Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 10 - Evidence - Meeting of November 1, 2006
OTTAWA, Wednesday, November 1, 2006
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:05 p.m. to examine and report upon the present state of the domestic and international financial system (study on hedge funds).
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: Ladies and gentlemen, welcome to the Standing Senate Committee on Banking, Trade and Commerce. This committee is one of the oldest committees in Parliament. We are delighted to welcome witnesses to a study we are undertaking about hedge funds in Canada, North America and around the world.
This committee was established right after Confederation, and its terms of reference were to deal with banking, trade and commerce. It is the only committee, by its terms of reference, with a responsibility for at least looking at questions that affect the economy as a whole. For the last several years, our committee has been looking at key issues that affect the economy as a whole, not only the financial sector but things that affect productivity, efficiency and the workings of our national economy.
We decided to focus on those issues where we think there is either a lack of knowledge or a lack of information to ourselves and to the public. After a number of discussions, we decided to focus this hearing on hedge funds, which we think are in the trillions of dollars. We do not even know the scope of hedge funds globally. Given the size and scope of our relationship with the United States and the integrated nature of our economies and the priority we have to give to financial global stability, it is imperative that Canadian policy-makers understand what is happening to hedge funds in Canada, the United States and, we hope, around the globe.
During our discussions several weeks ago with U.S. regulators and representatives of the financial services industry in New York, hedge funds emerged as a key issue. We thought we would look at this as quickly as possible, particularly in light of a number of high-profile hedge fund failures and the increasing number of investors, banks, pension funds and mutual funds, both sophisticated and retailers, who are now investing in this rather unique financial vehicle.
In June of 2004, based on the numbers we were given, we estimated that the Canadian hedge funds were at $26 billion. We hope to update that number during this hearing. In North America, we know it is in the trillions.
We heard from hedge funds during our recent study on consumer issues in the financial sector, and we recommended in our report some time ago that an eminent person should be appointed by the government to review the regulatory oversight, if any, of these funds. That was not done, so we decided to return to this question.
A key caution remains for us regarding the extent to which and the methods by which these new financial products should be regulated or supervised in order to provide consumers and domestic financial markets some confidence. This committee is open-minded on the question of regulation. We want to know more about the nature, scope and risk to investors in the economy. We were encouraged to do this study by the Governor of the Bank of Canada last week, which accelerated our hearing.
I should say to our listening audience that this is being watched from coast to coast to coast and on the Internet. We ask our Canadian viewers to please give us their views. We are interested not only in the views of the witnesses but also in the views of the Canadian public who are watching these hearings.
We are delighted to welcome our first two witnesses, Mr. Jean St-Gelais, president and CEO of the Autorité des marchés financiers, and an old friend of mine, Mr. David Wilson, the recently appointed chair of the Ontario Securities Commission.
David Wilson, Chair, Ontario Securities Commission: If it is all right with you, we will jointly make some opening remarks. I will begin and Mr. St-Gelais will chime in. I will finish and then be delighted to answer questions. We are pleased to be appearing before this committee.
Your interest in hedge funds is especially timely given the growth of this new product in both the Canadian and the global market places. In our opinion, the hedge fund industry in Canada has an appropriate oversight framework, but that does not mean that we cannot and will not do more to ensure that investors are appropriately protected.
Our remarks will be divided into three areas: First, I will describe the general framework for the regulatory regime for hedge funds; second, Mr. St-Gelais will look at the current hedge fund landscape in Canada; and, third, we will outline recent regulatory initiatives involving the hedge fund product. After that, we will be more than happy to answer your questions. If we are unable to answer your questions fully today, we will undertake to provide you with detailed answers in short order.
The first area is a regulatory framework for hedge funds in Canada and the U.S. Hedge funds are investment pools using various strategies to generate absolute positive returns for investors in all market conditions. Traditionally, hedge funds have attracted assets from institutional investors and wealthy, sophisticated individual investors. Canada does have a regulatory framework applying to hedge funds.
In Canada, hedge fund portfolio managers must be registered with securities regulators. The people and the firms who actively management hedge fund portfolios are all registered as portfolio managers with Canadian securities regulators. In addition, the people who distribute the hedge fund securities must also be registered with securities regulators. Hedge fund portfolio managers must follow the requirements governing registered portfolio managers. These include requirements related to proficiency, suitability, compliance and disclosure.
This registration requirement has existed in Canada for decades. This oversight system is supported by a compliance regime that checks compliance with securities laws and rules and by an enforcement regime that deals with breaches of securities laws and rules.
Senator Grafstein mentioned that the senators were recently in New York and had discussions about the U.S. hedge fund market. As you know, there is an important difference between the Canadian and American regulatory regimes. In the U.S., hedge fund portfolio managers are not required to register with the U.S. Securities and Exchange Commission, SEC. There is a safe harbour exemption that virtually all hedge fund portfolio managers use in the U.S. to avoid registration. The SEC recently tried to introduce a requirement for registration of hedge fund portfolio managers, but this proposed rule was overturned in the U.S. courts.
Hedge fund portfolio managers in Canada must be registered with regulators. The umbrella group of Canada's 13 provincial and territorial securities regulators, the Canadian Securities Administrators, CSA, is considering a change that would further distinguish our regulatory framework from the U.S. regime.
In early 2007, the Canadian Securities Administrators, which is the oversight body for all the 13 regulators in Canada, will propose a requirement for all hedge fund administrators, often called managers, to register in addition to the existing registration requirement for portfolio managers of hedge funds.
Hedge fund administrators manage the day-to-day operations of hedge funds, including valuations, marketing plans, investor relations, and so on. This new proposal by the Canadian Securities Administrators to register administrators will be subject to the usual public consultation process. I believe such a registration requirement for hedge fund administrators makes a great deal of sense, and we intend to move forward with it early next year.
Let me now turn to the current hedge fund landscape in Canada. What distinguishes hedge funds from other pool investment vehicles is that they are comparatively sophisticated investment strategies. Unlike mutual funds, they can use certain trading strategies, leverage and instruments, including derivatives, to capitalize on market inefficiencies.
Over the past decade, hedge funds under management have grown significantly. Globally, the industry now manages more than U.S. $1 trillion. Canada's market represents 2 per cent of the global hedge fund market, about $27 billion based on the latest numbers that we have. Of that $27 billion, approximately $11 billion is invested by Canadian pension funds.
The Chairman: I do not mean to interrupt, but we have a factual problem. In the United States, we believe the North American number was somewhere between $1.5 trillion and $2 trillion. We are not sure whether that included global or just North American investment. We believe it was just North American. Those numbers were from 2005 or 2006. When you give us your numbers, tell us the date you have to ensure we were not under counting.
Mr. Wilson: These numbers are from the end of 2004. They are still a bit out of date. New numbers will be coming in soon for Canada.
The Chairman: When do you expect those new numbers?
Mr. Wilson: Very soon.
The Chairman: This year?
Mr. Wilson: Yes.
Senator Angus: From where do you get the numbers?
Mr. Wilson: Investor Economics is the source.
The Chairman: We will ask them to come to see if we can get the source of that information. It is important for us to understand the scope of the matter.
Senator Moore: Are all numbers here in U.S. dollars?
Mr. Wilson: Yes, these are U.S. dollars.
Senator Goldstein: Canadian?
Mr. Wilson: The figure of $27 billion is the estimated amount invested in Canada in hedge funds. I believe that is U.S. dollars.
Senator Goldstein: Our information is that it was Canadian dollars; $26.6 billion.
The Chairman: We are trying to clarify the numbers. It would be appreciated if you could help our staff so that we can understand the scope of what you are talking about.
Mr. Wilson: After today's meeting, we will give your staff our staff's best estimate of what the numbers are and when the updated numbers will be coming out.
The Chairman: Yes, and the source.
Mr. Wilson: We will give you the original source, the most up-to-date numbers we have, and when the new updates are coming.
Of the $27 billion — and let us assume that that is the right number for Canadian hedge fund investment — approximately $11 billion is invested by Canadian pension fund investors; a small amount, about $1.6 billion, is invested by foreign clients of Canadian hedge fund managers; and $14 billion of the $27 billion is invested by individual Canadians, either of high net worth or retail investors. Over half of the $14 billion invested by individual Canadians was invested through hedge fund-linked PPNs or principal protected notes. I will speak about that in more detail later. The Canadian market is growing at about 30 per cent plus per annum.
Jean St-Gelais, President and Chief Executive Officer, Autorité des marchés financiers: As the industry expanded, more and more hedge fund-like products were sold to retail investors. One concern we have is that retail investors and some of the registered financial advisers may not fully understand hedge funds and their risks.
