Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 14 - Evidence - February 1, 2007
OTTAWA, Thursday, February 1, 2007
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:50 a.m. to examine and report upon the present state of the domestic and international financial system (the study on hedge funds).
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: I welcome honourable senators, Mr. Fotheringham and our Internet audience.
The Standing Senate Committee on Banking Trade and Commerce has been part of the history of the Senate since Confederation, being one of the first committees established by Parliament in 1867. From the beginning, the committee has had an overview of the economy. Although its original terms of reference were banking, commerce and railways, our mandate is currently banking trade and commerce. This is the only committee that has an overview of the economy as a whole, although its focus is on the financial sector as the nervous system of the economy.
In recent times, the committee has issued reports on consumer protection in the financial sector. One of the preoccupying questions is productivity in the economy because we believe that lags behind. Therefore, we are looking at all the elements in the economy to determine how we can be more productive and improve prosperity for all Canadians.
In fulfilling our general mandate, we travelled to New York last October to discuss such things as the hedge funds sector, which is valued at $1.1 trillion in assets globally. It is one of the fastest growing financial aspects of the international financial community and, given the size and scope of our trading relationships with the United States and the integrated parts of our economy that work closely together, we believe that priority must be given to financial stability. It is imperative that we, as policy-makers, understand what is happening not only in Canada but also in the United States, in particular in this new growth area.
During our discussions with U.S. regulators and representatives of the financial sector and sister organizations in New York, hedge funds emerged for them as a key issue. Committee members decided that this requires further study, given the high profile of hedge fund failures and the increasing number of investors, both sophisticated and retail, using this financial tool.
The value of Canadian hedge funds was estimated in June 2004 at $26.6 billion, and we understand that that has increased substantially. Thus, hedge funds represent a substantial segment of our financial activity.
The committee heard about hedge funds during its recent study of consumer issues in the financial sector and recommended the appointment of a person to review appropriate regulatory oversight of hedge funds. Nevertheless, a key question remains the extent to which these new kinds of financial products should be regulated, if at all, or supervised to protect consumers and the stability of the domestic and global financial marketplaces. This committee continues to have an open mind on the issue of regulation, the nature of regulation and the nature of supervision of hedge funds.
Mr. Fotheringham, we welcome your testimony to help clarify these issues. Please proceed with your presentation, after which we will go to questions from honourable senators.
Robert Fotheringham, Vice-President of Trading, TSX Group (Toronto Stock Exchange): Good morning, honourable senators. It is a pleasure and an honour for me to be here today to talk about hedge funds as part of the committee's study on their nature and scope within the Canadian economy. My perspective is as a market operator with more than 25 years of experience in trading. As such, I thought it best to structure my brief opening comments in the following manner: first, a quick overview of the markets we operate, providing a foundation for my perspective as the representative of a market operator; second, some statistics and numbers on hedge funds as they trade on our markets, primarily the TSX, our senior market; and, third, a few thoughts on the trends we are seeing in trading that pertain to your study of hedge funds. I look forward to the ensuing discussion.
First, a few words on TSX Group, our parent company. TSX Group operates Canada's two national stock exchanges: the Toronto Stock Exchange, which serves the senior equity market; and the TSX Venture Exchange, which serves the public venture equity market. We operate the Natural Gas Exchange, NGX, which is a leading North American exchange for the trading and clearing of natural gas and electricity contracts, and we operate Shorcan Brokers Limited, Canada's first fixed income inter-dealer broker. In this, our main job is to run transparent and efficient marketplaces for issuers, investors and regulators.
TSX are the initials attached to the core equity operations of TSX Group — Toronto Stock Exchange, TSX Venture Exchange, TSX Markets, TSX Datalinx and TSX Technologies. TSX Group is headquartered in Toronto and maintains offices in Montreal, Winnipeg, Calgary and Vancouver. Canadians hear about TSX every day in terms of the main market index going up or down. They reference TSX to that measure, but few people know about the tremendous overall strengths of our marketplaces both at home and abroad. These are numbers of which Canadians can all be proud, for these statistics derive in large part from the strong equity culture that is found across this country.
For example, we have over 50 per cent of the world's mining companies on one of our two exchanges. More than 50 per cent of all mining financing happens at TSX, making TSX Group the largest mining exchange in the world by far. We have the greatest number of oil and gas companies in the world, contributing to Canada's role as an energy superpower. According to the World Federation of Exchanges' statistics, TSX is consistently ranked in the top five exchanges, along with the New York Stock Exchange and the London Stock Exchange, in terms of total yearly equity capital raised. Our trading system is very fast.
