SFC Hedge Fund Survey

This is the link to the report on the SFC survey of hedge funds.

The survey wording was not good and it is possible that there is actually quite a bit more AUM than the SFC has reported here.

No more NCCT's

There are currently no countries listed as being non compliant countries or territories by the FATF:

Myanmar removed from money laundering black list

The last of the countries on the Financial Action Task Force (FATF) Non Cooperative Countries and Territories list (NCCT) was removed last week. The announcement that Myanmar was no longer considered non co-operative was made at a FATF meeting in Vancouver on Friday.

Myanmar introduced anti money laundering laws in 2002, giving its authorities the power to investigate and seize assets acquired through criminal activities such as trafficking in drugs, humans and weapons.

Police Colonel Sit Aye, head of the Home Affairs Ministry's Transnational Crimes Department, cited the 2005 deregistration of two banks as evidence of the enforcement of Myanmar's AML laws. Asia Wealth Bank and Myanmar Mayflower Bank were both deregistered after being accused by the United States of money laundering and being linked to drug traffickers.

MAS Proposals regarding licensing for exempt managers

Here is the link to The MAS consultation paper that deals with the possibility or requiring exempt fund managers to register and license representatives.

The proposal in our view is a step backwards for Singapore. One of the great advantages that Singapore currently has over Hong Kong in relation to asset management is the relatively light regulatory hurdle that has to be overcome to start up an asset management business that will only deal with a limited number of professional investors.

The proposals do not remove this advantage but they chip away at it.

The Hong Kong system is overdue for reform and it is in the best interests of the SFC to adopt a system where only corporations and responsible officers are licensed and the licensing of representatives is dropped.

Hong Kong should in fact adopt the Singapore proposals set out in the consultation paper. That would be a step forward for Hong Kong.

There is currently nothing to suggest that the Singapore system is broken. The MAS states in the paper that a good reason for the change is to level the playing field between traditional asset managers, who hold CMS licenses, and smaller firms who are exempt. We respectfully suggest that the two different types of firms do not compete for customers and there is no need for them to occupy the same playing field.

Retail investors dealing with a CMS license holder should be entitled to know that those people working for it meet minimum standards of probity and competence. Professional investors dealing with exempt fund managers have the resources and the motivation to make these determinations themselves. They do not need a regulator to help them.

September Newsletter

ComplianceAsia has published its regulatory newsletter covering Asia wide developments during September.

The summary is as follows:

This month we see discussion about the creation of a Super Regulator for China – although it might not be so super after all.

Back in June the Bank of New York published an interesting paper on Hedge Fund Operational Risk. With September seeing a lot of industry comment in relation to the losses at US fund Amaranth the paper, which can be found on the BONY website (www.bankofny.com) , is an interesting read. The topic deserves more detailed discussion than the length of this paper but it is a good primer.

As we go to print with this newsletter the HK SFC has just released the findings from its survey on hedge funds. The survey states that there are now 118 hedge funds / hedge fund advisors licensed and operating in Hong Kong. The findings were interesting and we will be discussing them further in the next newsletter and on our blog (www.complianceasia.blogspot.com ).

Singapore has released proposals to place some additional administrative burden on exempt fund managers in relation to licensing by bringing individual licensing of Representatives into line with requirements for CMS license holders. The consultation paper is online at the MAS website.

With the last quarter of the year upon us, Hong Kong licensed personnel should be reviewing their training hours for the year. The training requirements are based on a calendar year so it all needs to be done by December 31.

ComplianceAsia will be helping out here by hosting some client training and general training sessions in Hong Kong and Singapore between now and the end of the year. If you receive this newsletter you will get an email about the training. If you are a client and want to know more please contact Philippa in Singapore or Nick or Alex in Hong Kong.

Queenie Yu from our Hong Kong office has compiled an online database of all upcoming financial industry training that we are aware of that will, or may, qualify for CPT in Hong Kong. Clients can access this by contacting Queenie in the Hong Kong office. If you are from a law firm, prime broker or training provider and would like your courses listed please give Queenie a call.

Email Idy@complianceasia.com if you would like to subscribe to the newsletter.

Alexa Lam discusses hedge fund regulation in Hong Kong

The following is the full text of a speech that Ms Alexa Lam, Executive Director of the Hong Kong SFC gave on the subject of hedge fund regulation in Hong Kong:

HKSI

Luncheon Speech by Mrs Alexa Lam

Executive Director, SFC

10 October 2006

Good afternoon. Thank you for inviting me to share some of my thoughts on a very current topic with all of you.

Introduction

When it comes to the issue of regulating hedge funds, there is bound to be enthusiasticdebate. There are always questions about the risks hedge funds pose and whether they should be regulated and if so, how they should be regulated. Should hedge funds be offered to only private, high net worth, professional, institutional investors? Or should they be made available to retail investors?

There are no conclusive answers to these questions, as the market is always changing but I will touch on how we at the SFC approach the regulation of hedge funds in Hong Kong.

Hopefully this will give you a better understanding of the issues involved.