Senators, I am sure you have read media coverage about the hedge fund companies, for example, Portus and Norshield. I am sure you will understand that what I say about Portus and Norshield is limited to material already in the public domain.
The investigations of the collapse of Portus and Norshield involve allegations of fraud. A recent report of the review by the task force headed by Tom Allen to modernize the securities legislation in Canada found that in both funds, investors' monies were not invested as indicated in offering documents. It has been alleged that investor funds were used improperly.
The Canadian Securities Administrators launched enforcement proceedings against both companies. The charges laid in the Portus case include unregistered trading and failing to meet the duties as fund manager. Furthermore, Portus is being prosecuted in Ontario under provincial statute. The RCMP is also investigating the company.
The Task Force to Modernize Securities Legislation in Canada commissioned a research report on both Portus and Norshield. The report did not identify any gaps in the regulatory regime for hedge funds. However, it did say that more compliance checks on the firms might have raised red flags earlier.
Finally, the latest hedge fund story to attract considerable attention involves Amaranth. It appears Canadians own about 3 per cent of Amaranth, which is based in the U.S. It is important for the committee to know that Amaranth's huge investment losses were the result of high-risk investment decisions. There have been no allegations of malfeasance.
None of these cases involves a failure of our framework of securities regulation. Moreover, these cases do not by themselves suggest the need for additional regulation.
Mr. Wilson: I will turn to our final point, the current regulatory initiatives involving hedge funds. Last May the Ontario, Quebec and British Columbia securities commissions completed a review of hedge funds in Canada. The review was undertaken in response to the recent growth of retail investment in hedge funds and to failure of the three funds Mr. St-Gelais mentioned earlier. The review concluded that our regulatory regime offers an appropriate framework to regulate pooled investment vehicles, including hedge funds. However, it did note several areas of concern, one of them being principal protected notes. Individual Canadian retail investors have invested approximately $8 billion in principal protected notes that are linked to hedge fund performance. A segment of this market is comprised of deposit notes issued by deposit-taking institutions, including banks. These principal protected notes are not covered by any securities law disclosure requirements because they are sold as bank deposits and are not securities in technical terms.
Here are a few examples of our concern about principal protected notes. They give retail investors access to an asset class for which no prospectus is required or vetted by a securities commission. Investors may not be getting sufficient disclosure about principal protected notes regarding their structure, fees and risks. Some registrants make referrals to clients to purchase principal protected notes without ascertaining whether it is in the client's best interests, and some registrants selling principal protected notes may not be meeting the know-your-client and suitability obligations they have — two pillars for ensuring fairness to retail investors.
The Canadian Securities Administrators are currently studying the concerns associated with principal protected notes that are sold as deposits outside the ambit of securities law. We believe it is important to ensure that investors receive prospectus-level disclosure about principal protected notes. We also believe that principal protected notes should be sold by a knowledgeable salesperson who understands the product and the purchasing needs of the client.
[Translation]
Mr. St-Gelais: In conclusion, I wish to underscore that the Canadian securities authorities have ways and means at their disposal that we think are appropriate for overseeing hedge funds in Canada. Rest assured that we are still working on improving our tools so that our regulatory framework is as appropriate as possible for finding the right balance between consumer protection and the integrity of the Canadian capital markets. I wish to reiterate our support for your committee's work and to thank you for your invitation.
[English]
The Chairman: That is a tremendous introduction.
Senator Angus: As I think you know, we put our foot in the water with this subject back in June, when we were finishing a study on consumer issues relating to the securities business. People from the securities commission testified.
Mr. Wilson: We are aware of the report.
Senator Angus: You are aware that on June 8 and June 16 your predecessor was here. In any event, it is true we have been hearing more and more about hedge funds. In New York, we heard much about the landscape in the U.S. I think you said the regulatory landscape is different.
Mr. Wilson: That is correct.
Senator Angus: These are elementary questions, for the reasons the chairman said earlier. We hear about private equity funds and hedge funds and we are told some private equity funds are hedge funds. Is there a standardized definition?
Mr. Wilson: I will try to give one. I will do my best to standardize the definition, because there are different varieties of hedge funds. A hedge fund is essentially a pooled investment vehicle, meaning many investors put their money into a single pool of assets and a manager invests those assets in a series of securities. What makes a hedge fund different from a regular pool investment vehicle, called a mutual fund, is that the investment strategies are very diverse. The capital going into a hedge fund can be invested in stocks and bonds. It can be levered, invested in derivatives, in credit derivatives and in commodities — a host of different assets that mutual funds are not permitted to invest in. There are rules restricting what mutual funds can buy.
Senator Angus: What rules are those?
Mr. Wilson: Securities regulators have rules that prescribe what mutual funds can do — for example, limitations of leverage, limitations on shorting securities. For hedge funds there are no limitations. They can do whatever they want to maximize the return to their investors. Creativity is unlimited, but typically they are market instruments that are bought and structured in sophisticated ways. Sometimes they are structured to get risk reduced on a net basis and sometimes, as Mr. St-Gelais mentioned, with funds like Amaranth, they are structured with high risk, and with high risk you sometimes have huge losses. Amaranth lost $6 billion in two weeks. Hedge funds can be risky or low-risk. There is a big spectrum of risk under the umbrella of hedge funds, but they use sophisticated trading strategies to get returns.
Senator Angus: Is there any standard degree of gearing? We talk about the leverage, the initial fund, the first counter party and then the next counter party. How far does it go, or is it limitless?
Mr. Wilson: As regulators, we impose no rules on leverage for hedge funds.
Senator Angus: One difference from the U.S., as you have pointed out, is that there is some measure of regulation already in place in Canada.
Mr. Wilson: Yes.
Senator Angus: There is no regulation in the U.S. since the striking down of the Goldstein case. The measure of regulation is already in place here, if I understand it.
Mr. Wilson: It is the portfolio manager.
Senator Angus: That is not the hedge fund manager?
Mr. Wilson: It is. There are three entities I should describe. There is the fund itself.
Senator Angus: Is that a limited liability partnership?
Mr. Wilson: The fund is usually a corporation that has the ability to redeem shares. It is an open-ended corporation. That is the fund. No one regulates the fund per se.
In Canada we regulate the portfolio manager, which is another entity separate from the fund. The portfolio manager is registered in Canada and is overseen, which is not the case in the United States.
The third entity is the administrator of the hedge fund. That person is not registered in Canada yet. As I said in my remarks, the intention is to require registration of administrators of funds, including administrators of mutual funds and hedge funds, all pool vehicles, and we at the Canadian Securities Administrators are making the proposal early next year to register that third body. Once that is in place, the administrator will be registered just as the portfolio manager is now registered. The fund itself will not be registered and overseen.
Senator Angus: Are the administrator and the portfolio manager sometimes the same?
Mr. Wilson: Yes, quite often. It is called a corporate group.
Senator Angus: Those managers have to register today.
Mr. Wilson: The portfolio managers do, yes.
Senator Angus: With whom do they register? Is it with the Ontario Securities Commission or in the province in which they do business?
Mr. Wilson: They have to register with all the provinces where their head offices exist.
Senator Angus: How does the registration process work? Do they have to show that they have a license from the Investment Dealers Association?
Mr. Wilson: You apply to register with the local securities commission in the province where you do business. To be registered, you have to meet certain compliance requirements: proficiency, competency, integrity and financial solvency are the touchstones for getting registration.
Senator Angus: If it is in Montreal, for example, the person would come and say, "I am XYZ. I have a hedge fund. I am the portfolio manager, and I want to register.''
Mr. St-Gelais: Exactly.
Senator Angus: I am there as the president of that company. What do I have to go through? Do I have to pay a fee?
Mr. St-Gelais: You have to pay fees for registration. Perhaps they are not high enough, but there are fees. We do a security check for a criminal record. We ask about proficiency. We ask whether you have completed level one of the chartered financial analyst designation. We also look at integrity, good character, competency and financial solvency. We require a certain amount of financial solvency in order to conduct your business. Once you have it, you have to keep this registration ongoing each year.
Senator Angus: These seem like simple questions.
Mr. Wilson: Not at all.
Senator Angus: If am dealing with RBC Financial Group or CIBC Wood Gundy, I know that the broker I phone to make a trade with has had to take exams and get registered with the Investment Dealers Association, IDA, and perhaps other bodies. Is that what you mean by the competency test? Do the guys who are starting these funds have to be IDA members?
Mr. St-Gelais: I cannot answer precisely which type of proficiency courses they are taking, but they need to register with us, and they have to fulfill those competency requirements. I would say that usually most of them go through the CSI, Canadian Securities Institute, courses and tests.
