we do, the more money we make. Compliance officers who try and check this process are not going to be popular. In economic terms this leads to a mispricing of the transaction risk.

Secondly frauds are harder to detect in a bull market. Rising asset prices mask deals which would get greater scrutiny if times were tight.

Lastly look around your front office. How many of them have freshly minted degrees to go with their lovely suits and designer clothes?

Due to the shortage of talent generally in Asia, people are given more responsibility at a younger age. For all the outstanding degrees that these high achievers have, nothing beats a bit of gray hair during a bull market. Someone who understands the importance of documentation, of kicking the tyres before a deal and who understands the realities of enforcing collateral and counterparty risk. Someone who believes that they are employed to protect, preserve and enhance their employer’s capital, not just generate a fantastic bonus.

In summary

2007 is going to be very challenging for compliance officers around the Asian region. Education is going to be the key to helping you protect your employer and enhance value, value that will survive industry consolidation and market correction.

Education will also help you respond in a crisis. It will provide a clear compass to set a path by and the confidence you will need to respond to rapidly developing events.

Those on the regulatory side need to be encouraged to develop their professional expertise. They need to ensure that the rapid evolution of the market place is not stifled by poor implementation of market rules. Better education, more rounded experience will give them the confidence to evolve without losing their fundamental mandates.

I am a poor investor. If I could read the markets I wouldn’t be standing here talking about compliance issues. However I do believe that there are warning signs in the current environment that should not be ignored if compliance officers are to provide maximum value in 2007.

That ladies and gentlemen, is our view on the role of a Compliance Officer in 2007. We hope you are up to the challenges ahead and thank you for listening.