Before we do that let’s delve into some interesting real life case studies and see if there are any lessons we can learn from them. There’s nothing like a big bang to start things off!

The devil and the deep blue sea

You may ask, “Are hedge funds really that dangerous?” According to a World Economic Forum (WEF) study, “surging oil prices, a pandemic or extreme weather are more likely to negatively impact the world’s economic growth” than the collapse of a big hedge fund.

To put that sentiment to the test, Amaranth Advisors, a very large US hedge fund, imploded a few weeks ago and many expected its failure to shake financial markets around the world.

Indeed, Amaranth’s cash losses of about US$6 billion were significantly larger than the US$4 billion loss when LTCM collapsed in 1998.

An interesting fact of the melt down of Amaranth is that despite the size of the loss, itbarely affected the financial markets. In the years post LTCM, many were dreading the collapse of another major hedge fund and the systemic impact that this would create and how it could reverberate through the world’s financial markets. But this did not happen with Amaranth. Its collapse did not lead to any Armageddon in the financial markets around the world. In a matter of two weeks, the crisis was mostly over. As was noted in Fortune magazine, there were no emergency meetings by the US Federal Reserve or huge Wall Street institutions scrambling to devise a rescue package.

Proponents for less regulation of hedge funds could possibly hail this event as proof that the business is self healing. It has been reported that when Amaranth was melting down, bidding by other hedge funds for its loans and convertibles that were sold to cover its losses was so competitive that they were barely discounted.

One of the lessons learnt in the LTCM debacle is that the hedge fund managed to build huge levels of leverage because their major credit providers failed to be vigilant in their counterparty risk management.

Post LTCM, regulators have been calling on counterparties including banks, prime brokers and other liquidity providers, to put in place and implement rigorous risk management measures. Internationally active financial institutions have strengthened their due diligence regimes, and also their ability to measure potential risk exposures. The relative calm that followed the Amaranth implosion offers positive hope that hedge fund failures need not bring chaos. It also offers hope that counterparties and liquidity providers have diligently implemented their risk control measures.

Amaranth appears to be another classic case of a young, overconfident and aggressive trader who was allowed to make huge and highly geared bets from his home. And, while the world’s financial markets did not go into a tailspin, investors in Amaranth are no doubt still nursing their wounds.

Amaranth, therefore, is a timely reminder of 3 areas of weakness in the system:

(i) Hedge funds have become significant revenue contributors to some investment banks. Under such a competitive environment, the prime brokers may be tempted to relax their risk management and credit policy for some of their larger hedge fund clients;

(ii) The lack of proper oversight by senior management in hedge funds is a recipe for disaster; and

(iii) Investors must carry out thorough due diligence, and demand more risk transparency from their hedge funds.

Two regulatory models

Let us now drill down to define some basic terminology. When regulators talk about hedge funds, we are referring to the entity or product that offers investment opportunity to investors. Separate from the entity or product are the hedge fund managers. These are the people who advise the hedge funds and give advice or make investment decisions according to the mandates set out in that hedge fund.

First, the product. There are currently two regulatory schools of thought. The predominant approach is that because hedge funds are considered risky and complex products, they should only be made available to private, institutional and professional investors. The US and the UK are examples of this model.

However, there are a few jurisdictions, including Hong Kong, that believe while the bulk of the hedge funds should be for private, institutional and professional investors, a segment of hedge funds can be made available to retail investors as long as certain stringent requirements are satisfied.

Retail hedge funds in Hong Kong

We feel that hedge funds are an exciting product and should not be altogether barred from the retail public. 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.

The authorised hedge fund market is very small, with total AUM of authorized hedge funds amounting to only US$1.48 billion as at the end of June 2006. Although this is a very small section of the hedge fund industry in Hong Kong, we will not compromise on the high standards expected. If hedge funds wish to offer their units to the retail public, it is only fair that the fund product in question should adhere to the stringent authorisation requirements with respect to the authorisation of that product.

Private hedge funds

Private hedge funds constitute the majority of the hedge funds offered. They are not subject to the same stringent requirements as retail hedge funds. They do not need to be, as private hedge funds target professional institutional investors who should be savvy enough to do their own due diligence, assess the risks involved and monitor the performance of the funds.

In addition, such investors should be able to withstand losses should a fund fail.

That said, all private hedge funds are still subject to the laws against fraud, insider dealing, market misconduct, general principles that they should treat their clients fairly and manage conflicts.

Our hedge fund survey

You may be interested to know that we recently carried out a survey on all our licensed hedge fund managers on the hedge funds that they manage or advise. We hope to publish the results soon. This should help the market and industry, as a whole, to see where it is going. According to the survey, the good news is Hong Kong has a large AUM, which has substantially increased from just two years ago.

Licensing of hedge fund managers

Let us now move on to the managers. While private hedge funds are not subject to authorisation, all hedge fund managers operating in Hong Kong, whether the funds they manage or give advice to are offered to the public, are required to be licensed. In this regard, there are no exemptions and no shortcuts. Based on our recent survey mentioned above, we noticed that a number of our licensed hedge fund managers are part of large hedge fund groups that are headquartered in Europe and the United States and we welcome them.