[Translation]
Senator Angus: You check that these people have expertise in the area.
Mr. St-Gelais: We make sure that they have taken the required courses and passed them. The majority of them study with the Investment Dealers Association of Canada so that they can conduct their business as they should. It is the same type of course. We make sure that this check takes place annually.
Senator Angus: This is the same expertise, for example, as that of a broker with RBC. They have the same expertise.
[English]
Now we get to transparency. Is there any control over or regulation of the portfolio? Does anybody in Canada know what they are trading and investing in?
Mr. Wilson: If they are registered, we have the power, as their regulator, to say, "You are the portfolio manager for that portfolio or pool. We want to have a look at the portfolio.'' We have the power to do that if they are registered with us. If they are not registered with a regulator, as is the case in the U.S., the regulator cannot go in and say, "Show me what you are doing and what is going on here.''
Senator Angus: For some reason, perhaps a complaint or a whim, you go in. It is a small fund. It has just been started up as a hedge fund by the definition you gave earlier. It has $1 million in assets and is trading in the markets and churning the money over and over again. I understand it is like a private placement in the regular securities world. They have to be sold in units of $150,000. Do you insist that they have some degree of sophistication? You mentioned that 54 per cent of these funds are retailed to ordinary Canadians.
Mr. Wilson: Sophisticated, high-net-worth people who buy hedge fund products have to meet sophisticated investor tests, as you have described, senator — $150,000 individual purchase size or investable assets of $1 million. Those are the two key tests that let sophisticated investors buy hedge funds without a prospectus and without all the disclosure that goes with that. However, as I said in my remarks, over half of the individual investors' investment in hedge fund type products is delivered to them through principal protected notes. Those are sold without a prospectus as well, but the little investor can buy them because they are bank deposits under the rules.
Senator Angus: And they do not have to be $150,000?
Mr. Wilson: That is right. An exemption for the prospectus requirements for bank deposits was granted 25 or 30 years ago. Since that time, much more sophisticated forms of bank deposits have developed. A simple deposit that has been wrapped with a hedge fund index product still technically does not require a prospectus. We at the CSA are conducting discussions with various levels of government and the banks to determine how this regulatory gap should be closed.
Senator Angus: I know of a small fund like the one I described, selling units at $1 a unit. I assume you have to have $150,000 worth of units to get into the game, but they bundle the units among four or five people. How do you police that, and is that legal?
Mr. Wilson: The sales of those units are done by registered people, members of the Investments Dealers Association or the Mutual Fund Dealers Association. They are to police that. Each single investor must buy $150,000 or more. Breaking it up into smaller pieces and selling it among five friends is not allowed.
Senator Angus: How do you catch that?
Mr. Wilson: You reprimand the broker who did not police the sale to a single individual person with a single ticket.
Senator Tkachuk: Can a fund manager or administrator, once registered, manage more than one fund?
Mr. Wilson: Sure.
Senator Tkachuk: He does not have to register 10 times. Once he is registered, that is it.
Mr. St-Gelais: That is correct.
To go back to the previous question, once a person is registered as a fund manager with the securities regulator in Canada, he or she has to act by the know-your-client specification and all of that. How do we police that? The IDA polices the registered fund managers. We can step in if we find something, but we need to have evidence that there is a problem. With the hedge fund industry, the concerns are more related to the fact that people do not know what is happening. We are not saying there is a problem or there is no problem, but everybody selling financial products who is registered with us must comply with the requirements within the registration processes and filing.
Senator Harb: Canadian hedge funds have to be registered with your organizations. Can those hedge funds invest money in the U.S.? If they do, do they still have to register with you?
Mr. Wilson: What they invest in does not determine the registration. The requirement to register is determined by the domicile of the head office of the portfolio manager. If the head office is in Canada, operating out of one of the Canadian provinces, they must register.
Senator Harb: Do you police their portfolio in the U.S.?
Mr. Wilson: No. We do not police their portfolios at all unless they file a prospectus. These are not prospectus-filed funds.
Senator Harb: You mentioned in your opening statement that hedge funds are worth approximately $30 billion and growing at 30 per cent every year. It could be in the vicinity of $50 billion to $60 billion.
Mr. Wilson: It is likely $35 billion plus.
Senator Harb: With respect to pooling in the brokers industry, normally, before an application is approved and proceeds, there is a cooling-off period for the person borrowing the capital. Often in Ontario brokers would collect monies from five or six people and invest them or loan the monies to someone else. Ontario has said that that is no longer acceptable. The person putting money into the pool does not know where the money is going. Are you concerned that in some cases an investor at the end of the road does not know where his money is going?
Mr. St-Gelais: Of course it is a concern when the investor does not know what is happening, where his money is and what risk he is taking. That is one reason we want the people who sell those products first to know their products and second to know their clients' needs in order to advise them appropriately.
Usually it is sophisticated people using an accredited investor exemption who buy hedge funds, and they should be able to do their own due diligence.
Senator Harb: If I have a pension fund, that is not to say that I am a sophisticated investor. I have simply put my trust in the pension fund and, as you stated, they are approximately 35 per cent to 40 per cent of the total pie.
Mr. St-Gelais: The answer would be even simpler. Hedge funds are much more suitable for large, institutional investors such as pension funds than they are for the retail investor. If my pension fund is with a large, institutional investor pension fund that is managing and investing for me, then they can do due diligence. They can deal with the best hedge fund in the world. They cannot take all of them but they can deal with that and fully understand what is at stake and the derivative strategies as a leverage, as Mr. Wilson mentioned in his presentation. I would be less concerned about an investment made by an institutional investor than about an investment made by a retail investor with direct access to principal protected notes, for example, where it is very important for the investor to know what he is doing. Keep in mind that we are entering an era of good disclosure.
Senator Harb: During some of our meetings with officials in the U.S., it was brought to our attention that our system of investigating is extremely lax; we do not practice due diligence the way they do in the U.S. The Americans commented that, in some of these funds, a great deal of manipulation takes place in a portfolio by the portfolio manager. Therefore, I would ask, on a day like today when the markets have gone down substantially as a result of the government announcement on income trusts, would you take measures to determine what happened, who did what and whether there have been any irregularities? How would a black day like this affect hedge funds?
Mr. St-Gelais: Perhaps Mr. Wilson will want to add a comment to this very broad question in respect of the surveillance of the capital market in Canada and the relative strength of the enforcement activities that we conduct.
For surveillance of market activities on days like today, securities commissions in Ontario and Quebec have people looking after major swings in important issuers' prices of shares. We look at whether insiders of the companies have traded. They are the brokers that make most of the trades. We check to see whether they had information prior to these trading events. We have Market Regulation Services Inc. doing similar activities for the Toronto Stock Exchange, TSX, and alternative trading systems in Canada. When something unusual pops up, they connect with our enforcement, inspection, and investigation people. We begin work to see whether there was any inappropriate activity.
It is much easier when products are sold through a prospectus, because a prospectus is filed with us and reviewed beforehand. We can then ask the company what happened and whether it followed what was stated on the prospectus. In the cases of exempted hedge funds, investment funds and investment pools of all kinds not on our radar screen, we have to go through the registrant, the portfolio manager, to determine whether they have done something wrong.
The Chairman: If you find a wrongdoing, the only penalty is deregistration. The fund is not touched.
Mr. St-Gelais: It would depend on what we found.
The Chairman: Let us assume you found something of bad judgment or malfeasance. In the case of the latter, it would be referred to the authorities. As the industry watchdogs, what would you do?
Mr. Wilson: We would send in our enforcement branches.
The Chairman: At the end of the day, they came to a prima facie case of —
Mr. St-Gelais: Depending on what was done, we could have in place administrative fines and penal fines before the provincial court. We could send the case to the RCMP or to the Sûreté du Québec. We have many initiatives in this area. If the committee wishes to discuss it, I am sure we would be prepared to do so.
The Chairman: When you find something wrong, what do you do? That was Senator Harb's question.
Mr. Wilson: We can penalize and go to the courts to freeze the assets to protect the investors' money and to find out if something is truly wrong.
Mr. St-Gelais: We can put a receiver in place.
Senator Harb: I am interested in the comment you made about the pools outside your control, meaning you do not know what is going on because they are exempt. You mentioned that people can deposit their money with a bank and guarantee their principal. That cannot go wrong. In other words, if it goes wrong, then the bank is on the hook. If you deposit $100, the bank takes that money and invests it on your behalf. If there is a profit, what does the bank take out of that? Does the money all go to the investor?
