Hedge fund regulatory reform in South Africa

By Francisco Khoza and Berna Oluka


The global financial crisis has caused a number of countries to reconsider their approach to the regulation of hedge funds. Leading the way has been the Group of Twenty countries (G20) that have agreed some proposals for the reform of hedge funds regulation. South Africa as a member of the G20 is considering what reforms, if any, it has to make.

The purpose of this note is to set out broad principles that should inform regulatory reform in South Africa. In setting out the broad principles this paper covers the following: decisions of the G20 summits; regulatory reforms in the United States of America (“US”) and the European Union (“EU”); and the current South African regulatory framework.

G20 declarations

In the declaration issued by the G20 on 15 November 2008, following the summit on financial markets and the world economy, the leaders of the G20 recognised that,

“During a period of strong global growth earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the financial system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory action.”

The above statement reflects a realisation by the G20 of a gap in financial regulation that was finally exposed by the global financial crisis. Recognising the gap, the G20 adopted a set of common principles for the reform of financial markets. The principles include, among others, strengthening transparency and accountability; enhancing sound regulation; promoting integrity in financial markets; and reinforcing international cooperation.

The leaders of the G20 met again in London in April 2009. At that meeting the G20 the leaders agreed that major failures in financial regulation and supervision were fundamental causes of the financial crisis. The leaders agreed to build a stronger, more globally consistent, supervisory and regulatory framework for the future financial sector.

The G20 leaders also agreed to extend regulation and oversight to all systemically important financial institutions, instruments and markets. Such regulation will include, for the first time, systemically important hedge funds. Regarding the regulation of hedge funds, the G20 adopted the following principles:

hedge funds or their managers will be registered and will be required to disclose appropriate information on an ongoing basis to supervisors or regulators, including information on their leverage, necessary for assessment of the systemic risks that they pose individually or collectively;
where appropriate, the registration of hedge funds should be subject to a minimum threshold, below which a hedge fund will not be obliged to register;
hedge funds should be subject to oversight to ensure that they have adequate risk management; and
supervisors should require that institutions which have hedge funds as their counterparties have effective risk management systems in place. This should include mechanisms to monitor the funds’ leverage and set limits for single counterparty exposure.

The G20 declarations set out the broad principles for the global initiatives to reform the regulation of hedge funds. The US and the EU have taken the lead in implementing some of the principles agreed by the G20.

The US initiative

The US government reform proposals are set out in a document entitled the “Framework For Regulatory Reform” dated 26 March 2009. The US government has proposed the establishment of a single systematic risk regulator responsible for regulating what is referred to as “systematically important firms”. This may include hedge funds based on three characteristics: (1) the financial system’s interdependence with the firm; (2) the firm’s size, leverage (including off-balance sheet exposure), and degree of reliance on short-term funding; and (3) the firm’s importance as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

The US government’s proposals in relation to the regulation of hedge funds can be summarised as follows:

requiring registration of all hedge funds: all advisers to hedge funds whose assets under management exceed a certain threshold should be required to register with the Securities Exchange Commission (“SEC”).
mandating investor and counterparty disclosures: all hedge funds advised by an SEC registered investment advisor should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements.
requiring hedge funds to provide information necessary to assess threats to financial stability: the regulatory reporting requirements for such funds should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability.
sharing reports with systemic risk regulator: the SEC should share the reports that it received from the funds with the systemic risk regulator, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards outlined.

The EU initiative

The European Commission issued a proposed Directive on Alternative Investment Fund Managers dated 29 April 2009 (the “Directive”). The Directive covers hedge funds. The objective of the Directive is to create a comprehensive and effective regulatory and supervisory framework for alternative investment fund managers (“AIFM”) in the EU. The Directive will, among others:

regulate all major sources of risks in the alternative investment value chain by ensuring that AIFM are authorised and subject to ongoing regulation and that key service providers, including depositories and administrators, are subject to robust regulatory standards.
enhance the transparency of AIFM and the funds they manage towards supervisors, investors and other key stakeholders.
ensure that all regulated entities are subject to appropriate governance standards and have robust systems in place for the management of risks, liquidity and conflicts of interest.
permit AIFM to market funds to professional investors throughout the EU subject to compliance with demanding regulatory standards.
grant access to the EU market to third country funds after a transitional period of three years. This should allow the EU to check whether the necessary guarantees are in place in the countries where the funds are domiciled (for example equivalence of regulatory and supervisory standards, exchange of information on tax matters).