As a statutory gatekeeper, we are duty bound to perform our due diligence when these people come in for a licence. To do this properly, we need to understand the managers’investment strategies, internal controls, their expertise, substantial shareholders’ as to their fitness and properness, and financial resources, etc. It is against this information that we can assess whether they have the appropriate risk management models and expertise to manage the market, trading, liquidity and counterparty risks. Our key concern is how they manage the different risks.

Ongoing supervision of licensed fund managers

Once the managers are licensed, they will be subject to our ongoing supervision. This means that they would be required to comply with our general code of conduct and also the code for fund managers.

Last year, our supervision staff carried out a round of theme inspections on a sample of hedge fund managers. We detected some problems such as insufficient segregation of oversight responsibilities and lack of checks and balances, conflicts of interest (e.g. side letters), problematic valuation for complex, illiquid and bespoke financial products, substandard offering documents, and backlogs in counterparties’ back office operations. These issues are not just peculiar to Hong Kong. Overseas regulators of major financial markets and IOSCO are also looking at these issues.

Systemic risk

How do we address the issue of systemic risk? We do not pursue a zero failure regime.

Hedge funds, like any other business, can fail. Our concern, however, is that failure of a large hedge fund or a group of hedge funds may have serious consequences on financial institutions with significant hedge fund exposures. In addition, the impact of these hedge fund failures can be transmitted across the broader financial markets in the form of sharp price fluctuations and market turmoil. These failures can undermine financial stability.

The systemic risk may arise from a combination of factors:

• Multiple layers of leverage;

• Multiple sources of exposure of credit providers;

• Market dynamics amplifying price movements;

• Use of complex derivatives and model-dependent valuation; and

• Interaction between credit, market and liquidity risks.

We believe that direct regulation over hedge fund risk taking is not practicable and probably not possible. Many hedge funds are domiciled in tax haven jurisdictions. While we license and regulate the fund manager, it is the fund itself that takes leverage, and engages in trading. Because the funds are not domiciled nor do they operate in Hong Kong, such activities are out of reach of the regulator.

To claim that we have direct regulatory supervision over these hedge funds would be dangerous; at a minimum it could give rise to a moral hazard problem with the investing public thinking we have a firm handle over such activities, when actually we do not. So we have to rely on market discipline which are the constraints placed on the hedge funds by their creditors, counter parties and investors.

We maintain active and, I would hope, open dialogues with the hedge funds, and also their prime brokers.

Prime brokers are directly regulated by us. So, there are a few things we expect them to do:

• Demand a sufficient level of risk transparency from their hedge fund counterparties to assess the overall risk profile;

· Make timely risk aggregation of different types of risk exposures to hedge funds and be able to assess their overall concentration risk to the hedge fund sector as a whole;

and

• Develop appropriate risk analytics to better understand the linkages among different types of risks, and the likely interaction among market participants and across different but related markets under stressed conditions.

Concluding remarks

Finally, I would like to take this opportunity to say that we welcome quality hedge fund managers who have the proper risk parameters to set up in Hong Kong. We do recognize the role that hedge funds play in our market. They contribute to capital formation, promote market efficiency, and price discovery and add to market liquidity. Hedge funds also bring a wider investment choice for Hong Kong investors. And if they are properly used, they can help investors reduce their exposure to downside risks.

Hong Kong has a lot to offer to hedge funds, as it is the market with liquidity, openness,

depth and access to the exciting Mainland market. In order to create a viable and thriving hedge fund industry, what is important is that we continue to work with hedge fund managers and the counterparties, creditors and investors of hedge funds to manage risks and develop the market.

Thank you.

August Newsletter

ComplianceAsia recently published its August Regulatory Newsletter for the Asian region. Here is the announcements and comments section:

The standout or notable major regulatory events during August were the publication of new anti money laundering guidelines by the MAS in Singapore, new QFII regulations in China and the appointment of new Executive Directors to the SFC in Hong Kong.

The new guidelines will bring Singapore’s regime into line from an international best practice standpoint.

Firms who already have a risk based approach to AML will not find the transition difficult once the new rules are formalized. Firms used to a more proscriptive approach will find that they need to carefully go over the new provisions and they may require updates to existing manuals, practices and training.

ComplianceAsia has done quite a bit of work in this area, let us know if you would like to discuss your own requirements.

Deacons produced a paper on the QFII changes and we refer to this in this update.

We have launched our own blog at http://complianceasia.blogspot.com/

We will be using the blog to comment on developing issues and highlight some regulatory events in a more informal way. Like all blogs the content is quite subjective and we welcome comments from readers.

In September we hosted two regulatory breakfast meetings. Firstly Adrian Pay from NL Technology spoke about Treating Customers Fairly. Let us know if you would like a copy of this presentation. Philippa Allen spoke in Hong Kong on current regulatory issues. We also have copies of this presentation. Let us know if you would like a copy.

Also in September we jointly hosted a regulatory roundtable with Caymans law firm, Ogier, representatives from CIMA, Ernst & Young and Fortis.