Mr. Wilson: The capital is guaranteed by the bank to be returned at the end of the term of five or seven years or 10 years. The return on the capital is the element at risk in a principal protected note. In a 10-year instrument, the return on the capital is worth about 35 per cent to 40 per cent of the value.
Senator Harb: I see. If you were to ask this committee to do one thing,what would that be?
Mr. St-Gelais: We would have to think about that.
The Chairman: In the public interest.
Mr. Wilson: A very short-term thing we are working on is improving the regulatory regime for principal protected notes, which are a subset of hedge funds. Total principal protected notes are about $30 billion in Canada, sold without a prospectus. If the Senate could give their views on that particular product, that would be helpful to us at this time.
Mr. St-Gelais: We have started discussion with the major banks in Canada about that product, and we made clear at the outset that we want to work cooperatively with our colleagues from the Office of the Superintendent of Financial Institutions, OSFI, and the federal Department of Finance so as not to have a jurisdictional problem, just to make sure that this is properly disclosed.
Senator Tkachuk: I have a few questions to follow up on these principal protected notes, only because you honed in on them after that question. Why is that?
Mr. Wilson: They are being sold very rapidly in large amounts, and they are of varying risks, but the ones that have the greater risks should be subject to a more rigorous regulatory oversight, prospectus disclosure or prospectus-like disclosure, and sale by registered, proficient people who are trained in selling risk securities to clients. With the exemptions in place for many years, that is not a requirement at the present time.
Senator Tkachuk: Who would buy those?
Mr. Wilson: Retail investors, small investors.
Senator Tkachuk: Are they a complicated instrument to buy? Would the purchasers buy them directly on the Internet, or would they buy them through a broker?
Mr. Wilson: They buy them through stock brokers, mutual funds salespeople, bank branches, Desjardins branches.
Senator Tkachuk: You would think those people should know something about the product they are selling.
Mr. Wilson: Yes.
Senator Tkachuk: Why would we need to protect anybody here? I still think we have a right to make money or lose money.
Mr. Wilson: As long as the facts are disclosed before you put your money at risk.
Senator Tkachuk: Are the facts not being disclosed now?
Mr. Wilson: It is our view that there could be enhanced disclosure of the risks associated with some these principal protected notes.
Senator Tkachuk: You say that the investment is taken off the money that is earned from the principal.
Mr. Wilson: The return on the principal.
Senator Tkachuk: What happens to the return? Is it fairly secure? Is the initial deposit put into fairly secure investments, or is it put into stocks?
Mr. Wilson: To give an example, an investor puts in $100; of that, $65 will be go to purchase a zero coupon bond and $35 will be invested in risky assets like hedge funds or commodity indices. The zero coupon bond of $65 will accrue to the face amount at maturity, and whatever the other, riskier investment produces will be shared between the investor and the product manufacturer.
Mr. St-Gelais: You are right that there is nothing wrong with trying to make money or lose money if it is our money. Our view on this is that these principal protected notes are like securities, and for securities we ask for a lot of disclosure on many things. When you buy securities, you get disclosure of the prospectus, fees and all of that. On the other hand, those products are growing, yet the same type of disclosure is not available to retail investors who sometimes buy principal protected notes as if they were GICs.
Senator Tkachuk: That is only because, in those cases, all of the capital is being used to invest. A person deposits in some kind of RRSP or mutual fund, and all of the money is being invested somewhere, so he or she would have to know where the money is. In an instrument like this, they tell that you seven years from now you will get your capital back. You are guaranteed that. Either they could pay you nothing back except the capital, or you will be rich. If a person wants to believe that and make that investment —
Mr. St-Gelais: That is fine, but I am not sure they know what Mr. Wilson said, that 35 per cent of the whole thing over 10 years is at risk.
Senator Tkachuk: What is the responsibility of the investor and what is the responsibility of the salesperson? Where is that line drawn?
Mr. Wilson: The responsibility of the securities regulator is to make sure that disclosure happens. The responsibility of the sales person is to understand the product and to be sure it is suitable for the investor. The responsibility of the investor is to realize what risks he is taking. That is my best summary.
Senator Tkachuk: You do not think that is happening now.
Mr. Wilson: The disclosure is not at the level we believe it should be.
Senator Tkachuk: What has to be improved?
Mr. Wilson: There needs to be greater disclosure on the risks associated with the entirety of the product.
Senator Tkachuk: The risk is in the actual interest drawn or money made from the initial investment, and so they are not giving information as to the percentage they are taking off from that piece?
Mr. Wilson: That is right. How the return will be determined is complex. It can have caps on it; it can be tied to various indices. The fees to buy the derivatives to participate in the index can be unclear.
[Translation]
Senator Massicotte: I thank the witnesses. I have a few conceptual questions I would like to ask so that I first get a proper understanding. Do we agree, as managers, that investors who meet the criteria of sophisticated investors do not need to be protected? If they have assets worth $1 million to invest and they are qualified, do we feel an obligation to control them? Do we accept this concept today?
Mr. St-Gelais: Yes, absolutely. This is the sophisticated investor concept. In the Securities Act, we take for granted that these people have a great enough knowledge of the capital market and the risks they are taking. This is what we assume from the fact that they already have a lot of money accumulated, typically $1 million plus in assets. It is not necessarily so for 100 per cent of the people, but it is the basis of our regulatory regime for securities and hedge funds.
Senator Massicotte: In the U.S., the amount is higher. Is it not $2.2 million?
Mr. St-Gelais: Yes, I think so.
Senator Massicotte: And in the case of a couple with a high annual income, it is a million dollars or more?
Mr. St-Gelais: The highest is $1 million in assets, an individual investment of $150,000 and an income of $200,000 or a combined revenue with a spouse of $300,000.
Senator Massicotte: The three criteria must be met. It is not an either-or situation if I understand correctly?
Mr. St-Gelais: Yes.
Senator Massicotte: Public interest means the small investor's interest. If we are morally satisfied that it is not necessary to protect these people. The small investor wishes to make sure that when he purchases the product, he is well informed, he understands the risk. You talk about there being a gap, the PPNs. You say that the people who invest in them are not sophisticated, not aware of the risks they are taking. I would add to the comment made by Senator Tkachuk, that the salesperson — often an employee in a bank or a Caisse Desjardins — being the one who assumes the main responsibility, we have to make sure he is well informed so that he can advise the client. Is that not a gap to begin with?
Mr. St-Gelais: The more hedge funds are sold, distributed to individual investors, the more people have access to this type of rapid-growth investment, whether through PPNs, funds of funds, or a part of a mutual fund in a hedge fund, the more people are exposed to these funds, the more the people who advise them have to be well informed so that they can give advice and serve their clients well. At Desjardins and in the banks, most of the people who distribute these products definitely have these skills.
Now we say that the product itself being very complex, it should be subject to the same disclosure requirements as any other products that are complex securities. The capital may be guaranteed but the return accumulated on the capital, which is indexed to a security fund, is sometimes capped, and the fees may vary depending whether the cap is reached or not. The return on the index may be invested in the secondary market — these are extremely complex products — difficult for financial institutions to develop. So when it reaches their representatives, we think there should be a minimum, a document that says to people: You are exposed to such and such a risk, even though your capital is guaranteed and the charges may reach such and such a level.
Senator Massicotte: Even if they are given a prospectus, it does not change much. Generally investors do not read this document. And the main goal is for the institutions to provide clear advice and for the salespersons to be better informed. The gap exists. I think that the regulations are already adequate.
Mr. St-Gelais: As far as principal protected notes are concerned, they are covered by the Bank Act, which provides the general criteria for disclosure. The Securities Act is more detailed. Are we asking for too much information? The important thing is for the document to be written in clear and simple language. And the other thing I would like to add is, when you require a document from a financial institution, an institutional responsibility comes with the production of the document.
Senator Massicotte: That is not the case today?
Mr. St-Gelais: We think that the requirements concerning securities, which are similar products to principal protected notes, are greater. They could be reduced. The question is: are we going to reduce consumer protection?
Senator Massicotte: A task force produced a report on October 4 titled Canada Steps Up. The task force was made up of some very able and skilled people. They recommended, contrary to your recommendations, that the whole concept of hedge funds be regulated more strictly. Especially with regard to conflicts of interest, it seems to indicate that there is a lack of transparency. I understand that you do not agree with the report. You say that actually the regulations are adequate except for PPNs, but the rest seems all right. Can you explain why you are not in agreement with the report?
[English]
Mr. Wilson: We agree with much of that report. As I said earlier, in Canada the portfolio managers are registered now but the portfolio administrators are not. The Allen report, to which you refer, recommended that we register the administrators as well. We will be recommending that next year.
