The suggestion by UK regulators that the business activities of large asset managers, including their trading operations, could pose a major systemic risk has surprised market observers.
The disruption of big buy-side businesses could “threaten the integrity of a particular market” and will therefore be subject to an active supervisory programme, according to the approach document of the Financial Conduct Authority (FCA) which will become the UK's new financial regulator at the end of 2012.
The Financial Services Authority (FSA), the UK's existing regulator, is to be abolished following its failure to identify and prevent the effects of the global financial crisis in the UK. Its role is to be divided between the FCA, responsible for regulating the conduct of financial services firms, and the Prudential Regulation Authority, a unit of the Bank of England.
“Whether a single fund manager could be considered systemically risky, which is the implication, is at first sight quite incredible,” said Ruben Lee, CEO of Oxford Finance Group, a consulting firm, and author of ”Running the World's Markets: The Governance of Financial Infrastructure'. To be considered a risk to market integrity, noted Lee, a firm would have to be heavily interconnected with other counterparties, so that either an IT or credit failure would have a ripple effect across the market. Historically this has only been considered applicable to market infrastructure businesses such as stock exchanges and clearing houses. More recently, bulge-bracket brokers have been added.
“The collapse of the Long Term Capital Management hedge fund in the late 1990s was an example of a fund that appeared to pose a systemic risk,” said Lee. “On that occasion it transpired that the firm's positions were actually profitable when they were taken over by counterparties, but the firm didn't have the cash to support them.”
He added that the FCA document indicated that regulators were preparing to intervene in areas previously left outside their remit.
Richard Saunders, CEO of the Investment Management Association, a UK buy-side industry body, acknowledged that regulators should consider the wider impact of any disruption to the operations of a buy-side firm, but felt it unlikely these would pose a high risk to the market.
“Providing all the rules around segregation of client assets are followed, counterparty risk ought not be a problem,” he said. “The entity with which a counterparty would be dealing is the fund, which would still be up and running.”
According to Anthony Kirby, head of regulatory reform for asset management at consultancy firm Ernst & Young, the FCA will focus on ”thematic' reviews of firms' activities. “They will look specifically at client money, or product intervention, or in this case how an asset manager operates,” he said.
The expected wider range of regulatory intervention is in part a consequence of the new broad definition of ”consumer' that the FCA is charged with protecting. This includes investment funds and stockbrokers buying shares for their clients, hedge funds and day traders, in addition to retail customers.
“I was personally very surprised to see so many different types of entities categorised as a consumer, particularly the various wholesale consumers,” said Kirby.
Development of the FCA's responsibilities is in an early stage and the approach document is intended to raise issues that should be considered by the market.
The FSA is accepting comments on the approach document until 1 September 2011. The wider government regulatory reforms have been set out in a white paper, detailing the duties and structure of the regulatory bodies and a consultation document which will further guide development of legislation.
The consultation period is open until 8 September 2011.