We will be hosting some more regulatory events before the end of the year and this is a good opportunity to boost up your CPT hours for those licensed in Hong Kong.

If you are in the financial industry and would like to subscribe to the newsletter please email newsletter@complianceasia.com

CIMA Regulatory Roundtable

In September, ComplianceAsia co-hosted with Ogier, CIMA, Ernst & Young and Fortis a regulatory roundtable discussion on hedge fund regulation.

Peter Cockhill from Ogier and Gary Linford of CIMA spoke prior to the Q&A and here are their presentations:

Ogier Roundtable: Cayman's Regulatory Philosophy
Hong Kong
11 September 2006

An Update of Cayman's Fund Industry
By: Peter Cockhill
Partner, Ogier

Good afternoon. This is intended to be an interactive session and I would like to encourage everyone to feel free to ask questions following Gary Linford’s presentation. The reason we have assembled a panel of leading industry participants is so that we can obtain the benefit of different perspectives: regulatory, legal, audit, administrator and compliance. Although I am sure my fellow panellists have one or two questions in mind which they propose to ask of Gary and the rest of the panel, much of the value of these forums is derived from suggestions or queries from industry participants which in due course may lead to regulatory or legal clarifications or changes, so please speak up.

Before Gary shares CIMA’s regulatory philosophy with the rest of us, I would like to briefly set the scene of spending a few moments looking at the growth of Cayman as a domicile for investment funds and bringing you up to date with some of the industry developments that are currently taking place.

Screen 1 - Licensing Activity as at 30 June 2006

The screen shows the number of Fund licensed entities in Cayman as at 30 June 2006. The number of registered funds was 7,161 approximately double the number that were registered in June 2003. Registered funds account for approximately 90% of the 7,845 funds which CIMA regulates, and of those registered funds, 95% or more fall within the broad definition of what we understand to be a hedge fund. Registered funds are those which have a minimum subscription amount of US $50,000 or whose securities are listed as a recognised stock exchange (principally, the Irish Stock Exchange and the Cayman Stock Exchange).

Registered (i.e. non-public) funds continue to drive the growth of Cayman with CIMA registering new funds at an average rate of 37 per week during the first half of 2006.

As you probably know, there are two other types of funds regulated by CIMA: the administered funds and the licensed funds. Licensed funds are those which are effectively retail funds, offered to the general public, and you can see that the number of such funds is relatively insignificant (approximately 1% of all regulated funds). Administered funds tend to fall between the retail and the institutional sectors, these are funds which cannot take advantage of the registered funds filing (as minimum investment is not at least $50,000 and their shares are not listed), but which can avail of a relatively light regulatory environment because they are being administered by a regulated Cayman Islands administrator which is responsible for ensuring appropriateness of the promoter and principals of the investment fund. Overall numbers of administered funds have increased only slightly over the last three years, but these quasi-non public funds represent about 8% of regulated funds and I believe Gary will mention them later on as they continue to be used by Asian and Hong Kong based promoters.

The remaining statistics deal with administrators. The number of full licence holders has increased and CIMA now licences 15 of the world’s top 20 fund administrators, as ranked by assets under administration according to Hedge Fund Manager survey of November 2005. The restricted category is now largely a legacy as it was a way of investment managers being registered prior to the SIB Law which came into effect in 2004. Likewise the exempted category.

How does Cayman compare to the other offshore jurisdictions?

(Slide 2 - Jurisdictional Comparison: Dec 2000 - Dec 2005)

The number of funds globally has increased and each of the offshore centres (with one exception) has increased its number of domiciled funds. However, Cayman continues to dominate and in 2005 grew by a net 1,174 funds compared to a net growth of 234 by BVI, Cayman’s nearest competitor.

(Screen 3 - No. of Regulated Funds: 2000 - 2005)

So, the statistics tell a good story. There are several drivers to this growth, but there is little doubt in my mind that a substantial amount of the credit for Cayman’s continued pre-eminence as the domicile of choice for offshore hedge funds should go to CIMA and its investment and securities division, not least for its willingness to engage with industry and to work on developing with the stakeholders a sound and appropriate regulatory regime. The recent establishment of the Cayman branch of AIMA, the first chapter in an offshore jurisdiction, will provide a very useful conduit for the views of the Cayman hedge fund industry into industry on an international private sector basis. AIMA Cayman will be making contributions to the AIMA recommendations on two key areas which have been identified as areas of specific supervisory focus: the valuation of illiquid assets and the treatment of side letters. Many of you will have noticed that lawyers are recommending more explicit disclosure of the actual or potential existence of Side Letters in a fund’s offering memorandum. We are hoping to have a Cayman industry view on this issue to feed into AIMA in the next few months. In this way bodies representing the hedge fund industry such as AIMA will obtain the benefit of the accumulated hedge fund know-how in Cayman. This expertise resides not just in Cayman, but worldwide through the users of Cayman (such as yourselves) and their dialogue with Cayman service providers engaged in the hedge fund industry. I hope that today’s discussion will be an extension of that dialogue and will lead to greater mutual understanding between industry and the key offshore regulator.