From the summary of the initiatives in the US and the EU, it is apparent that the broad principles underlying the reform proposals include the requirement for the registration of hedge funds and/or their managers, transparency; disclosure of risk management systems and information sharing among industry supervisors or regulations. The question is whether South Africa should follow the US and/or EU approach in her own regulatory reform initiative?

The South African context

South Africa has not experienced the financial market failures to the same extent as the US and some EU countries. As such, the nature of any reform that may be initiated in South Africa should be informed by the real experience of the South African financial market and the hedge funds industry. Having said that, there is a shared global motivation (evidenced by the G20 declarations) for reforming the regulation of hedge funds.

Hedge funds are currently not regulated in South Africa. However, hedge fund managers are regulated under the Financial Advisory and Intermediary Services Act, 2002 (“FAIS Act”), which provides that all fund managers (as financial services providers) must be approved by the Financial Services Board (“FSB”) as category IIA discretionary financial services provider (“FSP”).

The code of conduct for administrative and discretionary FSPs (“the Code”) issued under the FAIS Act includes a chapter on hedge fund managers. FAIS and the Code broadly set standards of conduct and ensure that FSPs are fit and proper. In 2008 the FSB published a notice on hedge fund FSP risk disclosures.

Any reform has to recognise the current regulatory framework: this should entail a recognition of the positive aspects of the current regulatory framework and an assessment of any weaknesses that may exist.

There are definitely lessons to be learnt from the financial market failures in the US and EU. In this regard, the contribution of hedge funds to the global financial crisis should, among others, inform the South African regulatory reform exercise.

In light of the above we propose that the following principles should inform the reform of hedge funds regulation in South Africa:

the Constitution of the Republic of South Africa Act 106 of 1996: the Constitution is the supreme law of South Africa; law or conduct inconsistent with the Constitution is invalid and the obligations imposed by it must be fulfilled. The reform must take into account relevant provisions of the Bill of Rights, which include freedom of trade, occupation and profession; access to information; and just administrative action. In essence, the Constitution embodies principles of openness, transparency and accountability which should inform the extent to which such principles should be incorporated in the regulatory framework.
the track record of hedge funds industry in South Africa: Edward West writes that, “ South African hedge funds have stood up well to the volatile environment and global financial crisis in the past two years. Hedge fund returns in South Africa since August 2001, annualised, came in at 18.19%...While a fair number of hedge funds have struggled in the global financial crisis, South Africa has only seen one hedge fund failure in its history.” (“South African hedge funds not risky says portfolio manager” 2 June 2009 Business Day at page 12). The track record of South African hedge funds is a relevant consideration. If the current framework is working then all that needs to be done is to improve the system with an eye on the future.
the preservation of the local industry’s competitive position: the reforms should make it worthwhile for hedge funds to be established and to operate in South Africa. Any regulatory reform should facilitate innovation that would be beneficial to local and offshore investors.
take into account domestic economic and financial policy: reform should be aligned with South Africa’s economic and financial markets policy. The role of hedge funds and their operation must be assessed in light of how they may or do contribute to the economic and financial markets in South Africa.
regulation of cross border operation of hedge funds: recognising the cross border risk posed by hedge funds, South Africa must ensure that foreign hedge funds that operate in South Africa comply with certain standards by checking whether the necessary guarantees are in place in the countries where the funds are domiciled (such as equivalence of regulatory and supervisory standards).
whether hedge funds should be marketed to retail and/or institutional investors in South Africa: in light of the lack of understanding of hedge funds and the complexity of hedge fund strategies and products, there is a need to consider whether the marketing of hedge funds in South Africa.
Risk disclosures: consider whether the current risk disclosures required by the FSB are still appropriate.

The regulatory reform in South Africa should aim at striking a balance between domestic circumstances and the global concern for minimum standards of regulation of hedge funds and/or hedge fund managers.