Much has been written about how Sovereign Wealth Funds (“SWFs”) have developed over the years. But from the establishment of the Kuwait investment Authority in 1953 to those being currently developed or being contemplated, one overriding issue has always been at the fore – what is the optimum model for oversight and accountability – in effect ‘governance’. Different models apply for this also, but notwithstanding the differing set ups, the different cultures, the different purposes of Funds across the world, there are generally a number of key areas that need particular attention. This article examines some areas of such attention – and suggests some areas of emphasis.

First, it is worth considering why governance is so important. Although SWFs are governed by their own by-laws, normally set out in the formatory legislation creating the SWFs, SWFs will generally not be regulated by financial services regulators, since they do not have clients and merely act as asset owners investing for their own account. And, partly as a result of the lack of transparency that is a consequence of not being regulated by financial services regulators, over many years SWFs have developed a reputation for secrecy about almost all areas of their activities, including governance. That trend is now reversing, since all stakeholders – be they the citizens of the country whose assets are in the Fund, the government of the country, co-investors, partners, even employees, are keen to understand how oversight and accountability works. And if a SWF wants to be a successful participant in the world’s financial markets, and wants to have access to the best investments, it needs to be trusted. It will only gain that trust – and credibility – if it can demonstrate that it is subject to proper oversight and accountability. Getting this right will open doors to successful investment returns, getting it wrong will result in it being treated with suspicion and being cold shouldered by its stakeholders. There are many studies which indicate that for a commercial institution, good governance reduces the cost of capital and improves access to capital – nothing is different for SWFs, but they have the added aspect that they do not necessarily always have to raise capital on open markets, so sometimes that motivation of getting governance right to unlock that access is not as strong as it might be. The Santiago Principles – established by the IFSWF back in 2008 – are very helpful guidance about how good governance should work at SWFs. However, there are many practical considerations which can help achieve good governance also.

It is always worth remembering what ‘Governance’ is there for – the word ‘Governance’ derives, ultimately, from the Greek verb ‘kubernaein’, meaning to steer. Governance is all about setting and steering the organisation in the right direction; it is not therefore micromanagement of specific decisions, instead it is more about ensuring the right structures, delegations of authority, policies, processes and oversight practices are in place and are effective. And best decisions in relation to governance are made by groups of persons, not individuals acting alone – although of course sometimes there have to be exceptions.
The main areas where oversight and accountability comes to the fore are:

• Parliamentary Oversight;
• Appointment of the Chairman and the Board;
• Oversight of the Board;
• The need for a ‘Governance Strategy’;
• The three most important policies of a SWF;
• Oversight at Executive level;
• Alignment with the Santiago Principles;
• Other issues.

Parliamentary Oversight

In many countries with SWFs, the Parliament or other state body representing the people will want to have some oversight of the SWF and its activities. This is very understandable, as the SWF is in effect investing the funds of the citizens of the country – and indeed the activities and investments of a SWF will be a matter of keen public interest. The challenge is to find a mechanism that can provide that oversight but with efficiency.

A good method here is to create a mechanism whereby oversight is provided by those with some expertise in the financial sector. Some Parliamentarians may have backgrounds in business or finance or law or accountancy – and it may be helpful to provide training for others so that they are conversant with some of the technical aspects of the investment world. If a Parliament can find a mechanism to elect a cadre of representatives to a Parliamentary Oversight Committee of the SWF, including those with specific finance expertise but also some ‘lay members’, then that can provide a good combination. This can be similar to the Select Committee model that is used in the UK Parliament – introduced in its modern form in 1979, this provides a way for Parliament to oversight specific government departments or agencies, and is widely seen as successful.

Appointment of the Chairman and of the Board

The processes for this will normally be documented in the legislation setting up the Fund. But it is worth noting that a SWF can be as impactive and as high profile in some countries as the Central Bank, so if designing a structure from scratch, a model for appointing the Board of the SWF could be similar to that for appointing the Board of the Central Bank.

One model is that a Minister is the Chair, and is appointed by the government. The other Board and Board Committee members, including the Chief Executive Officer – or Governor – are appointed by the Chair through a traditionally Board selection process – but if the Minister is not the Chair it is helpful all such appointments are with Ministerial consent.

In appointing the rest of the Board, role specifications should be identified, and appropriate candidates sought. Any Board, to be effective, needs a mix of skills and experiences in its composition – for SWFs these may include persons with backgrounds in investment, finance, the public sector, governance, all with the ability to bring best practice in their own areas of expertise, and contacts for outreach, to the table. The Board should end up being a combination of ‘networkers’ – who can add value with their previous experiences, skillsets and knowledge of particular sectors, projects and practices in providing advice and guidance on how things can be done better, and ‘challengers’, who are able to use their experience and skills to challenge appropriately with knowing the right questions to ask in any specific situation and are not afraid to speak up.

In many situations there is also a strong case for creating and appointing an ‘Advisory Board’. This is a separate grouping of individuals who can provide advice and guidance to the SWF on specific areas without legal liability issues. They can be brought together periodically – and would potentially consist of experts in outreach, specific investment type opportunities, governance, ESG, and also can include stakeholders from outside government – for example representatives from a civic society and other groupings which could provide helpful input into the SWF’s strategic thinking. This grouping can become a useful consultative forum to the Board, and can include overseas expertise in the particular subjects, thus enabling international expertise to be garnered without such individuals needing to be on the Board of the SWF, nor for expensive consultants to be appointed.

Board level governance

Here traditional Board governance tools can be used – but for a SWF key areas where there is added risk and therefore emphasis required is that it must be expected that Board members – who are highly qualified individuals whose skills, experience and judgement can assist the SWF in achieving its objectives – will have other professional responsibilities, perhaps in public office. And these interests may conflict with their duty to the SWF. However, they are appointed to the Board in their individual capacity – not as a representative of another government department, and there needs to be an understanding of the difference between ‘vested interests’ – which are interests which are known about, cannot be avoided, and arise because of public office – and potential ‘conflicts of interest’ which normally arise because of commercial interests. The former can be dealt with on the basis that they are understood by all Board members, the latter need to be disclosed as needed and measures need to be put in place to address these. Protocols need to be established to achieve this – and a specific Code of Conduct for Board Members is a useful vehicle for this.

Some key areas where Boards should keep in view duties and responsibilities are as follows:

Ensuring that, practically, the external auditors’ prime relationship and duty is to a governance Audit, Risk and Compliance Committee (“ARCC”) – rather than to the Board as a whole or the Executive. External audit firms also sometimes have governance or other issues arising within them, and it is helpful to have these explained by the firms as and when they happen – so that the SWF can be assured that there is no impact on the firm’s ability to discharge their responsibilities to the SWF;

• Ensuring that professional advisers are fully clear about to whom they owe their duties – the Board may find it helpful to consider using separate advisers who are not potentially aligned to the Executive for sensitive matters;
• Creating standardised Board reportage from the Executive, including regular reportage from the CEO, other disciplines as appropriate, and reportage to the ARCC from Finance and Governance functions;
• Ensuring that the Board paper submission process does not become a ‘sanitisation’ process;
• Having Board members spend time with the SWF’s departments;
• Ensuring the expenses of the most senior persons are reviewed by the ARCC or the Board;
• It is also helpful to demonstrate inclusivity to the Board members by seeking periodic feedback from Board members regarding the operation of the Board;

The need for a Governance Strategy

Many organisations regard ‘Governance’ as a ‘Hygiene Factor’ – ie something that everybody does and knows how to do because that is how they have seen it done throughout their career elsewhere, and there is no need to change habits and practices now. There is therefore a real risk of thinking that it’s just a necessary process, with no one really thinking it through properly, and perhaps nobody really paying too much attention to it.

But that is not the right way to approach ‘Governance’. ‘Governance’ is a ‘discipline’, just like any other business focus – such as Investments, Finance, Operations and the sub-categories thereunder. It too needs a Vision, a Mission Statement, a Strategy, a Plan, a Roadmap with milestones and all the other aspects of corporate project implementation.

And for a SWF it should start with a ‘Governance Risk Assessment’, which drives the priorities, structure and detail, including matters specifically applicable to the SWF such as:

• Alignment with the country’s ‘National Development Objectives’ – by whatever name – these could include matters such as:
• Increasing employment for nationals;
• Ensuring international investment has a demonstrable return into the country in terms of expertise as well as simply monetary;
• Alignment with other government aspirations, such as climate change considerations, education benefits, gender diversity in the workplace etc;
• Specific legal, regulatory and other constraints applicable to government agencies such as data sovereignty laws (which potentially affect the Fund’s activities if the data is deemed ‘government data’), state secrecy laws (which potentially place more restrictions on government data confidentiality than in a private sector corporation);
• Required observance of government practices on other specific matters – for example procurement practices;

A standard best practice model for governance within a financial institution – and is suitable for SWFs – is the ‘Three Lines of Defence Model’, defining roles of a:

• 1st line of defence whereby business leaders at executive level are responsible for establishing and maintaining effective control environments within their areas of responsibility;
• 2nd line of defence whereby oversight control functions of Risk and Compliance, advise on and oversee accountable areas, review the controls environment, have stewardship of company-wide risk and compliance policies, and independently investigate and resolve incidents across the institution. A Board Committee, on behalf of the Board, will oversee these functions.
• 3rd Line of defence whereby an Internal Audit function ,a as an independent functions reports to a Board Committee on the controls effectiveness, and provides assurance on the workings of the 1st and 2nd lines.