I would stress this last point because our trading speed is particularly important with regards to the committee's study on hedge funds. The reason for that is straightforward. Many hedge fund strategies need high volumes, or liquidity, so that they can trade without unduly moving the markets. Liquidity needs speed, and we facilitate that speed.
A key influence on our work in this area is the increased use of algorithmic trading, which uses computer programs to split large orders into small packets that will not move the market. Compared to 10 years or even three years ago, we have more shares being traded on our exchanges. We have fewer shares involved in each trade. We have more order messages per trade. We have trades that are happening faster and faster. All of these things are chewing up our existing capacity.
Then there is the matter of speed itself. Any advantage we have over our competitors now has to be measured in milliseconds. A millisecond might not matter to you or me, but it matters to a computer. A computer program faced with a millisecond difference between two trades will take the one that is a millisecond faster.
How fast do you have to be? You can get a rough idea by blinking your eye. The blink of an eye takes an average of about 300 milliseconds, less than one third of a second. Our average trade has been taking about one tenth of that time, one thirtieth of a second. That is pretty fast — fast enough to keep us competitive with most North American exchanges. More important, however, it has been fast enough to keep us competitive in the specialized niches where algorithmic traders hold sway.
I will be happy to talk more about this in our discussion, as trading speed — indeed the whole trading system — is integral to how our market works and key to understanding the nature and scope of hedge funds on TSX.
I will talk briefly about hedge funds on TSX. It is difficult to estimate the trading volume directly linked to hedge fund managers as they employ many different strategies that cross asset classes. Equity, fixed income, commodities and currencies are all traded under the mandate of hedge funds. They use both cash and synthetic securities and operate in both domestic and international markets.
I know this committee has been trying to quantify the size of hedge funds across Canada. Numbers vary significantly, as you know. Based on our understanding, there are more than 200 hedge funds being managed in Canada today. Depending on whom you talk to, the total of these funds can range from U.S. $25 billion to U.S. $40 billion in assets under management.
We took these most recent figures from two studies, one done by the InvestmentNews group and the second done by a group sponsored by NBCN Prime Brokerage Services. They were able to give us these most recent statistics.
The Chairman: Is it possible for you to table those background materials? We are trying to get not only your conclusions but also on what you base your assumptions. We have been struggling with the size of this sector, but you have confirmed that it is growing like Topsy. We want to make sure we understand the underpinnings of the growth.
Senator Angus: Was the range you just mentioned $25 million?
Mr. Fotheringham: It was U.S. $25 billion.
Senator Angus: Is that at the low end?
Mr. Fotheringham: At the low end, we are seeing U.S. $25 billion; at the high end, it is U.S. $40 billion. Some of the explanation for the difference is that there is often double counting. As you know, there are some transparency challenges in this marketplace and it is often difficult to find out what the number is exactly.
When funds of funds are included in the calculation, you can have double counting and that can confuse things. Often numbers will be quoted net of principal protected notes; again, that confuses things somewhat.
Senator Angus: Those numbers do not reflect the size of any individual fund. That is the total amount of money in Canada, comparable to the $1.1 trillion number we have been using as the global number; is that correct?
Mr. Fotheringham: That is our understanding. It is subject to how you calculate those numbers and to individual practices.
Senator Angus: Is it only publicly traded hedge funds or does it include private ones?
Mr. Fotheringham: It includes private; it is the estimate of the industry that is under management.
While it seems a significant amount — and it certainly is — I would like to put that in the context of trading on TSX. The total dollar value of trading on TSX in 2006 was $1.416 trillion. The average daily trading value on that same exchange was $5.642 billion. Again, there are significant amounts on both sides; but to put it in context, we are seeing significant assets being managed around hedge funds.
We know that international investors have a keen interest in Canada, and they have been using both traditional and hedge fund managers to access our market.
The strategies that hedge funds employ are numerous. They include long/short or market-neutral relative-value strategies, event-driven strategies, and opportunistic strategies. Each group can be divided into subcategories.
We are also seeing evidence of their trading techniques as there has been a steady rise in the number of algorithmic traders accessing our market. We estimate that algorithmic trading now accounts for between 15 per cent and 20 per cent of our market volume. In fact, it may grow to account for an increase in the percentage of our trading volume over the next few years.
It is important to note, however, that algorithmic techniques are used in all classes by all types of managers, not just hedge funds. Huge funds provide benefits to both their individual investors and the broader financial market. To the investor, when added to traditional assets, hedge funds provide diversification in both assets and management style and the opportunity to access uncorrelated returns that assist in the portfolio management. They can potentially lower the volatility of the portfolio while achieving a stable return stream.
