A regulator's take on Amaranth

Alexa Lam, executive director at Hong Kong's Securities and Futures Commission, sat down with AsianInvestor to discuss lessons from the collapse of Amaranth and other issues in the hedge-fund industry.

AsianInvestor: The collapse of Amaranth: what are your thoughts?

Alexa Lam: It is a recipe that repeats itself every few years: a young, aggressive trader with one-way bets. Having said that, this is in some ways a refreshing case. After LTCM collapsed everyone worried that the next similar incident would suck in the worldÆs financial markets. Amaranth was a bigger failure but there was no Wall Street consternation and no ripple effect. It makes me think that a major hedge-fund collapse need not bring chaos.

There has been a move towards more stringent risk management, and even though AmaranthÆs own risk management was at fault, that was not the case with its counterparties. Positions were largely resolved quickly, though that was helped by market liquidity.

What lessons have you taken on board as a result?

I think we have learnt three lessons from Amaranth. Firstly, counterparties of hedge funds absolutely must have robust risk management and due diligence skills. Prime brokers should not let standards slip just to win business from competitors. Secondly, senior managers at hedge funds have to monitor staff stringently. They have to monitor risk on an aggregate portfolio basis.

And thirdly, Amaranth investors are nursing their wounds. They have to demand transparency from hedge funds. Institutional investors can definitely afford the financial costs of having their own proprietary due diligence done properly.

The SFC has just released a market survey. What are the highlights?
The number of hedge fund managers in Hong Kong has doubled in the two years from March 2004 to March 2006. The number of managers has risen from 58 to 118 and the number of underlying hedge funds that they manage increased from 112 to 296.

Assets under management in that period rose 268% to $33.5 billion. Of the funds polled, one third were equity long/short strategies, a quarter were multi-strategy and 20% were funds of hedge funds. The survey found that 40% of hedge funds managed in Hong Kong do not use leverage.

Big hedge funds still appear to be selecting Hong Kong as a base. What message would you want to convey to smaller hedge funds contemplating where to set up?

You have different opportunities here in Hong Kong. I completely understand that if you operate a Japanese strategy, then it makes sense to go to Tokyo. If you are Asean-focused, then Singapore is a good base. If your hedge-fund strategy is to be involved with China, and north Asia, then Hong Kong is the logical choice.

How do you think hedge-fund regulation in Hong Kong compares to other Asian jurisdictions?

I donÆt want to comment on other places, but I would say we are open and transparent here in Hong Kong. Our processes are transparent and its one set of rules for everyone. ThatÆs the key requirement for an international financial centre.

Hedge funds have requested clarification about who gets to vote if they have borrowed stocks. Is it them as the borrowers, or is it the original owners?

The borrower may exercise its voting rights in respect of the borrowed shares. However, the lender normally reserves the rights to call back the shares or instruct the borrower to vote in accordance with its direction.

Hedge fund employees taking the Paper 6 exam for responsible officers have said that the questions are worded in such a way that it is very hard to decipher the triple negatives and arcane convoluted English.

On the exam paper for responsible officers, the exam body is the HK Securities Institute. I will reflect those comments to HKSI. The purpose of the exam is not to test if you remember, for instance, how many days you have to file a particular piece of paper.

Is it true that a registered hedge fund in Hong Kong canÆt operate out of a serviced office?

Yes that is true. Having premises here adds to accountability, which you donÆt get if youÆre of æno fixed abodeÆ. We understand that when people arrive they need temporary offices, but final approval of licenses is dependent on having your own place.

Hedge funds have observed that establishment and registration in Hong Kong can take longer than elsewhere.

The average has been about 12 to 13 weeks for an in-principle approval to be given. Quality hedge funds that are already regulated in one or more of the world's major financial markets with clean records should have a shorter approval time. Often we come across hedge-fund managers whose applications have not been properly prepared by their advisers or are otherwise sub-standard. That could significantly lengthen the process.

Typically these advisers would not be entirely transparent to their clients as to the real reason behind the delay, and somehow the SFC ends up being the easy target to blame.

I would advise managers who encounter delays to directly contact us so that we could directly relay the issues for them to address immediately. Also, we have seen some managers come in without the necessary number of responsible officers with the required relevant experience. While we are happy to take an interpretation of what would be relevant experience, we wonÆt compromise on the requirements for experience and adequate risk-control measures.

And of course, when you talk about the time required for approval, you should start counting from the day all relevant information and documents are in, not the day when only bits and pieces were submitted.

Hedge funds have said that the SFC is becoming increasingly enforcement-oriented, and moves quickly to a punishment phase for infractions. What is driving this?

WeÆre not picking on hedge funds. Enforcement is strict across the board. You must have that to run a clean market. In financial markets you can encounter false trading, insider trading, and other forms of misconduct like front running and unauthorized trading. You simply have to enforce the rules in a strict way and its our duty to provide such investor protection.