Organisational Design

One of the first priorities will be to create an Organisational Design to incorporate effective but proportionate oversight and governance. A sample design is as follows:

As can be seen the idea here is to have a traditional structure with a Board and Board Committees and then with a CEO running the executive functions. Whatever the structure, in general there are pillars for Investments under a Chief Investment Officer, for Finance under a Chief Finance Officer and for Operations under a Chief Operations Officer. There are many other functions which could normally report into a CEO – Public Relations, Strategy, and the like, but in order to reduce the number of direct reports of the CEO, these have been garnered under a Chief of Staff, who in effect becomes the co-ordinator for the CEO of all the various functions – thus leaving the CEO time for outreach, dealing with stakeholders and strategic issues.

The three most important policies of a SWF

In any institution, there will be a Delegation of Authority, determining – amongst other things – which policies need to be approved by the Board, and which can be delegated to the CEO and Executive Management. There are a myriad of policies to be concerned about, but it is generally accepted practice that the Board should set the three most important policies at a SWF – policies which should not be delegated to the Executive to design and approve.

These policies are:

• The Investment Policy Statement – this will include:
• A Sanctions Policy, indicating which jurisdictional sanctions the SWF chooses to comply with – for example, US, EU, UK. The Sanctions policy should generally follow that of the SWF’s host country;
• Diplomatic Restrictions – there may be countries which the SWF’s host country does not deal with, or has not got diplomatic relations with, this should again be aligned to the country’s governmental policy;
• Financial Product Restrictions – this is where a policy states whether or not the SWF should invest in specific products such as crypto-currencies, derivatives etc or in what circumstances;
• Investment Categories – there may be desires not to invest in specific categories, either because of local legislation – eg organisations with material revenues from alcohol, gambling, pornography, military weapons and the like or, indeed, recognising the prohibition of investment into tobacco under the UN Convention. Other categories exist also.

• The Risk Appetite Statement – this sets the authorised parameters for the taking of risk, and establishes a structure for measuring and reporting deviations.
• The Code of Conduct – this sets the behavioural guidelines for all employees of the Fund. As noted above, a separate Code of Conduct for Board Members can be very helpful also.

Oversight at Executive level

Once the Board is in place, and the CEO has been appointed, the next task is for the CEO to create a Management Team and establish an Executive Committee, define a ‘Delegation of Authority’ schedule, and then begin to establish sub-committees such as the important Executive Investment Committee, which should consider all investments prior to their being reviewed by the Board

The three lines of defence model, as noted above, can be a helpful way to ensure that responsibilities for executive level governance functions such as Risk, Compliance and Internal Audit are laid out, together with Divisional Management responsibilities being articulated and well understood.
Roles, policies and processes for relevant areas can be defined, in particular:

• The Investment Process;
• Underlying policies of the Code of Conduct – including Financial Crime issues such as bribery and corruption and ani money laundering policies, confidentiality requirements;
• Other divisional policies as for any corporate organisation, ensuring internal controls and checks are embedded therein;

Monitoring architecture needs to be designed and implemented which can provide the Board with confidence that the activities of the Fund are being oversighted effectively by the CEO through the Executive Committee and the governance functions. Providing such confidence to the Board is absolutely key to the success of the Executive!

Alignment with Santiago Principles

The Santiago Principles represent an excellent guide as to the areas to be addressed in respect of being able to demonstrate overall good governance at a SWF. But they can look quite daunting at first glance, and may seem quite challenging to reach a point of full compliance with them all.

Full compliance will not happen instantly, and indeed there may be some areas where – by reason of the purpose, set up or driver of the SWF – there may be no expectation of full compliance for a number of years. So, like other areas of governance, it is helpful to have an aspirational level of compliance with the Principles and a timescale and put in place a roadmap to chart out the journey to get there.

Although some institutions like to measure compliance on a ‘Principle by Principle’ basis with judging percentages against each Principle and sub-Principle, a good overall sense of the state of alignment can be arrived at by simply analysing all the Principles and measure compliance through using the IMF categorisations of Fully Compliant, Partially Compliant, Non-Compliant – showing aspirations for the coming years, for example.

This format also makes it easier for reportage – it becomes simpler to make visually impactive for Board presentations, for example. Boards should request reportage on the Principles as a Standing Agenda item, perhaps initially after commitment to the Principles on a quarterly basis, but after a couple of years on say a six monthly basis.

Other issues

Lastly, getting proper oversight and accountability embedded into any institution is a journey, and as such the road is subject to trip hazards, pitfalls and potholes. ‘Stuff happens’, as the phrase goes – for example, some appointments of key individuals may not work out, external market factors may present other impediments, relations with stakeholders may not be a successful as wished, and incidents can occur.

But as long as the institution is on a path that is ‘directionally correct’ in terms of governance, with a proper strategy, plan and roadmap, then it’ll get there in due course.

Everyone is keen on promoting the need for integrity in the financial markets – and much has been written on this topic over the years, normally when scandals occur. Then there is usually a regulatory investigation – and/or a criminal investigation by the authorities about what went wrong, and what the root cause of the failure was. And so lessons are supposedly learned and measures are put in place to ensure that the whole system is tightened up so that the risks of such a failure occurring again are considerably lessened.

Everyone is keen on promoting the need for integrity in the financial markets – and much has been written on this topic over the years, normally when scandals occur. Then there is usually a regulatory investigation – and/or a criminal investigation by the authorities about what went wrong, and what the root cause of the failure was. And so lessons are supposedly learned and measures are put in place to ensure that the whole system is tightened up so that the risks of such a failure occurring again are considerably lessened.

But perhaps what we do not do enough of – either on an institutional basis or a marketwise basis – is try and measure integrity. ‘What is integrity?’ is the key question here; everyone has their own idea and definition thereof. But there is a compelling case to say that ‘Integrity’ equates for this purpose to ‘trust’. Because without integrity, an institution will not be trusted, and if you have earned the trust of the market, you have earned the right to be deemed to have integrity.

On the world financial state, there are unregulated actors – for example, Sovereign Wealth Funds, governmental bodies and major investors who do not act on others’ behalf and can therefore avoid the need for regulatory oversight. For these organisations to be credible participants on the world stage they need to be trusted. And in order to be trusted, an institution needs to demonstrate and promote itself as adhering to the rule of law and to the rules of the market – and to manage its own affairs in an orderly manner and in compliance with proper governance rules. There is a commercial benefit here also – from an overall markets’ perspective, those with good governance – and trust – will generally have lower rates of capital than those without.

So the question becomes – how do we measure trust?

This can be achieved on a bottom-up basis and a top-down basis.

From a bottom-up perspective, ie at institutional level, there are many incidents that can happen and dent a reputation. And, of course, it is important to remember that sometimes it’s not what actually happened that’s important, but what the stakeholders – in this case other market participants – think what the case is. Hence a PR Department in any credible institution will have lots of tools to measure what the press and commentators think. They – and top management – are concerned about ‘Reputation’, but of course that word covers many aspects – for example, adverse media comment vs positive media comment, surveys conducted of interested stakeholders, as well as internally known issues relating to Sanctions breaches, insider trading propensity, market manipulation allegations, bribery and corruption investigations, and regulatory compliance issues, to name but a few. And ‘Reputation’ – say in an investment institution – also covers factors such as investment performance, employee contentment, vendor relations (including prompt payment history!), as well as market conduct, bribery and corruption and compliance.

But Boards do not need a chapter and verse on each of these issues – so the best way is surely to create an ‘Integrity Index’, and track how this moves. This avoids having to get too granular in reportage, but a weighted composition of incidents and investigations known about internally, together with external reputation scores, can construct such an index. It doesn’t need to be scientifically accurate to the last delta, the important measure from the institution’s perspective is how the index moves over time. Some examples of what can go into this index could be past incidents of integrity failures, both at employee level and at institutional level, reputational profile (including Board and C-Suite personnel), current internal ongoing issues, whistleblowing incidents, and governance failings at the institution itself and at those investments which it controls.

From a top down perspective, there is no reason why such similar indices cannot be constructed by the regulatory community across markets. We can then compare integrity across marketplaces, applying a factor to take into account the nature, size and complexity of whichever market is considered.

So, assuming that we can do all the above at institutional and market level, we end up with some indices and some comparisons across institutions and markets. But of course the key question is to understand what is the norm?  Viz, how do we decide what is an acceptable level of integrity? Arguably, this doesn’t really matter – just being able to compare markets, or institutions, would be really helpful and let market participants make their own mind up. As we all do at present, but on the basis of what we might call ‘anecdotal evidence’ rather than ‘empirical evidence’ scientifically analysed.

We’ve all been where we think ‘Not sure about dealing with x’; and if we have to, and can do so, we put in more safeguards than normal. The anonymity of the current market can hide matters – we’re a long way from the old days of the London Stock Exchange, for example, when if you saw, say, an individual from a low quality firm with a dodgy reputation wending their way towards you, you’d know instantly to widen your prices significantly. Similar antics happen in all markets today – just more discreetly, away from the public eye.

It all comes down to people at the end of the day – and their own integrity.  But we need to bear in mind the Rumsfeldian quotation about ‘known knowns’, ‘known unknowns’ and ‘unknown unknowns’. We can’t do anything about the ‘unknown unknowns’ – and as far as the ‘known knowns’ are concerned, the above index concept can cope with that. However, the prime issue of a ‘known unknown’ here is the base integrity of people.