In the broader market, hedge funds play a number of important roles. They provide added depth and liquidity through their active participation, and they serve as important risk transfer conduits. In this role, they often act to absorb the market shocks that could result from an absence of participants. This reduces the volatility of the overall market. Increasingly, hedge fund managers are taking an active role in corporate governance and improving the position of all market participants.
That gets to my last point — trading trends in hedge funds. Clearly, hedge funds are growing as a factor in our equity markets by the number of funds and their collective size. They are a considerable factor in derivatives, itself a fast-growing segment of the overall market.
I know this committee will be familiar with the recent report commissioned by New York Mayor Michael Bloomberg on the state of the financial markets in that city versus other locations, primarily London. This storyline has played out in the Financial Times for the past few weeks, with many pointing to what they believe is an inevitable decline of New York in the face of an ever-resurgent London.
There are many reasons for that apparent decline. Derivatives is one. As the report said:
While Chicago leads in exchange-traded derivatives, Europe — and London in particular — is already ahead of the U.S. and New York in OTC derivatives, which drive broader trading flows and help foster the kind of continuous innovation that contributes heavily to financial services leadership.
I would argue that the same dynamic is happening in Canada with respect to hedge funds. The growing presence of hedge funds in derivatives, and equities, drives innovation, which, in turn, supports a vibrant financial services market.
Working with a wide range of market participants, including regulators, issuers and investors, we are building stronger, faster, deeper capital markets in this country. In sum, from the perspective of a market operator, hedge funds are a key part of those capital markets.
I would be happy to entertain your questions.
The Chairman: Before we start, could you spend another minute or two explaining to us in layman's language algorithmic trading and techniques? Remember, we are being viewed by the Canadian public.
Mr. Fotheringham: Algorithmic trading refers to computer-assisted trading. In its simplest terms, it is splitting an order. If someone has a large order to execute in the marketplace, they will use a computer to facilitate that trade. It will split that order into much smaller pieces to allow execution into the marketplace without significant market impact. Such a trading technique allows large orders to fit into the market while leaving no footprint at all.
These techniques can go from a simple execution VWAPT strategy, or volume weighted average price technique, whereby over the day you split your order and hope to get that volume weighted average price executed in the marketplace, to more sophisticated techniques, whereby two stocks are compared and statistical arbitrage trades take place. Those are convergence or divergence trades. When the relationship between two securities reaches a trigger point, a trade will be executed — selling one security and buying the other security, with the understanding that it will either converge or diverge to a point where it can be unwound.
Algorithmic trading then is a range of things, but traditionally, in general terms, we can refer to it as computer- assisted trading that helps managers to execute their trades more efficiently.
The Chairman: The trade secret in this technique is that each trader has a computer variation to determine what algorithms will take place automatically to expedite the trading. Is that the idea? This is an important trade secret as hedge funds and traders develop individual techniques to predict the marketplace.
Mr. Fotheringham: That is correct. These algorithms are closely guarded. Some standards are widely available to the market, like the slicing mechanism I spoke about. However, even that mechanism has its twists and tweaks that allow it to be applied in a special manner. Everyone is looking for an edge in the market and to the extent that they can outguess the next algorithm, they will do that. Yes, these are customized programs and traders put a great deal of work into building them. Thus, they are closely guarded in many cases.
The Chairman: Is the algorithm methodology a follow-the-leader technique rather than an independent analysis? As opposed to following the market, is this more a case of following the leader in the market in terms of coming to some conclusions as to how to execute a transaction? It is not any different from newspapers and television in which someone leads the story, after which variations of it are repeated endlessly. We do not have diversity of news but we have news leaders.
Mr. Fotheringham: Just as there are a number of different hedge funds with different mandates, there are a number of different algorithmic trading techniques that can be applied. The ultimate goal is to participate with the market flow, which allows you to leave a lesser footprint in the market and to work along with the natural flow in the marketplace. That is the volume weighted average price technique that I referred to earlier, whereby you participate as the market allows you to participate. You do not push or lag the market; you participate with the market. At the end of the day, you will achieve the volume weighted average price technique of the trade that happens that day. With those techniques, participation in the market does not push or lag the market beyond its natural direction. However, there are techniques that are counter-cyclical or that tend to be contrarian, and they would constitute a special approach.
Senator Angus: Mr. Fotheringham, I understand this is your first appearance before this committee.
Mr. Fotheringham: Yes.