So, at this point I would like to hand over to Gary Linford, head of the Investment and Securities division of the Cayman Islands Monetary Authority.

Cayman Islands Monetary Authority Regulatory Philosophy
By: Gary Linford
Head of Investment & Securities Division
CIMA

Distinguished guests, ladies and gentlemen – Good afternoon.

With all the meetings and events that surround this week’s Hedge Funds World Conference, I know your time is at a premium and therefore I thank you for attending this Ogier- sponsored function.

One of the main reasons for accepting the opportunity to speak at such gatherings, is to ensure our regulatory philosophy with respect to the investment industry, particularly hedge funds, is understood. At the Cayman Islands Monetary Authority (“CIMA”) we monitor the source of hedge fund business very closely to ensure we engage with those markets and jurisdictions that direct business to the Cayman Islands hedge fund industry.

Hong Kong is one such jurisdiction and I will be spending the next few days speaking with local service providers to Cayman hedge funds and obtaining feedback on the proposed changes to our regulatory framework. This is to ensure we maintain the appropriate balance between the needs of the investors and that of promoters as well as other stakeholders in the global hedge fund industry that might be impacted by the actions of service providers to Cayman regulated funds. Indeed, we are mandated by The Monetary Authority Law to undertake formal consultation with industry on any changes to the regulatory framework and this we do. However, we go beyond this and consult widely, on an informal basis, and this is part of the reason for my participation in this afternoon’s roundtable – not only to share my thoughts from the perspective of a regulator of 8,000 hedge funds but also to listen to you and learn more on the direction the Hong Kong hedge fund industry is moving.

Let me quickly remind you that the remarks I make today are generally my own and are not necessarily the thoughts or policies of the CIMA or that of my colleagues, one of whom is with me this afternoon, Judiann Richards.

Before we begin the roundtable, I would like to take 20 minutes or so to discuss the following three issues

1) Our regulatory philosophy towards hedge funds

2) The Goldstein decision in the USA

3) An update on our proposed changes to the regulatory framework governing the fund industry in the Cayman Islands

It is important to note that while our regulatory framework allows for both public and non-public funds, we have very few funds that seek a license under the more prescriptive regime appropriate to retail funds. Most of my comments today therefore relate to hedge funds that are targeted at the non-public investor, whether institutional or high net worth private individuals and are authorized by CIMA as registered funds, typically with a minimum subscription of US$1.0 million or more.

With the Hong Kong market keen to allow retail investors access to hedge funds, I wish to take this opportunity to remind all present that our regulatory regime does cater to this target market. We have what we call an “administered fund” – or for the lawyers in the audience - our s 4 (1) (b) fund, where the responsibility rests with a CIMA licensed fund administrator to ensure a) each promoter of the mutual fund is of sound reputation, b) the administration will be undertaken by persons who have sufficient expertise and c) the business of the mutual fund will be carried out in a proper way. With an “administered fund” we regulate the licensed fund administrator with a physical presence in Cayman who in turn is responsible for looking to the interests of investors. As a service provider already licensed by CIMA has conducted the initial due diligence and will provide ongoing monitoring of the fund in accordance with s16 of our Mutual Funds Law, the approval process to set up such a fund is very quick – typically less than five days.

Our regulatory approach for the sophisticated, non-public funds is “lighter” than our approach to retail funds because for the non-public funds there is either an additional measure of supervision such that another party provides oversight, for example, an approved stock exchange for funds that are so listed, or the investor is considered to be sufficiently sophisticated and capable of performing its own due diligence (because of the minimum subscription amount).

Our overriding regulatory objective for non-public funds is to compel proper disclosure by fund operators so that investors are not misled about the nature of the risk taken. The objective is achieved chiefly by requiring these funds to prepare and file offering documents that describe the equity interests in all material aspects such that a prospective investor may make an informed decision whether or not to subscribe. The principle of “buyer beware” is paramount, since it is the investor, and not CIMA, that is responsible for its own due diligence on a fund’s service providers, promoters, operators, strategy, risk-profile, track record, etc. With the debacle at Refco Inc, which, lets be clear, had nothing to do with hedge fund risk, more accounting irregularities or fraud at a US listed company, some 30 or more Cayman hedge funds were left with counter party exposure to the brokerage and cash management divisions of Refco. For some funds the exposure was fatal and they have commenced liquidation or have suspended redemptions and await creditor claims to be settled, others have managed to side-pocket the claims against Refco or sold out to distressed debt hedge funds. Notably, CIMA has not received one investor complaint. Why? Because the professional investors knew what they were buying and the offering document highlighted these risks. Disappointed investors – sure, aggrieved and looking to the regulator for help, no. An interesting consequence of the Refco debacle is that trading and cash management is increasingly spread amongst a number of prime brokerage houses, as hedge fund managers are now more alert to counter party risk.

Promotion of separate regulatory frameworks between non-public funds, such as our registered funds on one hand, and public or retail funds on the other hand, will allow the innovation, flexibility and creativity of the traditional hedge funds to prevail while also allowing access to funds of hedge funds by retail investors to progress under a more prescriptive, rule based, regulatory regime.