Are we all fundamentally honest? Or do we comply only when there are checks and balances in a system which strongly encourage us to comply? Generally, surveys about people’s honesty tend to find that individuals seek mostly to avoid a dishonest action that would bring about demonstrable harm to another individual. However, that is not so much the case where, rather than individuals, it is only institutions that might be damaged – and a prime example here is making a false insurance claim if a person thinks they can get away with it. Another example would include the ‘black economy’ – significant in most economies – and non-disclosure of income for tax purposes. There may indeed be lots of checks and balances designed to ensure that people are not tempted to act dishonestly, but the fact is that the base integrity index across the entire population of the world may be quite low. This leaves aside the whole issue that behaviour demonstrating integrity in one jurisdiction may not be judged the same in another – as the old saying goes, ‘Different markets, different customs!’

Lastly, a thought about whether the markets will have more integrity in the years to come – or less? Transparency can be a blessing and a curse here – for example, more transparency occurs because of the rise of social media, the increasing speed of information delivery and assimilation – and this leads to there being less places for miscreants to hide. But there are also examples of less transparency – for example, the anonymity of the internet, and the increasing complexity of some transactions. But whilst there are integrity-challenged people out there in the world, we will always need to look for ways of determining where the integrity is, who has it and to what extent and who doesn’t, and the above might be a way to start measuring this consistently and analytically.

Speech by Richard Collins, Managing Director, Qatar Financial Centre Regulatory Authority, to 29^th International Financial Conference

Amman, Jordan, 09 March 2009

Thank you, Mr Chairman for those words of introduction.   I am delighted to be here today to talk about the Global Financial Crisis, and I would like to thank the organizers very much for inviting me here to speak, I would like to thank the authorities here in Jordan for their welcome and hospitality and lastly I would like to thank the audience here – in advance – for being patient and listening to me!

Much has been written and spoken about the global financial crisis, and the real challenge is whether there is much new to say – apart from the fact that since I prepared this talk and now when I am delivering it there has probably been some further event which changes the dynamics! But in all the material I have seen, at least one thing comes through loud and clear – there is no monopoly of wisdom on the topic, and therefore although of course there is a major risk of people here saying to me today that I am completely and utterly wrong in my views I feel that the canvas of opinion on this topic is sufficiently broad to withstand this! Even in my own organization, with people from diverse backgrounds and experience, I am sure there is no unanimity of view, and I have here to give the clear disclaimer that the views I express here are my own and do not necessarily represent the views of the Qatar Financial Centre Regulatory Authority.

I wondered therefore what take I could put on the subject so that everybody is not going to say ‘Ah, we’ve heard all this before’. I’ve come up with a structure which will include some things that people have heard of before, plus some of my own – possibly provocative – views, with a couple of new twists.  Clearly, however, I need to go a bit further than simply to say ‘the oceans are deep, the sky is blue, the mountains are high, and there is a big crisis out there’ – and so what I thought might be of interest in terms of headings is the following:

• Where we are
• Main areas of agreement on root causes
• Areas of divergence of agreement on root causes
• A brief discourse on ‘Chaos Theory’
• Some solutions – in train and proposed
• What needs to be done
• A zero-based approach to regulation
• A ‘New Style of Regulation’ for the future

Stand by for the chaos theory – speaking as a former mathematician to me it is interesting and I think there is some relevance!

Main areas of agreement on root causes

Hopefully we should be able to rattle through the main areas of agreement – which everyone will no doubt be aware of.

In essence over the years macro imbalances of large current account surpluses have built up in some countries versus large current deficits in others. These in turn have meant that high levels of savings have built up in economies in surplus requiring a necessary return on investment – thus the financial services industry, whose role in summary is to provide the conduit between those who are providers of capital and those who are users of capital, has been chasing higher returns by seeking greater innovation in investment. One way that this has been done in developed countries is to have encouraged a rapid growth of credit extension – this has led to a degradation of credit standards and the fuelling of property booms.

Within the industry, there has been stimulation of demand of securitized credit instruments and an expansion in the scale and complexity of such instruments.

The authorities, however, failed to realize the exponential increase in total systemic risk arising from all of this and thus, when there was a trigger event such as the defaulting on sub-prime mortgages in the US, the whole pile of cards started to come tumbling down. People across the world suddenly woke up and started to have an aversion to risk and began to think rationally again that 2 + 2 does not equal anything more than 4.  The reaction sets in and the asset bubble bursts.

In summary this is no different from any other asset bubble – whether one talks about Tulipmania in Amsterdam in 1636, the South Sea Bubble in London in 1720, the Wall Street crash in New York in 1929, or the dotcom stock bubble of 2000.  However, the components are different, and everything is on a macro scale affecting everywhere – so in fact we could say we are witnessing ‘the Mother of all Asset Bubbles’!

Now, all that above is about what has been happening in the economies across the world. But in financial institutions too there have also been a few problems:

• Flawed business models which were inadequately stress tested
• Shortcomings in risk management philosophy, structure and people in institutions
• Sub-optimal incentivisation schemes
• Weak oversight of financial soundness within firms
• Lack of appreciation of real impact of off balance sheet exposures

What do I mean by the above? Well, there have been a number of business models, for example by banks relying upon borrowing in the marketplace rather than from depositors’ monies (for example, Northern Rock in the UK) where things have gone awry.   Nobody thought to stress test the models properly – or took a naïve approach that there couldn’t possibly be a problem in the marketplace.

As far as risk management is concerned, there have always been issues with risk management within institutions.  What is it there for?   Is it there to challenge, to sanction, or facilitate? I well recall the thoughts of Nassim Nicholas Taleb, who memorably likened them in his book ‘Fooled by Randomness’ to compasses – ie they gave you the direction that the organization was going in, but all the real executive decisions were made by the executive. And this is right, because risk appetite should be set by the Board, implemented by the executive, and subject to governance and oversight by the risk management function. But very few, in my experience, have the real power of sanction. This all needs to be reviewed – risk managers must accept some responsibility for not shouting loud enough with their concerns if they had them – or if they didn’t have them, were the structures and people adequate? Some re-thinking of the whole philosophy of risk management and what it is all about is overdue – and not by the vested interests of risk managers!

There has also been much said about the sub-optimal incentivisation schemes where Tomorrow’s Share Price is put ahead of long term value. Again, this has probably been a contributory factor. So too was a weak oversight of financial soundness and liquidity exposure within the firms, and a lack of appreciation of the real impact of off balance sheet exposures.

Areas of divergence on the root causes

Whilst there has been general agreement on the main root causes, there are few areas of disagreement that I have been able to find, save one. And that one is really all about who is primarily accountable and responsible for the mess we are currently in. Who is to blame?

• the industry?
• the regulators?
• the central banks?
• the governments?

Frankly, I think it is a very brave person who says any one of these does not bear some accountability and responsibility. It is the question of degree.

• Industry contributed through governance failures, complacency, flawed business models, trying to commingle and combine differing risk models in consumer banking with investment banking, and the culture within some institutions;
• Regulators contributed through inadequate supervision philosophy, models and practice
• Central banks contributed through lack of oversight of liquidity and systemic risk to nations’ economies
• Governments contributed through over-stimulation of economies, fuelling of asset bubbles, encouragement of unsustainable consumer debt

Where the real divergence comes is in differing views regarding the degree of culpability of each of the above. Industry may well have a tendency to blame regulators, central banks and governments – anybody but the industry, in fact – whereas all of the authorities, as well as pointing the finger at each other, may well have a tendency to blame the industry. And I should make it clear that in talking about industry, I for one include not just the financial services institutions themselves, but also the accountancy and auditing profession who are supposedly responsible for ‘information integrity’ in respect of financial statements and the like disseminated to the public.

All of these organizational groupings are currently having naval gazing sessions to consider where, if at all, they went wrong and what could be done better. In some cases sweeping changes are being made – as for example with President Obama in the US taking a clean broom to the Securities & Exchange Commission, the UK FSA reviewing all its modus operandi, various banking institutions now with major government shareholdings having to consider their own internal practices, and the workings of central banks being reviewed.

My own view, for what it is worth, is that by logic the primary responsibility for the crisis must lie with relevant governments. It is governments that have fuelled the culture of debt economies and have poured petrol on the flames of asset bubbles through their encouragement of credit expansion.  As examples, the ‘top three’ in respect of household debt as a percentage of GDP are UK 240%, US 180%, Australia 174%.  Truly staggering.  It is governments that have established the philosophy of regulation which has been responsible for overseeing the industry – in some cases missing the issues because there was no mandate, for example, to look at business models. And it is governments that have realized, far too late, that consumers with banking deposits are taxpayers, who are also voters, and that the concept of significant retail banks being allowed to fail has now become redundant – and if governments had realized this earlier then I have no doubt that a different regulatory philosophy would have been in place in many jurisdictions. In other words, governments are the underwriters of it all. More on this later.

But none of the others are blameless – and I think we would all agree that there are a number of cases in the industry where leaders of institutions have seriously failed to live up to the standards expected.  When you see what has happened to Lehman Brothers, Bear Stearns, AIG, Royal Bank of Scotland, Northern Rock, HBoS, to name but some – it beggars belief for any of those at the helm of these organizations to cast around for others to blame. But they try! Apparently it’s all the fault of the regulators for not spotting what was going on and not informing them – I heard someone from Lehman Brothers at a conference last year spout exactly this line and indeed recently in a BBC interview the chief executive of AIG thought so also.