Senator Angus: Have you been following our study on hedge funds?
Mr. Fotheringham: We have been reading it with great interest and following the work of the committee carefully.
Senator Angus: Do you and your colleagues think that this is an appropriate topic for current study?
Mr. Fotheringham: TSX Group finds it to be a very timely study. The organization supports the hedge fund involvement because the sector provides a very healthy balance in our marketplace. Diversity of participant and of market views is very important for us. That said, as a company that puts a lot of weight on transparency, fair markets and efficiency, it is important for us to believe and to communicate to the greater population that they are being treated fairly and that proper regulation is in place to ensure that people are secure in their investments. We believe that hedge funds bring many positives to the marketplace and that, with proper regulation, the positive factor will continue.
Senator Angus: You have just said the key words, ``with proper regulation.'' In our study we have observed a debate. We have travelled to New York and talked to some of the players to gain a sense of how big these new products are and what concerns have developed there. You have explained how active the TSX Group is and about the large trading facility that it provides in the capital markets today. What risks do you see in the rapid growth and spread of trading in hedge funds for the traditional, sophisticated or exempted investor and institution, as opposed to the retail person who is not down to the one-thirtieth of a second in his decision making? Given the risks that you see, what would constitute proper regulation for Canada?
Mr. Fotheringham: The highly positive thing we have seen in this process in Canada is an openness to look at the issues and accept the recommendations. The study by the Canadian Securities Administrators was released recently, and we are supportive of the direction they have taken.
The Chairman: Is that the Allen report?
Mr. Fotheringham: Yes, that is correct. Our role as a market operator is to operate a fair, liquid and transparent market for all participants. From our perspective, it is important that these issues are dealt with. The risks are being managed well. Just as hedge funds bring innovation to the market, this committee is bringing innovation to the way in which it views regulation and understands this market. For this kind of process, it is important that we continue with dialogue. Senators are well aware of the comments of the Governor of the Bank of Canada, David Dodge, when he appeared before the committee to speak to how hedge funds are influencing the marketplace and the risks. I would have to agree with his view, which is easy to do given his credentials, that hedge funds provide positives and benefits to the marketplace. The leverage employed by many of these funds, which is less in Canada than it is in the United States, I believe, has to be managed. The banks are aware of these risks and they are watching the hedge fund sector. That is the key risk.
Senator Angus: Is it the extent of gearing, as they say in the U.K., that is the big risk or is it the nature of the different players in the leverage chain?
Mr. Fotheringham: From the standpoint of financial stability, Governor Dodge confirmed that he thought there was not a risk to the stability of the market at this time. I look at it from a market practitioner's perspective. Speaking from my 25 years' experience as an investment manager before I joined the marketplace, the leverage was the concern; I had to ensure it was managed and controlled properly.
I think many of the rules we have in place are adequate to manage the market. Enforcement is key — applying the existing rules diligently, which we do see. We are great fans of transparency at TSX. We believe in an open market transparency, where price discovery happens in the open and true valuation of securities can take place. These things can all come together to ensure that we have a healthy market that does not have the risks that could be associated with too much leverage.
Senator Angus: You just said that we have proper regulation in place. Could you outline the critical components of that for us? Following Senator Grafstein's request, if they are written down specifically for hedge funds, it would help our work a lot to have a statement of what the trading rules are, as well as the regulations that you feel contribute to the transparency, market integrity and stability.
Mr. Fotheringham: I can talk about it from the perspective of a market operator who encourages the participation of all participants, not just hedge funds but traditional fund managers and retail investors. I can talk about the structure we have in place to make sure we have a liquid, transparent market that is fair.
On TSX, we allow direct trading by participating organizations only. The participating organization is the one that actually executes the trade on TSX.
Senator Angus: Would that be the hedge fund manager to which you referred earlier?
Mr. Fotheringham: This would be a broker dealer. The hedge fund managers themselves would not be executing trades on TSX; they would come through a registered broker dealer. That registered broker dealer has to be a member of the IDA, the Investment Dealers Association, which is a self-regulatory organization. They have their checks. The primarily responsibility of the IDA is to ensure there is capital adequacy for that fund or that entity to operate, but also that there are proper standards in place for their operation as well as the staff employed by them. The first criterion for becoming a participating organization on TSX is to have an IDA membership.
We then ask that a prospective participating organization be a member of a clearing entity, the Canadian Depository for Securities Limited. In the case of U.S. participating organizations, they would have an account at CDS and be a member of their local clearing organization.
Third, participating organizations have to have electronic access. We are a fully electronic exchange.