There has been considerable press coverage of late on the number of hedge funds closing down. Earlier Peter Cockhill, of Ogier, provided the impressive growth statistics on the number of new funds being established, some 37 per week. It should be no surprise to all of you that our friends in the press have instead focused on the increase in funds closing. Let me say that CIMA does not view the high fund closures with alarm, as we believe it demonstrates our industry is working, where sophisticated investors do not allow poor performance to go unpunished.

Of course, not all 600 terminations will be a result of poor performance. Many funds are simply unable to attract sufficient capital to commence trading and others reach the end of their useful life. In addition, ahead of the introduction of E-Reporting, CIMA is working hard on clearing a number of dormant funds from our list of active funds so do not be alarmed should the press misuse this number of fund closures in support of their never-ending suggestion that the hedge fund success story is over. In fact, our termination of approximately 600 funds in 2006 while authorizing 1,800 is almost the same percentage as the 13-year cumulative average - where we will have terminated a little less than 4,000 of the approximate 12,000 authorized since the fund legislation was introduced in 1993.

Where the barriers to entry are low, particularly cost of capital and regulatory, then it is understandable that more hedge fund managers will get into the game that possibly should not. As long as the lower barriers to entry from a regulatory perspective relate to professional, non-public funds, it is my view that investors can take better care of themselves than any regulator and can probably do so at lower cost. As long as we are establishing three times as many funds as we are closing, and frauds are kept to a minimum, I am not concerned with the current level of terminations.

When the FSA first set out its perceptions of the regulatory risks posed by hedge funds in 2005, it offered no convincing evidence at that time to suggest that hedge fund managers are likely to cause any more disruption to the market than other players - yet the FSA attributed a number of significant risks to the hedge fund sector. There is no rationale to justify a different regulatory focus for hedge fund managers from that applicable to other investment managers, or indeed other market participants.

Thankfully, the FSA views in their feedback to the 2005 consultation provided earlier this year reflect the commonsense approach that is needed for the regulation of hedge funds. At a time when IOSCO, FATF and the FSF continue to warn of the systemic risks posed by hedge funds, it is heartening to hear other national regulators have taken the time to understand the industry and provide some balance to this argument. This change in view at national regulator level is no more evident than with the new Chairman of the U.S. SEC. Let me quote from his statement on the 25^th July 2006 to the U.S. Senate Committee on the Regulation of Hedge Funds:

“Hedge funds are not, should not be, and will not be unregulated”. However, Mr. Cox went on to say, “I would counsel that to the maximum extent possible our actions should be non-intrusive. There should be no interference with the investment strategies or operations with hedge funds, including their use of derivatives trading, leverage and short selling. Nor should the federal government trammel upon their creativity, their liquidity or their flexibility. The costs of regulation should be kept firmly in mind. There should be no portfolio disclosure provisions. Hedge funds should be able to continue to charge their clients performance fees, just as they do now.”

I could not have articulated this better myself and yet, what Mr Cox suggested to the US Senate less than two months ago is our core regulatory philosophy to the hedge fund industry and has been for the last 13 years. This is the reason we have 8,000 active funds.

I share similar views to Mr. Cox when it comes to the issue of “retailization” which I understand to be a little at odds with the UK FSA and the HK SFC, where both regulators see some merit in retail participation in hedge funds. I do not think we should “regulate away” the current concerns with hedge fund valuation practices, the conflicts in determining fund performance fees, other inherent conflicts of interest found in many hedge fund structures and the higher risk that accompanies a hedge fund’s expected higher returns – these are simply not investments for Mom and Pop. Thankfully Mr. Cox does not advocate eliminating such risks; rather he proposes to limit retail investor’s exposure to these risks while promoting an improvement in “best practices” in the area of NAV calculation etc. One way to minimize retail exposure is to amend the current definition of “accredited investor” and Mr. Cox has suggested raising the net worth suitability threshold from $1 million to $1.5 million.

While I agree with this suggested increase in the net worth requirement for the U.S. market, it does not necessarily work in all markets. It is for this reason I have my reservations with the suggestion in the feedback to the FSA discussion paper that it might be advantageous to better coordinate regulatory consultation to minimize further fragmentation in regulatory requirements for hedge funds. While such an approach may reduce the likelihood that industry players will be subject to widely differing regulations, global regulators need to be careful that in dispensing guidance we are not forcing the hedge fund industry into a “one size fits all” approach. With Hong Kong and other jurisdictions pushing for retail investors to be given access to funds of hedge funds, I believe further differentiation between the retail and sophisticated market needs to be encouraged. Any attempt to harmonize hedge fund regulation could very well have adverse effects on innovation.

The one area I strongly disagree with the U.S. SEC is their requirement for non-U.S. hedge fund managers to register with the SEC when they have 15 or more U.S. investors. Since the US Court of Appeals vacated the hedge fund manager registration rule in the Goldstein case, I am not aware if the SEC is still wedded to the idea of regulating non-US investment managers. It is my belief that the SEC should work with regulators like the CFTC, UK FSA, HK SFC and others to avoid such duplicative regulation.