There are actions that can and should be taken against those responsible for the greatest irresponsibilities.  In the English law, we have words such as ‘reckless’ and ‘negligent’, other legal and regulatory systems have similar avenues with which to pursue these individuals. And I think that it is good for the industry if this is done – because one driving principle that we should continue to push is that of individual accountability and responsibility in the industry today.  There is not enough of that sometimes – so many things are apparently ‘everyone’s fault’. Not so, I say.  Someone makes the ultimate decisions and takes the credit – but with this should go the responsibility of taking the flak also.

Chaos theory

I now want to digress for a bit and do a brief discourse on chaos theory – which I think may well have some relevance to this crisis.

Chaos theory is a branch of mathematics which takes us on from classical mathematical physics. Traditional mathematics can calculate the motion of a satellites and the planets, but not that of a snowflake in a blizzard. It can describe the growth of a soap bubble but not that of a tree.

Weather systems are the classic case of where what are known as deterministic systems – ie those we feel confident in predicting because they obey natural laws in a rigid way – do not apply. To predict the weather these days we have computers which calculate millions of variables based on the current conditions of wind, rain, cloud, temperature etc – but even so I am sure we have all witnessed times when frankly the forecast does not seem to convert into reality.

The reason is that, with the best will in the world, the current conditions can be measured only to an approximation. For example, the wind is never exactly measurable to the required degree of accuracy, and indeed the calculations will be rounded off by the computers. So what we think we might predict with our very reasonable and very understandable and indeed very close approximations is never exactly the case. Multiply this by the number of variables in the inputs for the forecasting and even an infinitesimal change in one variable can have extreme consequences on the output. Hence the so called ‘butterfly effect’ – ie the flapping of a single butterfly’s wing today produces a tiny change in the state of the atmosphere.  Over a period of time, what the atmosphere does diverges from what it would have done. So, in a month’s time, say, a tornado that would have devastated the Indonesian coast doesn’t happen.  Or maybe one that wasn’t going to happen, does.

Now, let us attempt a read across to financial services.  We could say that in the financial services world there too are many variables – despite the precision which everyone feels in respect of any financial transaction. For example, we have n institutions operating in the world, conducting x trillion transactions, totalling US$ y trillion, representing the output of z number of decisions made in respect of financial transactions – all of which are subject to a degree of uncertainty in their outcome. When one inputs the whole derivative marketplace into the equation also we have a whole new host of variables, plus whatever happens on the various stock exchanges. All in all we have a large number of variables, with, I suggest, a potential for a large span of outcome over time. What I mean by that is that although it would be nice to think that with all the transactions, we have neat, ordered outcomes which we (or governmental authorities, central banks and regulators) could all predict with a reasonable degree of certainty, in reality any small area of uncertainty with a number of these transactions can multiply up and compound into something quite large. And there is uncertainty – for example, is a loan going to be repaid? Will a convenant be breached?  A natural event can create a stock index dive.

My point is that there is a strong argument for saying that the financial system is governed more by chaos theory than by deterministic systems – notwithstanding whatever the authorities would like to believe. Yes, regulators, governments and industry can do their bit – but at the end of the day the outcome is a result of many variables beyond which any one oversight body can review or will ever be able to review. And, despite the framework in place, for any of the authorities to try and predict what was going to happen was akin to trying to predict the weather – with imperfect and incomplete information. So there is an argument for not blaming anyone for not forecasting what would happen – and I think we all agree that we have not seen the end of these events. The butterfly effect from the sub-prime borrower in the US who defaulted on his mortgage has yet to run its course. And, of course, if we had not been able to forecast the crisis how could it have been prevented or mitigated in advance?

Of course, continuing this analogy, there is a counter argument which says that storm clouds were visible, and that it is prudent to get out the umbrella, and that a forecaster could have told us that it was best to stay indoors, but by that time it may have been a bit too late….

On a serious note, however, I do think there is some merit in someone who has the academic expertise and the time to spare, to research a little into the application of chaos theory here. Because if such is indeed the case, and financial systems are indeed governed by it, then this should influence the thinking of what the optimum structure of governance by the authorities in the future should be.

Some solutions – in train and proposed

Moving on to the solutions, or rather at this stage what are being attempted as solutions. There is no certainty whether these are working or will work. But there is some certainty that they are likely to cost a lot of people, mainly taxpayers, a lot of money.

As far as the recapilisation of the banks are concerned, the favoured approach by the UK and US, I have some sympathy with the thoughts of the Reserve Bank of Australia. The UK, EU and US have all provided billions of taxpayers funds to recapitalize banks. However lessons learned from the Japanese banking crisis shows that unless there is a decision to remove the bad loans from the banks as a precondition for recapitalization you will simply prolong the crisis. If bad loans are not removed from the balance sheet the potential for further asset deterioration in a period of recessed activity will require more capital and/or result in greater deleveraging. It is this slippage that causes the crisis to be dragged out for a longer period of time. This is a potential risk for the recent decisions of the UK, US and EU who have bypassed this step.

There also seems to be groundswell of opinion that an overall systemic overseer, conducted in general by central banks, is needed. This seems to emanate from, er, central banks or former central bankers. The philosophy is that someone needs to see what is happening on an overarching basis – myself, I am not so convinced by reference to the chaos theory above. Also, nobody has yet presented any convincing evidence that central banks would have had complete information to allow them to make the relevant deductions from this. The jury is still out here. But I do think that central banks could sharpen up their act in being able to act more quickly in crises – and of course this must be with wholesome communications between governments (who may have to write the cheques) and regulators (who know what is happening in individual institutions).

More regulation in respect of management, governance, incentivisation – this too will take some time to come to fruition. Where also I think we are in danger here is coming to a view that the cure is ‘more’ – and my analogy here is that if one looks at the road traffic network (also requiring licensing, supervison and enforcement, the same components as in financial services!) we do indeed have the odd crash and multiple pile up. But when there is a crash, there is a tendency to rebuild the car, put on an extra set of bumpers, strengthen the materials – and then decide we can go faster so let’s accelerate in a better machine. And sure enough another crash comes – and the cycle repeats. What we really need is safer drivers. Translated into financial services speak, we need a new way of thinking in the industry, a change of culture in many institutions and that needs to be led from the top.

I do not think anyone would argue that regulators need to strengthen the prudential oversight of institutions and examine their business models rather more rigorously than in the past. Unified standards would certainly help here. Lastly, enhancing cross border communication between authorities is always possible and very desirable.

What needs to be done

As a blueprint for change, the following needs to be done:

• Governments must take more responsibility for establishing appropriate debt levels in their economy and should also consider the ‘social obligations’ of institutions
• Industry must look at its business models, governance and culture
• Central banks should be able to intervene more quickly where necessary
• Regulators should be smarter – the issue is not ‘more’ but ‘more effective’

I will talk about what I call the social obligations of institutions a little later. But what we are saying is that everybody has something to improve.

A zero based approach to regulation

Everyone here will know about zero based budgeting – ie starting by building up from the ground in terms of what is necessary. Let us apply this to regulation going forward – ie if we were all redesigning regulation how would we do it, what do we need?  Let’s throw out the sacred cows and start again.

Well, in order to start we need what I call some ’guiding principles’. These are some ‘givens’ setting the framework of what we are going to regulate. I suggest the following:

• The world economic order will have shifted once the current crisis has settled
• Financial services profitability may well not reach the levels of yesteryear in the future
• There will need to be a fundamental shift in the philosophy of regulation – eg consumers, aka taxpayers, aka voters, have a greater voice than before
• The concept of a significant retail bank being allowed to fail has become redundant
• Business models do actually matter

As regards the world economic order, I defy anyone to state with any degree of certainty what it will look like. It has a number of dependencies – such as politics – but I think everyone would agree that at the moment it is all up in the air and it is still very unclear where it will all settle. But it is unlikely to be as it was 12 months ago even. Many people may take a shot on the centre of gravity moving east from where it is as present, but there is not much else unanimity on this.

Financial services has commanded significant P/E ratios in the past – on the grounds that the resources required for this art (whether financial or human) are scarce and need to be rewarded properly. Wall Street and the City of London paid highly for the brightest and the best of talent – will this really be the case in the future? Is financial services so ‘special’? Or now that governments have realized just what a problem the industry can create if left too much to its own devices, will there be some interference on costs of human capital – ie ‘wage control’, and the incentivisation payments and rewards will no longer be there.  Equally if we might be going back to good old boring banking do we justify such high returns? I think it quite likely that profitability of the industry may well not reach the levels of yesteryear.

Third, there needs to be a fundamental shift in the philosophy of regulation. What is it there for? Systemic stability and open clean markets used to be the watchwords, and consumer protection was usually mentioned somewhere.  Now, governments have realized that consumers, also known as taxpayers, also known as voters, are not going to take kindly to being disappointed by being told their bank has gone bust. So the concept of a significant retail bank being allowed to fail has become redundant. And this is critically important, because the debate where I originally came from many years ago was whether the banks are utilities just like power and water and the like – and should be regulated as such – or were different.  The industry cried ‘rubbish’ to this proposal – on the grounds that banks were allowed to fail whereas one of the pillars of utility regulation is that the utility cannot fail.  But with this ‘privilege’ go ‘obligations’ – more on these later. So there has been a real shift here.

Lastly, we have said before that business models do matter – and need to be assessed to determine their viability from a safety and soundness perspective.  It is not clear whether all regulators look closely at these.