If both the portfolio manager and the administrator are registered, then conflicts of interest between them can be overseen by the regulators. Mr. St-Gelais and I both support proceeding on that recommendation of the Allen report with respect to registering the administrator.
Senator Massicotte: What are your thoughts on the other recommendations, to ensure that there is a better summary offering?
The Chairman: This is an important question and I do not mean to short-circuit it, but could you respond to the recommendations in the Allen report and respond to Senator Massicotte in a complete way, indicating what you agree with and what you do not? That will give us insight as to where you think we should be going. It will answer more fully Senator Massicotte's question.
Before we decide whether there should be increased regulation — and we are still open-minded about that — we would like to hear from the industry to see what they think is the most viable way to go about it. We will then determine whether or not we accept your recommendations. We want the best information and advice we can get.
Please go through them seriatim and give us an aide-mémoire.
Mr. Wilson: Are you are giving us time to do that and get that back to the committee?
The Chairman: Yes.
Mr. Wilson: We can do that. We have looked at it. We have not studied it fully.
The Chairman: If you have not made up your mind, put a question mark on it. We are trying to get a consensus on where we should be going.
[Translation]
Senator Goldstein: Thank you for coming. It is always a pleasure to listen to you.
[English]
I have three questions, one following Senator Massicotte's question.
Dealing with the licensing or registration of individuals who are involved, you have told us that the distributors are regulated but the managers are not. Is that correct?
Mr. Wilson: The portfolio managers are registered. The distributors are registered. The administrators are not, but we will propose year next year that they be registered.
Senator Goldstein: What happens if a fund is in fact an FOHF, a fund of hedge funds, where the administrators and distributors of the hedge funds underlying the hedge fund are not registered? How do you deal with transparency problems in those situations?
Mr. Wilson: The person putting together the fund of fund would be registered. Your question is what they are buying. We do not have a requirement that assets that go into a fund of funds pool are all hedge funds registered in Canada. They may be hedge funds from outside of Canada.
Senator Goldstein: That is the point. I know that you do not. How does one deal with the transparency needs of those kinds of investments? If I buy a fund which in turn is a fund of hedge funds, how will I be protected?
Mr. Wilson: The person putting together the fund of funds will tell you what he can about your investment. You would be a sophisticated investor.
Senator Goldstein: Let us not talk about me, because I qualify. Let us talk about the man in the street who does not qualify.
Mr. Wilson: The fund of funds that is sold to a man in the street has a prospectus. The prospectus would have full disclosure at the outset and continuous disclosure every quarter until the fund is wound up.
Senator Goldstein: How do you deal with serial risk issues, where you get a host of hedge funds in, as it turns out, the same investment, the same risk, without perhaps the knowledge that six or seven or 12 of them are all betting on the price of oil in 2007?
Mr. Wilson: You are referring to the systemic risk issue. We securities regulators are not explicitly mandated to look at systemic risk, but we talk to our colleagues at OSFI and the Bank of Canada about that subject. We meet with them every quarter to talk about a number of issues, but we do not specifically, as securities regulators, focus on that issue.
Senator Goldstein: How would the systemic risk be susceptible to being managed?
Mr. Wilson: It would be better to ask your question to witnesses from OSFI or the Bank of Canada, or our friend from the Department of Finance, who will testify later.
The Chairman: In New York, Senator Goldstein asked the Americans the same question. One expert suggested that there be a clearing house. This is not dissimilar to the situation that existed before the banks had a clearing house for cheques. There were a lot of what we call scaffolding risks, where there was risk on top of risk, and no one knew whether the risks were accumulated in one place. I do not think OSFI necessarily looks at that. The suggestion was made that a clearing house be in one place so the risk can be identified. That is not really regulatory; it is an oversight. Would you be opposed to that idea?
Mr. Wilson: OSFI and the Bank of Canada do look at the risk of unsettled trades and large concentrated risks in financial instruments. I think Mr. St-Gelais can answer that question.
The Chairman: I did not mean to interrupt, Senator Goldstein.
Senator Goldstein: Thank you. That was a useful interruption.
There was a lead editorial two Fridays ago in The New York Times on hedge funds, called "Closing in on hedge funds.'' I would like to refer to a small passage:
Over the past several years, largely unregulated hedge funds have become a towering presence in the stock market, now accounting for roughly half of all trading on the New York and London exchanges. More recently, they have become major players in the debt market as lenders to companies, buyers of bank loans and investors in tricky derivative securities tied to companies' credit quality.
To what extent are Canadian hedge funds becoming involved in the purchase of debt as opposed to the purchase of shares, derivatives, et cetera?
Mr. Wilson: We do not have a detailed picture of Canadian hedge funds asset portfolios. We know the portfolio managers. Our general understanding is that Canadian-managed hedge funds can buy any asset, including debt, equity, derivative and commodities. It is an unfettered investment horizon to earn returns for their unit holders.
Senator Goldstein: You are telling us that even with the existing registration system for certain people distributing and managing hedge funds, we do not have appropriate regulation or transparency.
Mr. Wilson: We do not oversee what they invest in but we oversee their proficiency and their level of compliance with rules as they invest. We do not make investment decisions for them.
Senator Goldstein: The last question in that context is on the penultimate paragraph of this editorial, which speaks to a number of senators starting to solicit views on how Congress could improve hedge fund transparency. Do you think that there would be a way in which, aside from asking for registration, there could be such a regime, whether administered by the 10 provinces and the territories or whether administered by the federal government? I am not entering into the constitutional aspect of it because that is complicated. Could you envisage some transparency, available within Canada on an ongoing basis, recognizing that some hedge funds in Canada invest in hedge funds that are not in Canada?
Mr. Wilson: It is possible that a hedge fund trade association such as AIMA Canada, for example, could be asked or mandated to produce that kind of information.
Mr. St-Gelais: That would be possible. It depends on whether you are asking for more transparency on an ongoing basis, as we do for securities regulations. That usually requires a large set of descriptive, detailed regulations on how to proceed with the information. You would be asking AIMA Canada to provide information, which is different. It is also possible that the more large, institutional investors invest in those products, the more they will ask for additional disclosure on what they are buying and will ask credit rating agencies for more information. That, combined with the particularity of the investment pool funds, would raise the transparency. Would we need to add to that? We are not at stage of stepping into heavy regulation.
Senator Goldstein: That is not on your radar screens at the moment.
Mr. Wilson: On our radar screen are overseeing the registering of portfolio managers and administrators and closing the principal protected notes gap to ensure that registered sales people are selling suitable products. That is a quick summary of our priorities.
Senator Goldstein: Setting aside both constitutional issues and the definition of your mandate, given that your positions are statutory in nature, is it advisable that you should have some ability as regulators to impose obligations of greater transparency?
Mr. Wilson: As regulators, we do not like to impose obligations unless there will be a benefit from that imposition. We would want to study the benefits of imposing obligations.
[Translation]
Senator Goldstein: Is this also your answer?
Mr. St-Gelais: I agree with Mr. Wilson, but we are never opposed to too much power if you leave us free to choose.
[English]
Senator Moore: I am confused about how a fund starts and what a manager is and what an administrator is.
Does an investment house decide it will establish a fund to provide investment in certain areas of activity in the economy? Do they have to say what area they will invest in? Does every fund have a closing date? What does the manager do versus what the administrator does? One is registered and one is not.
Then, I will ask about the principal protected notes.
Mr. Wilson: On your first two or three questions, it varies a great deal as to what assets they choose to invest in.
Senator Moore: Who are "they?''
Mr. Wilson: The people starting the hedge fund. They are the portfolio managers in concert with the portfolio administrator, both of which I will explain.
There is much variety with different strategies, markets and approaches. There is no cookie-cutter or one-size-fits-all plan that describes what everyone in the hedge fund business does when they set up shop. I will try to be clear about the functions performed by the two bodies we have described today.
The portfolio manager decides what assets to buy and sell and what structures to put in place in the asset portfolio. That is the entity that is currently registered in Canada.
The fund administrator organizes the financial statements, communications with investors and evaluation of the assets and, at each month-end or quarter-end, the marketing plans to sell additional units through registered brokers.
Senator Moore: Is he the salesman?
Mr. Wilson: One of his functions is to ensure that salesmen are aware of the product. The fund administrator develops marketing strategies and keeps track of the numbers.
Senator Moore: Do the administrator and the manager both work for the same brokerage house?
