New world order for funds

Increased scrutiny by the SEC, the spectre of increased regulation looming closer, investors looking for far greater transparency and a rise in the need for insurance protection were all key themes at this year’s Campbells Fund Focus. Business Editor Lindsey Turnbull was in attendance and reports in a series of articles.

Global challenges
Although Cayman still retains a global stronghold when it comes to investment funds (9,888 registered on the Cayman Island Monetary Authority’s books as at September 2009, down from last year’s record of 10,291 but up from 2007’s 9,384, month on month) the industry sentiment is that this jurisdiction will see a marked retraction in this number in the first quarter of 2010. It has therefore never been more crucial for Cayman Islands fund practitioners and its regulator to be on top of global trends and movements within the industry, if the jurisdiction is to still retain its global grip. The annual Campbells Fund Focus, held at The Ritz-Carlton last month was therefore an extremely useful learning tool for professionals in the industry.

Assessing the global challenges and opportunities facing Cayman, moderator for the panel discussion Gary Linford, managing director of DTMC and former head of CIMA’s Investments and Securities division, said that the fund industry had suffered “multiple and unprecedented shocks” in the past twelve months and that hedge funds had been unfairly blamed for the meltdowns and crises in the market, such as the Madoff scandal.

“The near total panic that took place at the end of last year has meant that the rules of the game have had to be rewritten,” Linford said.

He defined the parameters of this new world order for funds, including a reduction in the number of funds in operation, not so much new cash available for the funds that remain and a number of closures by smaller funds in the early part of 2010. He also suggested that there would be a proliferation of rewritten Offering Memorandums, a flight by investors to quality and size and a balancing of interests between the investment manager and the investors themselves.

This new world order would extend to the way in which funds were regulated and taxed in future, according to Linford and Cayman would be unfairly targeted by onshore jurisdictions rather more interested in killing off the competition rather than truly interested in creating a level playing field.

“The Cayman Islands is a transparent, well regulated jurisdiction endorsed by the OECD in light of its positioning on the OECD’s White list, as well as the IOSCO with its recent acceptance of Cayman as a member. So if the debate was really about transparency and regulation Cayman would be in a strong position; however onshore countries are actually more interested in tax collection and wealth creation, a fight in which Cayman appears to be caught in the middle,” Linford explained.

Boris Onefater from Constellation Investment Consulting Group said that the US regulator, the Securities and Exchange Commission will soon be implementing mandatory registration of US fund managers.

“This is not an unusual occurrence in other jurisdictions, such as the UK, Australia and Hong Kong, however US managers are not happy about being regulated by the SEC,” he said. “The impact could well be significant, not just for hedge funds but for private equity funds, venture capital funds and other such vehicles. Regulation brings with it a heavy focus on reporting and disclosure. No one disagrees with the view that regulation will come, but the recommendations for disclosure that this regulation may bring may well make managers uncomfortable,” he stated.

The worry is that the SEC will impose too many restrictions on the operation of a fund (such as limits on leverage, trading strategies and positions, counterparties, etc) and that it will restrict a fund to such an extent that it will not be able to conduct business.

On the flip side, Onefater said that the SEC was in no position to actually process all the data it anticipates it will collect in any meaningful way.

“If anyone thinks the US government will be able to properly process all this information into meaningful data, that is just not how the US government works. They have no systems in place for basic monitoring. To say that they could take the information as at the trade date, process it in a timely way and produce meaningful information is quite fantastic!”

The impact on managers would be to impose infrastructure within areas such as operations and compliance which could have a significant impact on the fund’s bottom line.

As far as the Cayman Islands was concerned, Onefater did not think the impact would be too strongly felt because Cayman Islands hedge funds have been registered in this jurisdiction for a number of years.

How to spot systemic risk
Linford said the US and UK regulator bodies were working in tandem to attempt to identify and prevent systemic risk by heightening their focus on reporting requirements. In this respect Linford said that the onshore jurisdiction ought to understand that Cayman’s fund business (institutional, high net worth investors) was quite different from that of the US and UK’s retail fund investors, and thus quite different information and dialogue was required in each case.

Directing his comments to panellist Yolanda McCoy, Head of Investments and Securities at CIMA, Linford said: “It would be useful if we could actually assist these overseas regulators at the formulation of policy stage rather than just at the enforcement stage.”

McCoy responded that the CIMA’s hedge fund working group had been invited at various stages for their help in reporting standards with overseas regulators and that “great strides” had been made in this area.

Onefater gave an insight into current US government thinking when he described the US as “more inclusive than a year ago. With the new Obama administration the US now believes less that it owns the world and is focusing more on trying to eliminate regulatory arbitrage between jurisdictions. The thrust of the G20 initiative is to create convergence so everyone is on the same page. It won’t be possible for everyone to have exactly the same regulatory regime but that is where they are heading.”
Cayman’s strength re IOSCO principles
Colin Nicholson of KPMG gave an analysis of the six principles (see sidebar) produced by the International Organisation of Securities Commissions’ Technical Committee in its Hedge Funds Oversight report, which it produced in June of this year, and said that Cayman was well poised to take advantage of its strong position as it relates to each principle. 

“IOSCO is a big player in the exchange field and it is therefore important that Cayman is now a member. For its part, Cayman is in good shape. For example, the first principle states that hedge funds and or its manager must be regulated. Cayman’s regulator already required registration by funds.

Cayman’s regulatory environment is already strong with high operational standards required. In fact, Cayman’s regime is unusually robust. This jurisdiction would stand up in any examination of IOSCO members,” he confirmed.

With regard to IOSCO, Linford reiterated that the distinction needed to be made between public funds and those registered in Cayman which were mainly for institutional and hnw investors.

“They need to compare apples with apples,” he stated. “I’m sure the CIMA would have no problem in making any required amendments to the very small number of retail funds registered here.”    

He continued: “There is no prudential regulation of funds here in Cayman for the majority of funds. We operate on a “buyer beware” standard whereby everything an investor needs to make a decision is disclosed in the offering documentation.”
More opportunities for Cayman
Linford suggested that Cayman was actually very well positioned and could embrace the SEC proposed amendments with regard to disclosure and transparency fairly easily, speedily and cheaply.

Cayman registered funds already had to complete what is commonly known as an MF1 form with the CIMA and so, according to Linford, the automation of this required filing and slight tweaking of the format could easily and cheaply provide the CIMA with all the information it would ever need with regard to spotting systemic risk.

“A continuation of the e-filing mechanism at CIMA would mean the regulator could quickly extrapolate any information it needed to determine whether a failure was caused by systemic risk. For example, when Lehman Bros failed last year the CIMA could have easily spotted which Cayman funds were at risk at the push of a button, rather than waiting six months later for all filings to be completed manually,” he said.

Read about what CIMA is doing to keep Cayman’s top positioning (in particular reworking the SIBL) as well as threats to the industry from the EU. The Journal also reports on how the SEC is ramping up its push on hedge funds, so don’t miss December’s edition.            
IOSCO six principles
1. Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration;

2. Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to:
a. Organisational and operational standards;
b. Conflicts of interest and other conduct of business rules;
c. Disclosure to investors; and
d. Prudential regulation.

3. Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds;

4. Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks);

5. Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate;

6. Regulators should have the authority to cooperate and share information with each other, where appropriate, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

From left,  Colin Nicholson, Gary Linford, Boris Onefater and Yolanda McCoy

From left, Colin Nicholson, Gary Linford, Boris Onefater and Yolanda McCoy