Sir - The Financial Services Authority’s decision to engage the industry in a discussion of how to oversee hedge fund activity should be welcomed, but its oversight should be based on how hedge funds fit into the new structure of the capital markets industry.
A lot has happened to the structure of capital markets since 1998. In the old structure, investors accessed markets through broker-dealers who innovated financial products, provided liquidity and traded on their own account. Investors were the customer whom every player in the financial markets served, but had little ability to influence the governance of corporations in which they invested or to foment competition for their business.
This has changed. Investors now demand (and get) direct market access at a much lower cost. Institutional investors give each dealer just enough profit to keep them competing for the rare, high-margin transaction. Most importantly, investors have caught up with broker-dealers in their ability to innovate new types of trades. Broker-dealers now face off with investors that have substantial analytical horsepower and balance sheets big enough to engage in market-moving transactions.
The larger hedge funds have taken on characteristics of broker-dealers: they innovate products, provide liquidity, and trade for their own account. Several of the larger hedge funds are seeking broker-dealer licenses and are encroaching on the traditional turf of bankers by offering stock lending, market making and clearing their own transactions. That some bankers have provided hedge funds with inside information and advantageous mutual fund trading indicates how desperate they are to maintain hedge funds as clients rather than competitors.
What are the implications for the FSA and other oversight bodies? First they should recognize that the structure of the capital markets is changing. In a few years, investors will play a much more important role in providing market liquidity and innovating new products, so the focus of regulation should shift from intermediaries to principals.
Finally, with over 8000 hedge funds, it is clear that not all of them will be equipped to execute the role they have carved out. Nor will they be able to achieve the investment performance their investors expect. A consolidation in the hedge fund industry is inevitable, and the FSA and other oversight bodies should prepare to manage this consolidation in such a way that it creates, rather than destroys, confidence in the industry.