Mr. Wilson: They are typically owned by people who are sponsoring the hedge fund. At times the manager is out- sourced and is hired to do the work by a hedge fund founder. Brokerage houses are the distributors. Most hedge funds are not founded and managed by brokerage houses. Brokerage houses distribute the hedge fund investment securities — the securities that people put by when they put their money into a hedge fund.
Senator Moore: The manager does the research regarding where the investment should be?
Mr. Wilson: The portfolio manager does that research.
Senator Moore: Are the fund manager and the portfolio manager the same person?
Mr. Wilson: No. The fund administrator does the administration and the fund portfolio manager invests the assets. They are two distinct functions.
Senator Moore: The portfolio manager and the fund manager are the same person.
Mr. Wilson: The portfolio manager performs one function and the fund administrator performs another function.
Senator Moore: The windup, or closing, date, varies depending on the area of the investment and what the creator of the fund decides?
Mr. Wilson: That is correct.
Senator Moore: Is the fund registered or is only the fund manager registered?
Mr. St-Gelais: The portfolio manager is registered. Perhaps I did not answer that properly before. In order to register as a portfolio manager, an individual needs to complete certain courses — chartered financial analyst, level 1, and certified investment management — plus have five years of industry experience.
Senator Moore: Who started up the principal protected notes? How long have they been on the market?
Mr. Wilson: Principal protected notes other than plain bank deposits have been around for 10 or 15 years. They started to gather speed during the period of the Internet bubble on the stock markets. People bought over-the-counter guaranteed investment certificates, GICs, at their banks where the interest rate was indexed to the NASDAQ index. That is how it all began. In the last few years, the quantity of these principal protected notes has grown substantially, to around Can. $30 billion, all in the hands of small investors.
Senator Moore: I think you said $8 billion of that is linked to hedge fund performance. Can you explain how that works? I go into the bank and the bank manager says, "Well you have $20,000 in your account. I can put that in an investment for you. I recommend a principal protected note.'' I say okay, and he takes that money and does what with it with regard to this hedge fund example? What happens?
Mr. St-Gelais: The return is promised over seven, eight or ten years and is linked to the performance of those hedge funds.
Mr. Wilson: In the worst case, you will get your $20,000 back in seven years. In the best case, you will get your $20,000 back plus an annual return of 10 per cent, 12 per cent or 14 per cent. It is unknown. It is at risk.
[Translation]
Senator Hervieux-Payette: I have noted that with the natural resources, oil, gas, mines, et cetera. I was wondering whether a public company that has stocks or bonds, would set up a hedge fund to make an acquisition? Is there not a conflict between the interests of stockholders, bondholders and those who purchase securities linked to a hedge funds or a speculative fund? When we say speculative fund, it sounds risky. When we say hedge fund, the "risk'' does not seem so big. But I was wondering whether there is not a conflict between the various investors when a single company is involved in different instruments.
Mr. St-Gelais: I think that your question may cover various elements of what is determined by the regulatory framework of financial institutions. It is not impossible, for example, for an issuer who wants to expand to use some financial instruments such as hedge funds for his own company. If the sector is a risky one, he can use it to reduce the risk and take advantage of bigger returns. But if he wants to get into another strategy, it is a matter of governance. Some have described hedge funds as "pressure funds'' and others have called them "terrorist funds,'' because they are very aggressive. This is linked to the governance of the company.
Mr. Yvan Allaire, of the Institut des administrateurs de sociétés in Quebec, whom you must know, recently wrote an article in the review Forces about whether we should let hedge funds adopt very aggressive positions so as to force mergers, force acquisitions. This would not necessarily be to the advantage of minority shareholders in the company. That raises the following question: from the time when someone puts his money at risk in the same capacity as other shareholders, why would he have a smaller or larger voice than anyone else? This is a complex issue.
Senator Hervieux-Payette: Generally, the return will not be the same. With a bond, the ROI is preset. In this case, the return is increased. The more speculative it is, the greater the return is.
Mr. St-Gelais: Or is not there.
Senator Hervieux-Payette: But if there is no return, I do not see why 40 per cent of pension funds are investing in these financial instruments. My understanding was that the proliferation of this financial instrument was due to the fact that, with it, there was no longer any need to aim for good returns on shares, no need to pay dividends and no need to increase the value of shares. So the very creative and imaginative people of the financial sector came up with another way of attracting investors. Is there a real value in this? What I am talking about is the possible conflict between different investors in the same company. With a public issue, you have a say because you receive the company's financial statement. It seems to me, however, that if this company gets involved in financial instruments in respect of which there is no disclosure requirement, the company's future may be compromised. And the other, less speculative instruments, with lower returns, may be placed at risk. How does one reconcile these factors and what do you suggest so that companies do not rush into these instruments and make acquisitions that may actually be ill advised?
Mr. St-Gelais: What is being asked for with disclosure, with prospectuses, is that Canadian issuers completely disclose what they are doing. From the time they have disclosed what they are doing and they invest in a hedge fund, no one is going to ask about the soundness of the investment. If the investor has the information, we stop there. Second, why are hedge funds successful? We think in general, and the majority of analysts agree, that, by getting into areas of activity where other traditional investors cannot go, they are going to make up for the deficiencies and inefficiencies of the markets and that is where they are going to seek additional returns that others cannot go after. Having the freedom to invest in anything, anywhere, gives them an advantage over others and it is beneficial. But it raises questions of disclosure.
[English]
Senator Moore: Mr. Wilson, I think you mentioned that these principal protected notes are sold as bank deposits. How? When you put your money into your bank account, that is not a selling transaction. How are these notes determined to be a bank deposit? It looks to me like it is the selling of an investment vehicle.
Mr. Wilson: To answer your question, I have to get into some detail. There are two classes of principal protected notes. Some are deposits. GICs are sold over the counter in branches, but the interest rate is tied to another index, and there are notes issued by banks that are sold through brokerage firms and mutual fund dealers for a commission. They are the same sort of product. The principal is guaranteed by a bank in both cases, and the return is invested in some riskier element. The interest is invested in some riskier element, and the capital is guaranteed at the end of the term. Stock-indexed GICs are one form, and principal protected notes is another name for the same sort of instrument, but they are all issued off the balance sheet of a bank.
Senator Moore: They are. Is it an accurate description of what they are to say that a deposit is invested in a hedge fund?
Mr. Wilson: The bank gets the money and promises to pay it back. It is the return on the money during the period the bank holds that is put at risk.
The Chairman: Let me, if I can, briefly sum up. In the United States there is no regulation, and what we have here in Canada we would consider light regulation, because essentially it does not touch the subject matter of the investment pool. It deals with the investment advisors and the administrators, and that is the control. As Senator Tkachuk and Senator Massicotte said, this relies on the caveat emptor of the investors, who in turn rely on the skilled or experienced portfolio managers and administrators. Is that right?
Mr. Wilson: That is an excellent summary, senator.
The Chairman: On June 28 — and I thank Senator Angus for bringing this to my attention — the chairman of the United States Senate Committee on the Judiciary noted that hedge funds are estimated to trade in North America between $1.5 trillion to $3 trillion in securities every year. It is growing, as you have said, in leaps and bounds with a compound rate of 30 per cent per year essentially on market funds.
Then we have a situation — and this is along Senator Massicotte's line of questioning, with which I agree — where this is essentially a blind trust. Sophisticated investors put their money towards a blind trust, relying on the administrators or portfolio managers to manage the funds subject to a document that might outline a process but might say nothing. They just tell you they will invest your funds. They can leverage it as much as they want: 100 per cent or 200 per cent or 300 per cent based on whatever leverage they can obtain in the marketplace onshore or offshore.
Mr. Wilson: Agreed.
The Chairman: The question many of us have is this: What about the potential conflicts of interest here? They are not regulated at all. Managers can be buying, selling, self-trading or self-dealing. Essentially, conflicts of interest are not being monitored.
I believe Senator Angus learned in New York that the industry said this area is replete with conflicts. One will never catch them all, and there is no way of handling them because of the burgeoning funds. I do not want to quote Senator Angus out of context, but I believe that is correct. Is that a fair conclusion?
Mr. Wilson: The conflicts of interest I think you are referring to are between the managers of the funds and the fund investors themselves. There is no regulatory oversight to ensure that the conflicts are managed fairly because there is no board of directors or oversight committee.
The Chairman: To use an extreme case, somebody could invest $500 million in one of these burgeoning funds, and that could be on condition that those monies would be reinvested in assets or interests they have, and there would be nothing to monitor or prevent that.
Mr. Wilson: There is no regulatory oversight for sophisticated investors putting money in. They must pick the right manager who is, in their opinion, trustworthy, but managers can make mistakes.