A ‘New Style of Regulation’ for the future

With the above ‘guiding principles’, there will be a real shift in the focus of regulation needed. Here I offer some ideas, and I am sure that we will have a good discussion about these and others later.

• A more active role in setting and understanding macro economic policy of the relevant government
• The balance of prudential regulation vs conduct of business regulation
• In conjunction with government, in some jurisdictions the introduction of a new pillar of ‘Public interest regulation’
• Reviewing their locus in competition policy areas
• Tightening international co-ordination between regulators
• Smarter supervision, including seeking real time information in key areas
• Developing Key Performance Indicators for their business

First, regulators will need to have a more active role in understanding the macro economic policy of governments in order to their job effectively in alignment with such. And there is no point in trying to implement a regulatory philosophy over an industry aligned with such if the policy doesn’t work within institutions – hence the regulator actually needs to be involved in setting the macro economic policy so that the result is achievable.

Second, development through the ages leave regulation standing on the two pillars of prudential regulation – for ‘safety and soundness’ issues – and, very late in the development, ‘conduct of business’ regulation – for consumer protection. Now, the balance of resource and effort applied to each depends upon the risks involved. This will have to be revisited by each and every regulator.

Third, in respect of both the competition issues arising as a result of the reduction in the number of banks across each country consumers need a blueprint for regulation that helps them in the new order right now. They are entitled to a regime which not only sets policies on matters such as product availability, debt collection and other what might be called ‘social obligations’.

So I submit that what is needed is a third pillar of regulation – perhaps called ‘Public Interest Regulation’, Like all regulatory frameworks, a structure will need to be put in place to design the rules, supervise compliance with them, and enforce them. This should also be part of a financial regulator’s remit – to keep the one-stop regulatory oversight principle; and the regulator can agree with government on what needs to be included here.  There is an analogy to this in the ‘price control’ of utility regulation – but for the financial sector it is rather different and wider, and the regulator will need to develop the necessary skills. Whether or not ‘wage control’ should be included here I am not sure, but I suspect that some jurisdictions will do so.

Fourthly, in conjunction with this, the consolidation of the banking industry in many countries mean that the competition rules are likely to be going to need to be rewritten. A regime is needed which prevents abuses of any dominant market position through product pricing controls.  For example, one banking group in the UK has an estimated 33% personal current account market share, and a 29% market share of mortgages in a consumer market of instinctive inertia, viz the effort of changing and the associated paperwork makes this often a route of last resort. Who is it who is going to credibly ensure that this group will not use its dominant position to the detriment of consumers?

This could be aligned to the ‘public interest pillar’ above.

Lastly, I have spoken earlier about the need for tightening international co-ordination between regulators, but also we need smarter supervision in some areas. This can include different styles of supervision, perhaps even accessing real time information within institutions. After all, risk managers within banks have such access – why perhaps should banking supervisors not seek this and consolidate it to see across the board?

With that, ladies and gentlemen, I am going to conclude. Some of what I have said may hopefully have been interesting, some may be known to you already, some may be scary, but nevertheless I wanted to be a bit provocative. But one thing I think we all know – the world has changed and is changing in terms of the interaction of the industry, the regulators and the governments, and it will be a very different one that you assess at your 30^th meeting next year.

I wish you all success in the year ahead. Thank you for listening.

Presentation to the Middle East Alternative Investments Summit, Dubai

Richard Collins, 18 February 2008

Introduction

I am delighted to be here this afternoon to participate in this Middle East Alternative Investments Summit where I have been asked to cover the topic of ‘An Essential Precondition: Debating the Issue of Transparency within the Context of Hedge Funds Adoption’.   And when thinking about what to cover here, it seems to me that I am being asked to provide a debate with only myself – which makes it easier!   Normally I have a lot of empathy with President Reagan’s view of economists – he once said ‘Give me a one handed economist – because they’re always saying ‘On the one hand, and on the other hand’.   So please forgive me if you feel afterwards that there has been a lot of ‘on the one hand, and on the other hand’!

The main issue I have had to deal with in preparing this talk is what new can be said. In the research conducted, there are umpteen different studies by esteemed practitioners, regulators, president’s working groups, academics and others, all covering the issue of disclosure and transparency of the industry.  But I will try and add a little to the debate rather than simply regurgitating what everyone else has said – and I should emphasise at this point the usual disclaimer that the views expressed are necessarily my own and do not necessarily represent those of the Qatar Financial Centre Regulatory Authority.

I know that the ‘Context of Hedge Funds Adoption’ really means disclosure to investors in the funds. But my first postulation is that I do not see how one can really isolate that from the wider issue of hedge fund transparency and disclosure to the wider world – ie to anyone who has an interest in what is happening in the industry. The logic goes – if it’s suitable for disclosure to an investor about what’s happening within one of these entities, why not for a regulator, why not [in a suitable way] for the marketplace? So my analysis will go slightly wider than simply investors.

I thought it might be helpful to structure the talk into the following:

• The Macro picture – ie some helpful backdrop;
• Who has said what – ie some summary of the umpteen studies referred to above;
• Areas of Broad Consensus – ie where opinions seem reasonably convergent;
• Areas of Divergence – ie where they are not so;
• Specific Areas of issue – ie some particular topics of interest;
• Hedge funds and the sub-prime debacle – roles and responsibilities.

We have heard from Paul McNamara about the outlook for the industry.  And let’s put the industry in context.   The last decade has seen a rapid growth in both the number of hedge funds and the scale of their assets under management, currently understood to have risen by well over 400% since 1999, to stand in the region of $2 trillion.  They are also responsible for an increasing share of trading volume, with some estimates putting this at 50% of the market total.  This growth, in combination with hedge funds’ perception as secretive, amorphous, highly-leveraged structures, the recent market difficulties has caused attention to turn to the issue of transparency and disclosure.  Put simply, there is a general feeling out there that we need to know more.  Yet, exactly what more we need to know, and how much of it, is the subject of much debate.

The hedge fund industry remains one in evolution, particularly with regard to the growing investment by institutions.  In its 2007 study, State Street noted that around two-thirds of institutional investors are allocating more than 5% of their portfolios to hedge funds, while only 4% have no hedge fund allocation at all.  The corresponding studies for 2005 and 2006 showed less than half of responding institutions were allocating more than 5% to hedge funds, with 16% having no allocation.[1]  With that increase, has come a gradual realisation within the industry itself that, to continue to attract and maintain such investment, it must change significantly, including being more transparent.

Transparency is, however, not a magic bullet, a one-stop cure-all for the issues facing the hedge fund industry, real or imagined.  But before we can analyse the pros and cons of greater transparency, we need to consider some sort of analysis of the benefits and risks of the industry – and, of course, many of the dangers attributed to hedge funds are not exclusive to that industry.  Indeed, as the industry matures, the differences between hedge funds and traditional investments are becoming less marked.  In Europe, new rules introduced under UCITS III are blurring boundaries between alternative and traditional vehicles by allowing the use of exchange-traded instruments and over-the-counter derivatives, although these remain subject to rather tighter parameters and restrictions.  The more traditional financial service providers, including banks, pension funds and mutual funds have moved into some of the instruments, such as derivatives, more commonly perceived to be the tools of hedge funds, so the debate needs to be put in the context of issues facing the financial services industry as a whole.  Indeed, it might be said that a number of the investment banks’ trading areas are no more than giant hedge funds. And it is interesting that one of the criticisms that has been levelled at Societé Generale is that its lack of transparency and disclosure in unwinding the positions of Jerome Kerviel contributed in no small measure to the market turmoil towards the end of January 2008.

Defining what a hedge fund is

Given that there is no legal or regulatory definition of a hedge fund, it may be better to define the entity by its characteristics – ie by what an entity does rather than what it is called.

In broad terms, a hedge fund may be regarded as a private investment pool, loosely regulated, funded in the main by experienced, high net worth and institutional investors and creditors, that invests in a variety of assets, often utilising considerable leverage, are professionally managed and, generally, not directly available to the retail public.  As Sir Callum McCarthy, Chairman of the UK Financial Services Authority, has pointed out, however, hedge funds should not be regarded as an asset class in and of themselves.

Although hedge funds can certainly be regarded as heterogeneous with regard to strategy, size and management style; typically, however, they exhibit some or all of the following characteristics:

• They tend to be both long and short in the market, although not necessarily market neutral, or fully ‘hedged’;
• They utilise leverage, or gearing, in their trading strategies;
• They have a performance-based fee over and above a fixed fee structure (the traditional 2 and 20 scenario), thus compensated on both scale and performance;
• Their managers are usually co-investors;
• They are broadly invested across a wide spectrum of instruments, including derivatives;
• They have an objective of absolute return;
• They can have ‘lock-in’ periods for investment;
• They are unrestricted in the trading strategies and instruments they utilise; and
• They demonstrate a high degree of opacity.

This can be contrasted with ‘traditional’ funds, which are typically invested long-only, not leveraged, restricted from utilising derivatives and more narrowly invested, often benchmarked against an index on a relative return basis, and have lower fees.  A further important distinction is that traditional funds are usually heavily regulated, with more onerous requirements in relation to transparency and disclosure.

Given the dramatic growth in hedge fund assets under management, it follows that the industry must be seen as providing benefits that are not available from the traditional investment industry and which overcome investor concerns about high fees and lower reporting transparency.