This extraterritorial nature of the former registration requirement of the SEC is not helpful and the US authorities should be mindful of unintended consequences. Good intentions do not mitigate disastrous outcomes – one need look no further than the introduction of Sarbanes-Oxley in the USA. According to Paul Atkins, SEC Commissioner, the actual costs of compliance were 20 times more than the SEC estimate when it first introduced the legislation. The SEC Commissioner went on to quote the Wall Street Journal that up until the year 2000, nine out of every ten dollars raised by foreign companies through new stock listings were done in New York. By 2005, the ratio reversed such that nine out of every ten dollars are raised outside of the USA. I am sure all of you know this well as I believe the Hong Kong Stock Exchange is probably a huge beneficiary of Sarbanes-Oxley.

OK, let me now turn back to Cayman and talk a little about the latest developments in our jurisdiction.

Some 85-90% of our 8,000 regulated funds have a December year-end. With most funds taking the full six months or more before they file the audited accounts, it is July and August when we receive approximately 6,800 sets of audited accounts through the post or by fax. With each set of audited accounts running to 50 pages or more, you can imagine what my division’s daily in-tray looks like. Our new electronic reporting initiative is designed, in part, to improve the efficiency in handling these accounts.

For the past several months, we have invested heavily in structuring the E-Reporting proposal, and in the last week of August, we signed with an IT vendor to deliver the business requirements set out in the public RFP. We expect a tested system to be in use by 31^st March 2007.

The industry’s stakeholders, particularly lawyers, auditors, and fund administrators, regularly ask us for current statistics concerning the Cayman Islands funds industry, such as size, growth, change, market share, and investments by and in funds. At the same time, international bodies such as the International Monetary Fund continue to ask financial centers around the world to provide aggregate statistics so that they may understand and map macro-economic and global financial flows. The data we collect from E-Reporting will provide that kind of information. In fact, I believe that the information that we will be able to supply (once the new system has been running) will be better in quality and quantity than any other hedge fund jurisdiction.

We have taken great care to ensure that E-Reporting does not increase the scope of regulation. We are aware that our regulatory philosophy is a significant factor in Cayman’s success as a hedge fund jurisdiction, and we are seeking to make it more efficient, and even more cutting edge.

Our E-Reporting Proposal asks all regulated funds to submit their Annual Audited Financial Statements to CIMA as a PdF through a secure electronic transmission. In and of itself, this is not cutting edge, and should not pose any concern for any party. It will, however, reduce the physical storage space that CIMA requires. In addition, with the growth rate in CIMA-regulated funds, electronic reporting will also enable the Authority to maintain the appropriate supervisory capacity without a proportionate increase in staff.

CIMA also proposes that 32 specific data items be reported on a web-based electronic form.

This list of questions can be found on our website. You will note that approximately half of the data should be contained in any set of financial statements, and the other half is an update to information that is generally in a funds’ offering memorandum or registration documents.

In this way we are hoping to be able to provide some useful statistics for the 8,000 funds we expect will be active as at December 2006. For example, it should be possible to highlight the subscriptions versus redemptions for a particular year, for a particular investment strategy, for all funds or a group of funds in a specific geographic location, say hedge funds associated with distressed securities managed out of Hong Kong. We should also be able to compare expense ratios of, say, single managed funds to fund of funds and be able to produce useful statistics on the number of funds that receive a qualified audit.

The funds will file their financial statements and the key data through their locally approved audit firms. There are 24 such firms approved by CIMA. While we are asking the auditors to file the key data and PdF of the audited accounts with us, we will stipulate clearly in the regulations and guidance notes that the legal responsibility to provide the information remains with the operator, in keeping with the operators’ other obligations under the Mutual Funds Law. We have had preliminary talks with the USA SEC to ensure the filing of data by auditors on behalf of the operators will not be a breach of the SEC independence rules for the auditors.

We have worked hard to ensure the impact for the fund and its service providers, both in terms of time and cost, is minimal and we are confident that compliance with this new process for submitting audited accounts will be good. Information submitted to CIMA has always been and will continue to be managed in an extremely confidential manner. In no way will fund- or manager-specific information be made available to the public, only aggregate industry statistics.

The Mutual Funds (Amendment) Bill, 2006 has been drafted and will shortly be tabled before the Cayman Islands Legislative Assembly. There are no major changes to our fund regulatory framework. The Bill proposes:

· An increase in the minimum subscription for Section 4(3) funds from US$50,000 to US$100,000.

· An amendment to the definition of “carrying on business in or from the Islands” to allow a foreign-domiciled fund to be administered in the Cayman Islands without the need for registration with CIMA.

· An amendment to allow CIMA to specify the manner in which audited accounts are to be transmitted. This is to cover the E-Reporting initiative I discussed earlier.

· To give CIMA the discretion to waive the requirement for an annual audit to be submitted

· To empower CIMA to cancel the registration of a mutual fund in certain circumstances, if, for example, the fund is carrying on business in a manner prejudicial to its investors.