The Chairman: I understand. It is a blind trust relying on the reliable trust of your steward.
Let me conclude with a little problem that Senator Angus and I found amusing and interesting. We looked at the Amaranth situation in the United States. We were told it was a $4-billion loss, but the good news was that the market was able to absorb it and it did not affect the economy. Then we discovered, to our curiosity, that one of the fund managers of Amaranth was immediately able to get back into the marketplace and raise somewhere between $750 million and $1 billion. The guy struck out, and without any problem he jumped back in. Some of the people we talked to in New York, we discovered to our curiosity, supported him.
Would that situation have been caught in Canada? An expert fund manager goes down, not through his own fault but as a result of the market. Then all of a sudden he flips and goes back up. He has lost $4 billion to $6 billion, but he walks across the street and convinces people to raise more money.
Mr. St-Gelais: To our knowledge, there was no breach of law in the Amaranth case. He lost money.
The Chairman: My point is, it was not a breach of law, but it was certainly a breach of professional judgment. No, that is not fair. It was certainly a questionable judgment call, so there was no penalty or accountability or responsibility for a magnificent loss to investors. Is that a fair statement?
Mr. St-Gelais: I do not think there is any such situation here in Canada. If someone loses a lot of money, they do it in good faith.
The Chairman: To conclude, we are left with the old caveat emptor: Let the consumer beware. All they can be aware of is that the professional managers have a track record. After that, as my colleague has said several times in the press most recently, it is like the Wild West when it comes to the investment. Is that a fair conclusion to draw?
Mr. Wilson: I would not say the Wild West principle applies to Canada specifically; rather, it describes the hedge funds space globally. There is nothing wilder about Canada than anywhere else in the context you are describing.
The Chairman: We are also given to understand that banks and pension funds in Canada are investing heavily in these vehicles.
We can understand that the sophisticated investor is investing. We have applied a caveat emptor to that, as is the position of Senator Tkachuk and Senator Massicotte. It is the price of freedom.
On the other hand, the unsophisticated investor who invests through his pension fund, mutual fund or bank is now subject to the same risk. We are doing indirectly what we cannot do directly. Is that fair?
Mr. Wilson: Let us use the example of the Caisse de dépôt in Quebec. They are an investor in multiple hedge funds. They invest in around 100 hedge funds. They are very sophisticated. They screen and analyze them thoroughly. The beneficiaries of the Caisse de dépôt, the citizens of Quebec, are participants in the success of those hedge funds indirectly. I do not see anything wrong with that scenario in terms of the beneficiaries of the pension funds in Quebec.
The Chairman: I am not suggesting there is anything wrong at all. I am trying to clarify for us and for the public the scope and nature of the matter we are considering. We are not meaning in any way, shape or form to be adjudicative here. The purpose of this is so that we ourselves can understand what is being discussed.
Senator Massicotte: I thought the essence of the issue was whether the investor realizes the level of risk he has taken. If he is sophisticated and he wants to reinvest some of his lost money, he has the right to make mistakes and may make the same mistakes repeatedly. You cannot legislate people losing their money.
The Chairman: There is an argument in the United States that commends itself to us. Most of the members of this committee believe in the capitalist and free market system. Whether this is the most efficient allocation of capital is a good question on the public interest side, yet there are questions as to how the investor can have some mode of understanding if there are serious questions of malfeasance. That is the issue with which we are wrestling.
We have not come to any conclusion, but we want to thank you very much for enlightening us today. This has been a very interesting and informative session.
I apologize to our next witnesses. You can see the previous witnesses went over their allocated time. We appreciate your patience. You can see the senators of this committee are trying to wrap their minds around the nature and scope of hedge funds, which are a growing phenomenon in North America.
We are delighted to have as the next witnesses Mr. Serge Dupont and Mr. Jeremy Rudin from the Department of Finance. If we do not have adequate time, which I am sure we will not, we do intend to call you back for a second round or, if you choose, you can respond to us in writing if you wish to answer more fully.
Serge Dupont, Assistant Deputy Minister, Department of Finance Canada: Senator, no apologies are necessary. It was an interesting discussion for us as well. I have provided a written statement to the committee. I will draw from that in summary terms. Ten minutes should do it, and then we will be pleased to answer questions and come back if we can.
[Translation]
Thank you for this opportunity to provide you with some information to help the committee with its work. I will summarize why hedge funds are attracting the attention of the political decision-makers and the regulators, refer to some of the work undertaken by various international bodies and domestic market regulators, and describe federal government activities regarding hedge funds.
Briefly, the interest generated among decision-makers and regulators in hedge funds arises from their size, their rapid growth, their characteristics and the important role that they play in financial markets.
[English]
I have some numbers on assets under management of hedge funds. Given the confusion earlier, my numbers are roughly similar to the ones Mr. Wilson gave. He will give you some detailed numbers further on, so I will skip that. We are in the same ballpark.
The Chairman: What are your figures?
Mr. Dupont: In Canada, I have $28 billion in funds under management, in Canadian dollars, as of the end of 2004.
The Chairman: We have heard his numbers to take us up to a compound rate of 30 per cent, so that would be about $50 billion currently.
Mr. Dupont: I am not sure what the compound rate would be for 2005 or 2006, but it was in that range at the end of 2004.
The $28 billion has to be put in perspective somehow. Mutual fund assets under management in Canada are estimated at $525 billion. They still represent a relatively small part of overall funds under management in Canada. That said, they play an important role in specific products and markets. This arises because of their use of leverage and techniques such as short selling as well as very active trading. For example, hedge funds dominate the market for credit derivatives. This means that hedge funds may significantly influence overall market developments. In short, they punch above their weight.
The significance of hedge funds is also reflected in their growing share of the business of those major investment banks that act as their prime brokers. For those investment banks, the hedge fund industry is an attractive and growing business. It is also a risk that needs to be managed. While becoming a significant part of the financial system, the hedge fund industry globally has remained largely unregulated and non-transparent. This raises issues of investor protection, and you had a discussion of that earlier.
Hedge funds originally targeted wealthy and sophisticated investors. However, in Canada and abroad, they are now marketed increasingly to a less wealthy clientele. In Canada, this is done through principal protected notes. It is important to recognize that the international literature and dialogue on hedge funds underscores as well the potential positive contribution of hedge funds to a modern, dynamic, efficient financial marketplace. Hedge funds contribute to the efficient reallocation of capital and risk by stimulating market innovation, adding liquidity and assisting price discovery. For investors, they also create opportunities for portfolio diversification.
The two key risks that must be weighed by policy-makers and regulators are the risk posed by hedge funds for financial stability, what is called systemic risk, and the risk to investors, particularly retail investors. These issues are receiving a great deal of attention, both internationally and domestically.
At the international level, discussion has taken place in particular in the Financial Stability Forum, which was created by the G7 after the Asian crisis in the late 1990s. The FSF has initiated work and taken on a role of facilitator by bringing together national financial authorities and senior members of the hedge fund industry. These discussions have been helpful in fostering an improved understanding of the industry. Regulators and central banks in the United States and Europe, particularly in the U.K. where global hedge fund activity is concentrated, have engaged most actively. For example, the Federal Reserve Bank of New York spearheaded efforts with the industry to improve the infrastructure that supports the over-the-counter derivatives market, a market in which hedge funds are particularly active.
[Translation]
The private sector has also taken initiatives to enhance discipline and foster better risk management in the industry, as advanced, for instance, in what is called the Corrigan report.
Initiatives related to investor protection have also been reviewed in a number of jurisdictions.
Domestically, hedge funds issues have also generated considerable attention, including through reports prepared by the Investment Dealers Association, a federal-provincial interagency group, and most recently by the task force headed by Tom Allen. A number of significant observations have arisen from international and domestic dialogue and initiatives to date.
[English]
First, there are limits to the capacity for effective, direct regulation of hedge funds. The dynamic nature of the industry and the sophistication of its investment strategies make reporting of the actual funds difficult and of limited value to regulators. Moreover, funds are mobile and will engage in regulatory arbitrage in deciding where to locate their mind and management. In the Canadian context, it must be recognized that most of the hedge fund activity in our marketplace will originate from outside our borders.
Second and correspondingly, the focus of regulators in respect of systemic risk has been to promote effective, counter-party risk management among their regulated prime brokers — in Canada, the Canadian banks. This includes the normal application of minimum capital rules and the careful measurement, monitoring and management of risk, for example, through collateralization. Emphasis is placed by regulators on enhanced risk management tools and techniques, including value at risk measurement and stress testing.