The Benefits of Hedge Funds:

At a market level, the benefits are traditionally seen as being that hedge funds offer:

• A valuable arbitrage role in reducing or even eliminating mispricing in financial markets;
• The addition of breadth and depth to capital markets;
• An important source of liquidity, both in periods of calm and stress; and
• An important source of risk transfer and diversification by taking risks that would otherwise have remained on the balance sheets of other financial institutions.[2]

Hedge funds are active traders and contribute to increased market efficiency and liquidity through their frequent trading and ability to exploit arbitrage opportunities.  In a study, the Federal Reserve Bank of New York has said that this activity is thought to be generally stabilising and provides considerable benefits in terms of greater market liquidity, lower volatility and more stable relationships in the relative prices of financial assets.[3]

At an investor level, the benefits of hedge funds are generally considered to include:

The potential to reduce overall portfolio risk through an additional asset class;

• The potential to provide returns in both bull and bear markets;
• The potential for superior risk-adjusted performance, through precise areas of expertise, greater freedom and flexibility and a broader range of financial instruments;
• A focus on absolute as opposed to relative performance – they are only concerned with generating positive returns, rather than benchmarking performance;
• Greater incentives for the managers since hedge fund managers’ interests are generally aligned more with those of the investor than in traditional vehicles, often with the manager’s own capital invested;
• A degree of sophistication, recognised by banks, pension funds and insurance companies as a way to reduce portfolio volatility and potentially enhance returns;
• A huge variety of investment styles – many uncorrelated with each other – provides the investor with a wide choice of strategies to meet investment objectives;
• Providing an ideal long-term solution, eliminating the need to time entry and exit from the markets; and
• Diversification not otherwise available through traditional vehicles.[4]

Hedge funds are perceived as deliverers of superior ‘Alpha’, that measure of profit attributable to managerial strategy over and above simple market correlation.

The Risks of Hedge Funds:

The commensurate risks, however, are the:

• Capacity for leverage – they can be vulnerable to pressure to liquidate assets quickly if they sustain significant losses;
• Complexity of instruments utilised which makes it difficult to assess risk;
• Potential overimportance in the markets;
• Opacity – they are not subject to public disclosure or regulatory reporting and operate largely outside the framework of other requirements.

As far as the first of these is concerned, however, the fact that they are able to liquidate quickly can put them at an advantage.  An oft quoted example is that the better hedge funds’ willingness to take decisive action has been compared with the inertia of one big investment bank’s management, who it is alleged knew in August 2007 that its proprietary trading desk was taking large positions, but missed an opportunity in October to take advantage of the market rally.  One insider estimates that swifter action would have capped losses at around $1 billion, rather than the $9.4 billion written off in December[5].

The risks can also be said to break down into three categories: managerial, operational and systemic.  The first two tend to be the focus of investors, the last the issue that most concerns regulators.

Systemic risk

It is generally accepted that banks have considerably enhanced their counterparty credit risk management processes since the LTCM crisis of 1998.  However, hedge funds create systemic risk to the extent that they can disrupt the ability of financial intermediaries or financial markets to provide credit efficiently.  The US President’s Working Group on Financial Markets identified the potential for liquidation of a highly leveraged institution to lead to volatility and sharp asset price declines that heighten uncertainty.[6]  But in the context of systemic risk, we should also remember that hedge funds are generally invested across a wider range of assets than banks and traditional funds and are more directed towards arbitrage.[7]

Systemic risk is not always clearly defined, but is broadly seen as the risk that an event represents such a crisis that it impacts not just on the financial system, but also on the real economy.  This could happen, as we have seen recently, through repercussions from an event resulting in a reduction in productive investment by the curtailment of credit provision.  However, it should be emphasised that the optimal level of systemic risk is not zero.  While a regulator might sleep easier through the imposition of stringent limits on leverage or investment in illiquid markets, this would unduly hinder the proper workings of the financial sector, with obvious wider implications for the economy.  That being the case, the concern should, rather, focus on the existence of inefficient systemic risk.

Hedge funds could well link to the real economy through banks’ direct exposures to them. If a bank has a large exposure to a hedge fund that defaults or operates in markets where prices are falling rapidly, the bank’s greater exposure to risk may reduce its ability or willingness to extend credit to worthy borrowers.

Hedge Funds and Liquidity Risk

We have affirmed that hedge funds are viewed as being liquidity providers within capital markets, thus contributing to market efficiency.  But recent experience and history suggests that hedge funds are also moving increasingly into less liquid markets, such as structured credit and distressed debt.  In combination with leverage, these rather more illiquid assets, together with short-term financing, expose the hedge fund to possibly significant liquidity risk.[8]  It is perhaps this that has driven some hedge funds to incorporate longer lock-up periods on withdrawals and increased use of notice periods for redemptions.  At the same time, the prime brokers are seeking added transparency in respect of hedge funds’ positions.

It is useful, also, to distinguish between ‘market liquidity’, the facility to trade without affecting prices, and ‘funding liquidity’, which is the ability to obtain funding in circumstances of credit curtailment or other event.  While distinct, these two phenomena interact in crucial ways.  In times of abundant funding liquidity, traders can finance positions, trade in higher volumes to smooth prices and inject liquidity.  Conversely, weak market liquidity tends to increase volatility, leading to variation margin and collateral calls that reduce funding liquidity.  Market liquidity shocks impact on the trader’s ability to fund positions, driving prices lower by selling assets to meet margin calls.  If hedge funds, usually smoothers of market imbalance are themselves weakened by losses brought on by unusually large market shocks, it raises questions about who would be available to step in to stabilise the situation.

In this sense, collateralisation may prove inadequate.  Clearly, the current concern is the banks’ exposure is to hedge funds.  Banks’ direct exposure to hedge funds has been growing in tandem with the hedge fund industry itself, although this is heavily collateralised, with each bank having a clear self-interest in managing risk exposures.

Nevertheless, it is generally accepted that it is the very characteristics of hedge funds, in particular their opacity and incentive structures, together with leverage, that fuel the potential for a substantial market disruption.  With the increasingly complex and heterogeneous nature of investments, the unwinding of positions may prove more difficult and inefficient.  Also, the large commercial banks and broker-dealers provide substantial funding to the hedge fund industry through the absorption of counterparty credit exposure, credit lines, financing and direct investment – so a shock to a bank brought on by a hedge fund could have wider impact should that bank, and/or others, curtail the provision of liquidity to other funds or the wider market.

Who Has Said What?

I mentioned earlier that there had been umpteen pontifications by great worthy bodies on the whole issue of transparency.   Here are some of them listed.

• UK Alternative Investment Management Association – guidance on valuation of positions
• UK Hedge Fund Working Group – Hedge Fund Standards, January 2008
• US Managed Funds Association – Approaches towards Alternative Investments.
• US President’s Working Group – Agreement Among PWG and US Agency Principals on Principles and Guidelines Regarding Private Pools of Capital
• New York Federal Reserve
• UK Financial Services Authority
• OECD – The Role of Private Pools of Capital in Corporate Governance, May 2007
• IOSCO – Principles for the Valuation of Hedge Fund Portfolios, Final Report 2007
• CFA Institute Centre for Market Integrity has produced the Asset Manager Code of Professional Conduct
• Banque de France – Financial Stability Review: Special Issue on Hedge Funds, April 2007
• European Parliament Policy Department – Economic and Scientific Policy studies on Hedge Funds Transparency and Conflicts of Interest (December 2007) and Hedge Funds and Financial Stability (November 2007)

All of the above studies, encompassing industry participants, governments, central banks, regulators, academics and trade bodies, approach the issue from the perspective of raising standards through adherence to voluntary codes of conduct.  The common theory is that adherence to standards will encourage all participants to ‘raise their game’ by virtue of the fact that investors will naturally gravitate towards those funds and managers applying these standards.  Standards have been applied to such important and topical issues as disclosure, professional conduct and valuation.

Most recently, in January 2008, the UK Hedge Funds Working Group, a practitioner-led body of 14 UK hedge fund managers, has issued its final report on hedge fund standards.  These standards have been established as a voluntary code and based on a ‘comply or explain’ premise, with the emphasis on disclosure.  In this way, signatories to the Hedge Fund Standards Board code will either demonstrably comply with its requirements, or explain why it chooses not to do so, thus providing the investor with disclosure of information on which to base his investment decision.

The European Parliament policy study on Hedge Funds Transparency and Conflicts of Interest, while broadly welcoming the Hedge Fund Working Group Standards, suggests that, in certain areas, for example in relation to independence of valuations, the Standards do not go quite far enough.

The CFA Institute seems unique in arguing for full position transparency on top of disclosure of strategy and risk measures.

Now, I come from a long career in financial regulation, the vast majority of it spent on the private sector side of the regulatory fence.  So I am afraid that I am slightly cynical about suggestions from the industry – there is usually an element of ‘they would say that, wouldn’t they?’  In particular, I would have to say that if industry are setting out standards for disclosure, it is only because this will benefit the industry first and the investor second.

Areas of Broad Consensus

But let’s look at the areas of broad consensus in the various reports above.  Regulators, academic studies and industry experts are all in general agreement as to the benefits of hedge funds to the wider market as providers of liquidity, takers of risk and price stabilisers.  There is also a general consensus that hedge funds’ opacity to investors and the market will need to change, with a move towards greater transparency and disclosure.

