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