Third, and subject to constraints already cited, there is broad interest in steps toward enhanced disclosure and accountability as may be achieved, for example, through registration of hedge funds' advisers. In Canada, these requirements are within the domain of provincial regulators, as you have just heard. The private sector is also taking some steps through voluntary disclosure or initiatives by the rating agencies to assess hedge funds.
Fourth, there is also wide-spread recognition that attention must be paid to the protection of the retail investor. The Department of Finance and federal agencies are engaged on both the issues of systemic risk and retail investor protection. The systemic risk from hedge funds is managed through the ongoing monitoring of the hedge fund exposures and risk management practices of the Canadian banks. As supervisor, the Office of the Superintendent of Financial Institutions continually monitors the risk management practices and procedures of the banks, and I gather you have invited the superintendent to testify.
OSFI recently completed work on the exposure of banks to hedge funds. This review indicated that the risk exposures are small in relative terms and that risk management practices in general are adequate. Banks were typically found to be taking a cautious approach to hedge funds in Canada. Federal financial sector agencies, including the Department of Finance and the Bank of Canada, are kept apprised of such work through the financial institutions supervisory committee, which is chaired by OSFI.
As regards the retail investor, the department's interest and activity arises from the role of banks in the market for principal-protected products that may in some cases link the return to the performance of a hedge fund. In this regard, the department is working in step with the securities regulators to ensure that the marketing and sale of these products is conducted in a fashion that ensures full and meaningful disclosure and that protects investors.
[Translation]
In conclusion, the rapid development and dynamic nature of hedge funds provide that they will continue to merit the attention of policy makers and regulators globally and domestically. Frameworks will need to be responsive to ensure that the objectives of market efficiency, financial stability, and investor protection are best advanced. The committee's interest in the issue is timely. I would be pleased to answer any questions.
[English]
The Chairman: Thank you very much.
[Translation]
Senator Hervieux-Payette: People are always talking of London and New York, but is this a world phenomenon? Is the Tokyo stock exchange and other ones in Europe also involved in this area?
Mr. Dupont: Investment in hedge funds is taking place around the world. Investors tend to concentrate in the large financial capitals like London and New York and in certain offshore jurisdictions also. From the point of view of financial market operation, this is a world phenomenon.
Senator Hervieux-Payette: So on the Tokyo stock exchange —
Mr. Dupont: Or the Toronto stock exchange, yes. It accounts for a large share of the activity.
Senator Hervieux-Payette: Is there a place where more information was required or where rules of the game were put in place? Or is it open, with very little intervention by financial authorities around the globe?
Mr. Dupont: There are different forums where these questions are raised and where the needs that these developments may cause in the financial markets in regulatory terms are raised. Regulatory action is up to national jurisdictions or, in some cases, provincial jurisdictions, as in Canada, for example. It is up to each one to draw its lessons from international experience and international dialogue to see how to make sure that the necessary protections are in place within its jurisdiction.
Senator Hervieux-Payette: In Canada, we know that the banks, via their brokerage subsidiaries, account for a large part of the financial market, and thus of the distribution of these financial instruments. As you say, control over securities occurs at the provincial level, but do we operate along the same line of thought as elsewhere? Are you interested in that because your banking system is very involved in this industry?
Mr. Dupont: I think that you are right on all points, that is, in point of fact, in Canada, the stability of our financial system depends in large part on the large charter banks, which are under federal jurisdiction. But this is also true internationally, where the limits of controlling, understanding and keeping with view all the hedge fund investment strategies are quite clearly recognized.
I attended a meeting called by the Financial Stability Forum and someone said, "There are too many moving parts.'' It becomes very hard for a regulatory authority to try and get hedge fund disclosures and to control what is going on, to understand what is happening. However, better control is possible with regard to the banks, which are governed by very strict regulatory criteria, with an international framework and basic criteria that are very sensitive to market development, risk development. This is how we get better control over what is called "systemic risk.'' Certainly there are concerns for investors, but insofar as the system as such remains solid, in terms of policy, it is the main concern.
Senator Hervieux-Payette: I assume that there is a rather limited number of individuals who manage the large pension funds in Canada. They say that 40 per cent of hedge funds come from pension funds. Does the fact that 25 people — perhaps I exaggerate, there are fewer — who decide all the rules of the game not represent a danger, regarding the purchase and sale of stocks and bonds or investment in hedge funds? Finally these are the people who hold Canadians' money in their hands. If so, then perhaps we should be taking a little deeper look at the situation. For all practical purposes, a very small number of people can have a very important impact on the whole financial system.
Mr. Dupont: If we look at all the capital invested in Canada, the share in hedge funds remains, for now, relatively slight. It is true that this is a concentrated industry, in that there are a lot of small hedge funds and a few others that are very large. There is nevertheless a trend that is there, that is, there is a little more disclosure on the part of these hedge funds insofar as they use the private savings of sophisticated investors who can also demand financial statements. Also, I mentioned the initiatives rating agencies that are trying to see the extent to which these funds are being well managed.
So there is a dynamic within the market that is calling for greater disclosure. I do not think we can say that a small core of people controls all Canada's savings. Savings are after all in pension funds, mutual funds and in lots of other instruments besides hedge funds.
[English]
The Chairman: We will come back and give Senator Hervieux-Payette and others more time tomorrow. We have four minutes left. We must finish precisely at six o'clock. I will return to you tomorrow, and to Senators Massicotte, Harb and Moore, who have been so patient. Senator Goldstein, please continue.
Senator Goldstein: Thank you very much, Mr. Chairman.
[Translation]
Thank you for providing us with all this information. We appreciate it very much.
[English]
The Canada pension fund, as many other funds, has invested in hedge funds. Does the Department of Finance know to what extent the Canada pension fund has, in fact, invested in hedge funds?
Mr. Dupont: To my knowledge, senator, the Canada Pension Plan itself is not invested in hedge funds at this time.
The Chairman: Excuse me. That was not the information we received. We heard that the Canada pension fund was investing in hedge funds.
Mr. Dupont: The information I received today, senator, is that it has not. I will certainly undertake to make sure the record is clear on that.
Senator Goldstein: I have a recollection that we were told that.
The Chairman: So have I.
Mr. Dupont: I certainly do not wish to mislead the committee on that point. This is information I received. I will certainly verify it.
The Chairman: Please get it back to our clerk.
Senator Goldstein: Are you aware of whether the Quebec pension fund has invested in hedge funds?
Mr. Dupont: You heard from Mr. St-Gelais and Mr. Wilson earlier that, yes, they have.
Senator Goldstein: Do you know what the percentage is?
Mr. Dupont: I do not have the percentage, no.
Senator Goldstein: You were here while the previous witnesses were testifying, and you heard that the various securities regulators across Canada, all 10 or more of them, are trying to put their act together to find some additional form of regulation, or at least of knowledge of these hedge funds, for Canadians. Do you see any role for the federal government to play in this attempt to get better information out to Canadians?
Mr. Dupont: I do not directly, senator, in respect of registration requirements or other such requirements that clearly are within the domain of the provincial regulators at this time.
Senator Goldstein: We live with that, because that is essentially a constitutional issue. That having been said, however, let me move backwards. Much of the concern expressed around this table and when we were in New York for our study several weeks ago was for the retail investor. We are not overly concerned with sophisticated investors because they are able to judge their risks and act accordingly.
We are concerned about investors who are unable to make judgments about those risks and who, nevertheless, invest in these risky instruments. Is there any way to bypass the paralysis of Canada's not having a single securities regulator by using some availability that the Department of Finance Canada has to do that?
Mr. Dupont: The Department of Finance Canada has the capacity, building on existing authorities under the Bank Act, through regulation, to oversee principal protected notes that might be issued and sold by banks. We are looking into that.
Senator Goldstein: That is encouraging. Given that banks are essentially financing these hedge funds, is there any way in which Finance Canada or the Office of the Superintendent of Financial Institutions could use that power to enhance the public's knowledge of hedge funds and what they are doing? Banks are putting significant amounts of money into those hedge funds.
Mr. Dupont: The responsibility of OSFI and the policy interest is to ensure that the banks have appropriate risk management practices with regard to their dealings not only with hedge funds but also with all entities. It would not necessarily be a lever that the federal government could use to impose requirements on hedge funds directly; rather, it would be an obligation on the part of banks to establish the right risk management.
The Chairman: I apologize to senators and to the witnesses because we have had more questions and interest in this subject than we anticipated. If we have questions needing your answers, we will come back to you. If the witnesses have additional information to add to the record during the course of these deliberations, they may do so freely. We will take it under advisement because we want to ensure that the information we receive is accurate before we develop our recommendations.
The committee adjourned.