There is a sentiment within regulators that qualified investors in hedge funds have a right to open themselves up to the potential rewards of hedge funds, and expose themselves to the commensurate risk of loss.  While it is agreed that it is indeed opaque to both investors and the market, there is a recognition that the hedge fund industry is only open to direct retail investment to a very limited extent, if at all, so the usual caveats in relation to investor protection and compensation do not apply.  By the same token, market players have a duty to exercise their own effective due diligence and risk monitoring.

It is also a common theme that investors themselves have a role to play in driving the impetus for greater transparency and disclosure.  As institutions play a greater role in hedge fund investment, they, together with funds of hedge funds, are able to demand greater disclosure of information.  This institutional involvement is bringing greater focus on issues such as asset valuation, risk monitoring and internal controls.  In selecting and adopting a hedge fund manager, it is incumbent on the investor to carry out thorough due diligence, to gain an understanding of risk controls, investment strategy, management and governance.  Important areas to cover include:

• Ownership of the fund management company to ensure the fund’s terms – such as redemption policies and lock-ups – tally with expectations and that compensation is aligned with performance;
• Adherence to strategy, through analysis of current and historical track records;
• Background check on both the fund and its principals;
• Trading procedures;
• A review of documentation such as the offering memorandum and disclosure documents; and
• A review of internal procedures to ascertain what the manager does himself and what tasks are outsourced to third party service providers.[9]

As another driver towards transparency, it is important to remember that many pension funds are themselves bound to disclose details of their investment portfolios, which must necessarily involve a review of the entire investment portfolio, including alternative investment strategies.

It is also recognised that one of the important elements to be developed in relation to hedge funds is that of international regulatory cooperation.

And from the funds’ perspective, some who are seeking to develop business with institutional clients see improvements in professional standards, including transparency, as providing a useful means of boosting investment by creating an asset class with demonstrable integrity, which will only encourage more investors to diversify into hedge funds.

Areas of Divergence

Opinions tend to differ not in substance, but in emphasis, with the most common areas of debate being:

• Hedge fund correlation and contagion risk
• The degree of regulatory oversight
• Too much transparency may not be a good thing for investors
• Retailisation
• Side Letters
• Perception and its consequences
• Conflicts of interest – performance fees and valuation
• Shareholder activism
• Moral hazard
• Agency issues
• Knock-on effects

First, hedge fund correlation and contagion risk

Given the very wide variety of trading and investment strategies and vehicles employed within the hedge fund sector, there is some disagreement with regard to how close is the correlation between hedge funds and, thus, whether a shock to one would necessarily have implications for others.  However, the recent near-collapse of two Bear Stearns hedge funds in 2007 demonstrates the potential for contagion risk between funds and this is an area where further study is needed.

The degree of regulatory oversight

As noted above, the general industry consensus is that a voluntary, industry-led code of practice, coupled with effectively implemented measures of market discipline, is the best way forward for the industry in addressing the concerns of investors.  However, this consensus houses a spectrum of opinion and, at one extreme, is the call for outright regulation of the hedge fund industry, through such measures as restrictions on capital, activities or use of leverage.  So far, this point of view has not received too much attention, the general feeling being that such measures could bring with them substantial costs that would, in practice, outweigh and diminish the benefits of hedge funds in terms of market liquidity and price discovery.  Moreover, prior regulatory responses to a perceived laxity in credit risk management have involved an increase in the oversight of lenders, so to impose such supervision on hedge funds, the borrowers, would reflect a significant switch in policy.  In addition, such a policy of outright regulation runs the risk of driving the hedge fund industry entirely into jurisdictions with lax regulatory regimes.  A Securities and Exchange Commission initiative to bring more regulation to hedge funds was rejected by the Supreme Court in 2004 and the SEC is now proposing raising the bar for investor eligibility instead.

Too much transparency may not be a good thing for investors

An argument, propounded by certain industry practitioners [what a surprise!], is the idea that investors think they want transparency in terms of strategy and position reporting but, in fact, it will be detrimental to them in the long run.  Disclosure of such information, it is argued, will adversely affect the fund manager’s ability to put into practice the very techniques he has developed, as he will be faced by others either trying to emulate that strategy, or trading against him.  Furthermore, the emulation of these strategies by less adept managers is likely to end badly, with possible damage, both financial and reputational, to the industry as a whole.  In addition, short positions are inherently different from long and greater disclosure could lead to destabilising trading by competing investors.[10]  Personally, I never noticed this being a problem in the investment banking world of new products and strategies!

‘Retailisation’

One of the comforts that regulators take from the hedge fund industry is that, broadly, they are not open to direct investment by the retail public.  However, a recent European Parliament study[11] argues that the various national regulations in Europe are fragmented and has highlighted the anomaly that, during the bear market in 2001 – 2003, retail investors lost substantial proportions of their assets in ‘traditional’, highly regulated products, while better diversified and more secure investments are not open to them.  By the same token, while a wealthy individual can buy into any hedge fund, well-qualified, and regulated, investment managers acting on behalf of retail clients are restricted in terms of the products they can sell.

There has also been a rapid growth in investment products that closely resemble hedge funds, such as structured products and closed-end funds that are already marketed to retail customers.  Moreover, retail investors are already indirectly, and to a degree, invested in hedge funds through pension or life funds, predominantly through multi-manager funds or funds of funds.  This can lead to a number of layers of costs which ultimately are not transparent and are not to the benefit of the retail investor.

Notwithstanding the above, however, I submit that opening hedge funds up to direct investment by retail clients at this stage in their evolution would be most unwise.   Put simply, it is bad enough expecting retail customers to understand much of what they invest in at present, to allow them entry into a new market with greater opacity is, frankly, dangerous. We should not forget that in many of the various market crashes of the past – from the South Sea Bubble in 1720 to the Wall Street crash of 1929, and the dot com bubble of 2000, there was much in terms of a contributory factor from panicking retail investors.

Side letters

Side letters represent bilateral arrangements between a hedge fund and certain investors, often conferring favourable terms in respect of redemption, lock-in periods, fees, enhanced disclosures, or subscription rights.  Such undisclosed side letters are now being regarded as unfair to other investors in the fund, but it may not be feasible or desirable to do away with them altogether; for example, funds of hedge funds could utilise such arrangements to maximise returns for their own investors.  That being the case, there is a general move towards disclosure of at least the existence of such side letters to all investors, along with material terms contained therein.  There is some divergence of emphasis on materiality between regulators and codes of practice, but, for example, if a fund manager could be compelled to sell more liquid holdings to meet a client’s redemption terms in a side letter, this would be something that could materially affect other investors in the fund and should arguably be disclosed.

Perception and its consequences

The hedge fund industry is perceived as being opaque and secretive.  This, in combination with its use of leverage, as well as often highly complex, perhaps illiquid over-the-counter instruments has contributed to the nervousness with which the industry is often viewed.   Now, many may say: does this matter?  I postulate that it does – the very perception that there are a large number of market players doing things ‘in the dark’ which have an impact in the markets, could of itself contribute to uncertainty in the markets.   It’s a bit like the ‘Heisenberg Uncertainty Principle’ in physics – ie the very act of observance changes what is being observed. [For the non-physicists amongst us, the most common form of the principle is if one opens a door onto a darkened room containing a plant – the light that you let in to observe the plant contributes to a growth of the plant and therefore what you observe is not what the status was before the door was opened].

So if we expand this thought, what we have is that hedge funds are a contributory factor to market uncertainty – which is not necessarily a good thing.

Conflicts of interest – performance fees and valuation

Often, and it would appear increasingly, hedge funds can invest in illiquid, obscure or untraded and complex instruments which are consequently difficult to value, particularly in the structured credit markets.  A conflict of interest is inherent due to the presence of incentive fees, which encourage a manager to place the highest possible value on assets at the time of fee calculation, normally at calendar year-end.  An academic study has found that hedge fund returns are significantly higher in December than in other months.[12]  By the same token, managers may be tempted to postpone bad returns until after the fee calculation period.  Such practices represent a clear case of market abuse, if not outright fraud, and a number of the organisations listed above, including the Hedge Funds Working Group, have proposed valuation best practice guidelines for adoption by the industry.

Shareholder activism

This issue arises through the separation of economic and voting rights through hedge funds’ utilisation of derivative instruments and stock borrowing, which might be used to reduce the transparency of their interests in a company and voting activism.  Opportunities can arise through lax corporate governance for activism to take place, notwithstanding the operation of the EU Transparency Directive, which sets disclosure at 3%, with 1% increments thereafter.  For example, a hedge fund could borrow stock to vote, while at the same time taking a short position in the derivatives market to the same or even greater amount.  Such empty voting has the potential to harm the economic interests of the shareholders in general and has clear implications in terms of market abuse.  This could be combated by the aggregation of all derivative positions, both long and short, for reporting purposes along with other forms of interest in the company.[13]  The Hedge Fund Working Group proposed standards suggest that funds should not vote in situations where they are not economically exposed.

Moral hazard

There is an argument that greater regulation may lead to a situation where moral hazard persists.  The argument is that, with more transparency being imposed by regulators, the incentive of investors to carry out their own thorough due diligence is weakened by over-reliance on these regulatory standards.  On the other hand, while there is no indication that there is any likelihood that governments would ever bail out a hedge fund, the perception that the largest financial intermediaries are ‘too big to fail’ may engender a laxity in monitoring credit risk and limiting exposures in currently profitable areas.  However, it seems to me that this is an argument which is perennially postulated by industry when there is any increased transparency suggested – I for one am not persuaded by it!

