Praise, Caution in Hedge Fund Speeches

Date: Monday, November 13, 2006
Author: Chris Clair, Senior Financial Correspondent,

TORONTO (—Maybe he was playing to his audience, but David Longworth, deputy governor of the Bank of Canada, the nation's central bank, had some very nice things to say about hedge funds at a speech before the World Hedge Funds Summit.

Mr. Longworth praised hedge funds as a source of innovation and liquidity, and said they probably had something to do with a reduction in financial volatility in important Canadian markets.

His comments came in the middle of a week when securities regulators in Canada and the United States said they were considering tweaking rules governing how hedge funds operate, and who can invest. David Wilson, chairman of the Ontario Securities Commission, said that a report on hedge funds in Canada, being prepared by the Canadian Securities Administrators, is due out around Christmas.

Specifically, Canadian regulators are looking at tightening rules regarding hedge funds that use principal-protected notes and considering addressing referral fees. Both issues are central to a case involving Portus Alternative Asset Management Inc., a Canadian hedge fund that regulators shut down two years ago amid allegations that assets were misappropriated by the managers and that some financial advisers were paid by Portus to refer clients to the hedge fund Previous HedgeWorld Story. Portus, which filed for bankruptcy in 2005 and was put into receivership, invested the bulk of its assets in principal-protected notes issued by Société Générale Canada. Most of those notes do not expire until 2009, which makes recovering assets for investors via the bankruptcy process more difficult.

In its Nov. 11 editions, the Toronto Star quoted David Wilson, chairman of the Ontario Securities Commission, saying while there are certain areas like principal-protected wrap programs and referral fees that the commission feels need to be looked at, overall the Canadian regulatory framework is "adequate" to protect investors and allow regulators to do their jobs.

Meanwhile, U.S. Securities and Exchange Commission Chairman Christopher Cox said on Friday [Nov. 10] that the commission would propose new rules in December that would raise the standards for accredited investors and increase anti-fraud provisions. Mr. Cox, who delivered a speech on simplification of the self-regulatory organization structure to those attending a Securities Industry and Financial Markets Association conference in Boca Raton, Fla., told reporters later that the commission wanted new rules to make it clear hedge funds are not for everyone.

One way to do that, he said, was to raise the standards investors must meet before they can invest in hedge funds. He did not disclose any specifics of the proposed changes. Currently to qualify as an accredited investor, an individual must have a net worth, singularly or with a spouse, exceeding $1 million, or income exceeding $200,000 for each of the past two years singularly, or $300,000 per year with a spouse.

Several pension funds and funds of hedge funds got caught up in the September meltdown of Amaranth Advisors, a multi-strategy hedge fund firm that lost two-thirds of its assets on bad natural gas bets Previous HedgeWorld Story. Since then, the SEC has renewed its push to make sure ordinary investors aren't hurt when hedge funds fail.

Additionally, there were pre-election clashes on Capitol Hill regarding greater hedge fund transparency. Sen. Charles Grassley (R-Iowa), who chairs the Senate Finance Committee until the new Democratic-controlled Congress takes over in January, wrote to the heads of the SEC and the Treasury, among others, asking what information hedge funds are required to disclose Related Reuters Story.

But in Canada, the Bank of Canada's Mr. Longworth spent a considerable amount of his speech extolling the virtues of hedge funds. He said advances in electronic trading and back-office systems have lowered trading costs and increased transparency and competition. This has all resulted in more liquidity and less volatility.

New derivatives have allowed risk to be better distributed and managed.

He said any concerns the bank has about hedge funds are systemic in nature; in other words, the bank worries that hedge funds could possibly be using similar strategies, and therefore respond similarly to a system shock, exacerbating price movements "away from fundamentals, potentially leading to financial problems for other investing institutions."

This concern is lessened by the fact that Canada has number of "good sized" hedge funds, all following different styles and using different strategies. Still, counterparties such as banks that provide prime brokerage could be overexposed to hedge funds, and if several larger hedge funds suffered losses at the same time, it could lead to a rise in systemic risk and perhaps even a crisis. "Prime brokers are now much more aware of the risk than at the time of [Long-Term Capital Management], and are carefully monitoring their risk exposures," Mr. Longworth noted.

And hedge funds are sophisticated and diverse in their objectives and strategies, as well as the instruments they use to achieve those.

"Hedge funds add to the depth and liquidity of Canadian financial markets," Mr. Longworth said. "And the ability of hedge funds to use leverage and their tendency to actively trade greatly amplifies their presence in the markets, and further adds to liquidity. . . . The overall effect of increased liquidity and more effectively managed risk should, in principle, be lower volatility."