· To obligate an auditor to notify the Monetary Authority if, in the course of carrying out an audit of the accounts, the auditor obtains information, or suspects that a regulated fund is

1. Insolvent, or likely to become so

2. Carrying on business, or effecting a voluntary winding up, in a manner prejudicial to investors or creditors

3. Not keeping adequate, auditable accounting records

4. Carrying on business in a fraudulent or criminal manner, or without due compliance with pertinent Laws and licence conditions

There are other minor amendments but the ones I have mentioned will be of interest. Sadly for you lawyers, we have “grand-fathered” all existing funds in respect of the increase in the minimum subscription so there will not be a need for you to update 8,000 offering documents.

In Cayman, our fund administrators often look after the offshore fund in a Master-Feeder structure involving an onshore fund, for example Delaware. Where the U.S. promoter wants the Cayman administrator to look after the books and records of the domestic fund, our legislation requires the Delaware fund (or BVI fund in case of some Asian structures) to register with CIMA. The Bill seeks to remove this impediment and allow our administrators to take on more business in the Cayman Islands without imposing Cayman regulatory requirements on foreign funds. Sensibly, however, the Bill proposes that we limit such derogation to foreign funds from countries approved by CIMA. To avoid duplication, we will probably make use of our Schedule 3 list that is currently used in determining appropriate jurisdictions for Anti-Money Laundering purposes. I am certain Hong Kong will be on this list.

The existing legislation requires a fund to submit audited accounts on an annual basis and gives CIMA no discretion to vary this condition. Let me be clear, CIMA has absolutely no intention on waiving the need for audited accounts due to cost reasons, or because all investors so agree, or because audit firms have not completed the audit in a timely manner or the audit firm unexpectedly resigns. This waiver will only be used for exceptional circumstances.

The existing legislation does not allow CIMA to terminate the registration of a regulated fund if we believe circumstances so warrant. CIMA does not have a heavy-handed enforcement style. We typically look to the corporate governance structure of a fund to resolve any issues and generally work with the service providers to a fund to find a cost-effective solution to complications that arise from time to time. There are some of you in the audience who have had experience in working with me, on so called “problem funds” that can attest to CIMA’s approach to enforcement. Thankfully, it is only occasionally that a fund promoter or operator will walk away from a fund prior to terminating the fund in compliance with our requirements. If there are still investors in such a fund, we will typically ask the Court to appoint a Controller to effect an orderly liquidation. However, where the assets have been redeemed it will not be cost-effective to go through the Court and this amendment will now provide CIMA with the authority to terminate the fund, where circumstances so dictate, and to do so as an enforcement action, with the names of the promoter and/ or operators posted to our website.

The whistle-blowing responsibilities of an auditor that I mentioned earlier already exist in the current law. However, it is proposed that the obligations be extended to include reference to an auditor that was engaged to carry out such an audit but resigned before carrying out the audit or whose contract was otherwise terminated. It will therefore be important for an auditor to withdraw the Letter of Consent that is provided to CIMA if an auditor wishes to limit their exposure. Until CIMA is notified that an auditor no longer acts for a fund, the liability attached to the whistle-blowing obligation remains. In the past the liability was limited to a fine, payable upon summary conviction but the Bill now empowers CIMA to disqualify a firm, temporarily or permanently, from being an auditor to a regulated fund.

The changes in the law proposed by this Bill follow many of the findings of the Mutual Funds Working Group that was made up of representatives of relevant private sector associations and senior personnel from CIMA. When considering such recommendations we recognise the need for proportionality and that any benefits to be obtained from amending legislation, regulation or policy should exceed the burden imposed on the industry. We believe we have retained all the flexibility and attractiveness of the existing legislation. Indeed, we believe we have added to it with the proposal to allow CIMA to waive audits and allow foreign funds to be administered in the Cayman Islands without the need to register, while enhancing the scrutiny obligations imposed on service providers. We will also be in a position to provide meaningful, credible statistics on the global hedge fund industry once the E-Reporting initiative has captured the December 2006 audits. I suspect CIMA will be ready to provide aggregate statistics in a year from now – perhaps at the 2nd Annual Ogier-sponsored HK event in 2007?

I am confident that the global hedge fund industry will continue to grow and that the Cayman Islands will remain the jurisdiction of choice for the domicile of funds. We do not see centres like Hong Kong as a threat to our business and we welcome the appointment of Hong Kong based investment managers, administrators and operators to Cayman domiciled funds. I remain convinced that our regulatory philosophy towards hedge funds remains attractive to all and continues to balance the needs of investors, promoters, operators, investment managers, prime brokers and fund administrators while increasingly finding favour with national regulators who come to realise the benefits the hedge fund industry has to play in our global financial system.

You have been a very patient audience, and I appreciate your attention. I trust you will participate actively in the roundtable format that follows by asking a number of difficult and probing questions of E&Y, Fortis and Ogier while giving me the easy ones.

Thank you.

Gary Linford

Amaranth Implosion

An interesting perspective on the Amaranth debacle can be found at this blog.