Agency issues

It is the general consensus among regulators that market discipline, through the application of counterparty credit risk management, rather than direct regulation, is the best way to mitigate risks posed by hedge funds.  Most recently, this has been reiterated by the US President’s Working Group on Financial Markets (2007).  However, there may prove to be circumstances where counterparty credit risk management is insufficient and these are likely to be exacerbated by a lack of information. or in situations of heightened competition, Both of these , of course, apply to hedge funds.

Agency issues may arise through different incentives of participants, where the agent may act in his own self-interest and a lack of information coming from the hedge fund may accelerate these by making it harder to define the correct counterparty risk ratings to apply to credit terms and trading limits.  In this scenario, insiders’ incentives may lead to excessive risk-taking.

The total return basis of hedge fund compensation creates a strong motive to take on risk and, with limited transparency, it is easier to conceal those risks from both counterparties and investors.  Risks that are most easily concealed are those with a small probability of severe adverse consequences but which, in exchange, offer high levels of compensation at other times.  Credit derivatives represent just such an investment.[14]  We are familiar with controls such as margin, collateralization and trading limits but the key question remains how effectively these are implemented and enforced.

‘Knock-on’ effects

Banks’ credit exposure to hedge funds may have a number of wider implications, the most obvious being a hedge fund collapse weakening banks and degrading their ability to provide liquidity to the financial system of credit to borrowers.  Alternatively, where there is close correlation or common exposure to market risk between a bank’s proprietary desk and the hedge fund, defensive trading by the fund after a shock could impair that proprietary position; this would magnify the impact beyond the bank’s credit exposure to the fund, or hedge funds in general.  Clearly, the size of such exposures would dictate whether these conditions might reflect a systemic crisis.

The Subprime Debacle and its Consequences

I now want to turn to a brief analysis of the sub prime debacle and the consequences that have flowed therefrom. And there is no better person to look to for his marvellous quote about what we know and what we don’t than Donald Rumsfeld, who came up with the gem:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

And in the hedge fund world, I’d like to postulate that there’s a lot that we know we don’t know, but there’s probably also an awful lot of things that we don’t know we don’t know!

Examples of collapses

Headline-making collapses of hedge funds have, thus far, not been too numerous, although hedge funds as a class see an annual closure rate greater than that for ‘traditional’ funds.  Amaranth remains fresh in the memory, as does the near-collapse of two Bear Stearns funds in the summer of 2007, referred to above.  2008 has already seen the closure of Sailfish Capital Partners, which managed $2 billion in the summer of 2007, with the indications being that this will not be the only such closure this year.  Atticus Group Fund lost over 13% in January, Maverick Capital 9%, as reported by SYZ & Company.[15]  MFA President John Gaine, however, speaking in November 2007, believes, “…while I believe…it may be premature to draw lessons from these events now, I equally believe that concern about proper valuation practices (not just to deliver returns, but also to measure risks) are at the heart of unease about hedge fund and other strategies where there is no ready market for the instruments being held or traded.”[16]

It is this unease that I believe could see issues or events being magnified into crises by market apprehension based on inadequate knowledge and understanding of hedge funds’ strategies, risk management and ultimate asset value.  It is this information gap which also leaves us unable to answer with any certainty whether the financial markets are over the worst of the crisis.  Again, this is a sort of Heisenberg Uncertainty Principle in operation – if we were all able to observe what was happening then we would be observing something different!

Let’s also think about whether the hedge funds have contributed to the credit crunch.

 There is a disparity of opinion on exactly how large a part the hedge fund industry has played in the subprime crisis of last year and the ongoing credit crunch.  The linkage between banks and hedge funds was amply demonstrated by the recent examples of BNP Paribas, Goldman Sachs and Bear Stearns, all three of whom were adversely affected by their own hedge funds.  BNP was forced to suspend withdrawals from its funds invested in illiquid, hard-to-value credit securities, causing a spike in the inter-bank rates and a resulting loss of confidence in that market. In August last year, Goldman Sachs was compelled to provide funding to one of its leading global equity fund which had lost 30% of its value in one week.

On the other hand, in a speech on 20th November 2007, no less a personage than Hector Sants, Chief Executive of the UK Financial Services Authority, stated that, “FSA’s view…is that hedge funds were not the catalyst or the drivers of the summer’s events and their subsequent behaviour was broadly in line with the assumptions which underpin our regulatory approach.”

It may well be the case that hedge funds were not the prime catalyst. But I think we would all agree that it remains unclear whether the market has now fully absorbed all the toxic waste that has flowed from the debacle, hedge funds included..  With the subprime crisis now appearing to shift towards the prime market, the worst may not yet be over.  Arguably, the last several years of low volatility and liquidity have engendered an element of investor complacency and far more leverage, perhaps not necessarily within the hedge funds themselves, but within the fund of funds industry.[17]  The fund of hedge funds industry has generally been seen as a ‘safer’ and more diversified way for investors to access hedge funds.  However, there is now some debate over their exposure to the credit crunch and the implication arising from that – and it has been postulated that it is possible that  funds of hedge funds have suffered from an expanding ‘duration gap’: what they owned was longer-dated than what they owed.[18]

While some hedge funds made considerable profits last year by shorting the ABX subprime index, the collapse of Sailfish Capital Partners in February 2008 demonstrates that not all of the ramifications of last year’s market turmoil have necessarily worked their way through the system.  A leading industry expert has said: “This year will be the year with the highest number of hedge fund failures given the huge number of new and untested hedge funds.  Last year there were some easy trades: short financials, short subprime, long non-US and emerging Markets.  This year there’s no clear trend and no safe place to hide.”[19]So far, 2008 has produced some uncomfortable indications, with the average stock-picking hedge fund posting a 4.1% drop in January.

And we come back to the question – even if hedge funds were not the catalysts or driver for the sub-prime debacle, has their presence and opacity in the marketplace helped or hindered the situation?  In other words, if there was more transparency in their operations, would the sub-prime debacle have been identified sooner? Would everyone have dealt with it sooner? Is this desirable?

Well, I think it is generally accepted that the fundamental cause of the subprime debacle and the ensuing credit crunch was the irresponsible lending by instititutions on a grand scale to people who really couldn’t afford it.  Packaged products of these toxic loans were sold by the lenders to whoever may have been willing to purchase – of which hedge funds may have been ready buyers.  And the longer that the hedge funds were able to conduct these transactions without any external party being aware of this and perhaps asking what on earth was being bought here and on what basis, the longer the ticking bomb of the subprime crisis was able to be kept just ticking. It is possible to postulate that had the hedge funds been questioned earlier over their exposure to these products then the issues could have been identified earlier.  I recognise that one might say the same thing about the supervision of banks themselves, and there has already been some callings to account in respect of some regulators’ actions. I suspect there will be more to come.

But this brings me to another, wider issue in the debate. Here we are, in the 21^st Century, with all the latest information technology at our disposal, and all commentators are still saying that we don’t know the full extent of the subprime debacle.  Frankly, I would ask – is it right that, in the advanced financial markets of the 21^st Century, we simply do not know?

And this is what I think is likely to be the greater overall issue which will contribute to hedge funds becoming more transparent than probably they really want to.  I think it more than likely that, whilst the dust from the subprime issue settles, people will say – why did it take so long to work out what was going on? And one very substantive part of the answer is – because there was insufficient information available to the authorities when they needed it and in the format they needed it. People will then say – there are large elements of the financial marketplace who currently conduct business in an opaque manner – these include these entities called hedge funds. And they will conclude that, notwithstanding whether or not the hedge funds were any catalyst or contributor towards the crisis last summer and the consequences thereof, we need to have systems in place so that we know what is happening more quickly and action can be more quickly taken when something not good is happening.  And the only way that this can be achieved is by having more transparency and disclosure about what everybody is doing, not just the hedge funds, but also other parts of the marketplace.

And so the alternative investment industry, I think, will in all likelihood be swept up in more such rigorous disclosure of everybody’s actions.

Thank you for listening.

References:

[1] 2007 State Street Research Study – ‘Vision Volume 2 – Issue 1: Hedge Funds, a State Street Report’

[2] Address by Timothy F Geithner, President and CEO, Federal Reserve Bank of New York, 17th November 2004

[3] Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[4] © The Hughes Trustco Group Limited, 2007

[5] Financial Times, January 29, 2008: ‘Hedge funds demonstrate resilience in thorny times’.

[6] Quoted in Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[7] “Hedge Funds and Financial Stability” Study by the European Parliament Policy Department, Economic and Scientific Policy, November 2007

[8] See Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[9] 2007 State Street Research Study – ‘Vision Volume 2 – Issue 1: Hedge Funds, a State Street Report’

[10] Brunnermeier and Pedersen, “Predatory Trading”(2004), quoted in Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[11] Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[12] Agarval, Daniel, and Naik, Narayan (2007) “Why is Santa so kind to hedge funds?  The December return puzzle!”

[13] Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[14] Rajan (2005), ‘The Greenspan Era: Lessons for the Future.’ quoted in Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[15] The New York Times, February 12, 2008: “Bad bets and accounting flaws bring staggering losses.”

[16] Ibid.

[17] Doug Kass, TheStreet.com, 3/5/2007, “Subprime’s Next Victims: Hedge Funds.”

[18] Dave Shastri, The Hedge Fund Journal, Issue 33, December 2007 / January 2008: “Painting a clearer picture.”

[19] Bradley H Alford, Alpha Capital Management, quoted in The New York Times, February 12, 2008: “Bad bets and accounting flaws bring staggering losses.”