Once they have satisfied those criteria, we ask them to apply formally. We do background checks; and there has to be a personal information circular that gives us information on the officers, significant shareholders and board of that company. We make sure that they are aware of, and agree to abide by, our trading rules. We feel it provides a secure environment for trading.
Relating this back to hedge funds, the hedge fund managers come through a broker dealer, an entity we know has been vetted and has secure and high standards of operation.
On the rules side, where we govern these entities, we have our TSX trading rules. I know that you heard from the Montreal exchange earlier. Where we differ from the Montreal exchange is that we have regulations services that do surveillance on our market enforcement, which ensures compliance. The regulations services are an independent entity. We have our own trading rules. The regulations services have established what they refer to as the universal market integrity rules. They apply those standards and they are watching.
Beyond that, there are the regulators. In our case, we have the provincial regulator — the Ontario Securities Commission. We have several layers of a secure and well-managed process to help us.
Senator Angus: You are the vice-president of trading and you have been an on-the-floor trader in your career, so you understand how it works. We have been told that the broker is there and behind the broker is a hedge fund, the ABC fund, for example. ABC goes to the broker and starts doing its trading. You do not know that it is ABC, right? It is CIBC Wood Gundy or RBC putting in a trade for ABC; is that correct?
Mr. Fotheringham: Yes.
Senator Angus: They are trading all day long. Their traders are on the floor representing their different clients.
Mr. Fotheringham: That is correct. We know anecdotally, from visiting these clients, who has assets under management. As a public entity, we do talk to them but you are absolutely correct: we do not know who it is.
Senator Angus: There are different kinds of funds, but to take a typical fund, let us say this ABC fund has $1 million of assets in play. I understand they have their computer model, some iteration of an algorithmic pattern. They trade all those assets every day, sometimes in various markets. Am I correct so far? They might be putting them to work all day in the Japan market and then move them over to the U.K. market and now the sun is coming up in the TSX Group. Is that how it works, according to your understanding?
Mr. Fotheringham: That is certainly how some funds are managed. To extend your point, the trading may be beyond equities; it may be into fixed income, for instance, or commodities.
Senator Angus: Anything that is a hedge — an interest rate, a thunderstorm, a gas price; I understand that. After the chairman and I talked with Governor Dodge, we thought we had better talk to our colleagues here and decide whether we should be doing this and why. What we understand is that the people who have invested in the ABC fund, which is being traded through one of the recognized registered entities, do not know what they are doing all day as they are busily trading. In a mutual fund, there are X shares of Alcan Inc. or whatever and you can see it going up and down on your computer screen. However, in these nanosecond transactions being traded all day by ABC, the consumer has not got a clue what they are doing. Also, there is no regulation that will open that kimono and show us the transparency that you are talking about as being so important. This is what we are trying to get to.
Really only the big boys know what they are doing. We saw at Amaranth all kinds of crazy conflicting bailouts by huge banks that were the backers and lenders to these ABC funds. However, you and I have put our $25,000 in there, and how are we protected?
Mr. Fotheringham: Again, as a market operator, we are focused on the day-to-day trade and how that trade comes in and is executed efficiently. That is from a TSX perspective.
You are leading to the requirements or obligations of the regulators to ensure that individual investment advisers, outside the responsibility of TSX, know their clients and understand the investments they make for their clients. In that way, advisers ensure that the investments are appropriate for the clients' risk profile and that they are able to explain the investments to their clients to the satisfaction of the clients. In the case of an investor who has the financial means to satisfy the test that they do not need the full prospectus, they would have that dialogue with their investment adviser to determine whether the investment is appropriate.
There are seven hedge funds traded actively on the TSX. In that case, a prospectus is filed so that one clearly understands the mandate and objectives of the hedge funds. You would not know today what they are trading, and that is part of the value added that they provide to the investor, much like a traditional investment manager would do.
Speaking as an exchange operator, I would say that the greatest difference is that on exchange we ensure that the rules are in place and that the markets are efficient. When we list a company, we ensure that they adhere to all the rules and regulations required, which include many things.
The Chairman: Out of 200 hedge funds, seven are listed on the TSX, meaning that 193 hedge funds are not listed. There is little difference in terms of oversight between the example Senator Angus used where the terms and objective of trading are much broader and much more capacious and a more staid, regulated or geared mutual fund. At the end of the day, we still have a vast, unregulated group of activities happening to which the word ``transparency'' could not be applied. Is that fair? We are trying to understand what you mean when you say ``transparency'' in this context.
Senator Angus: The chairman pointed out that people are listening to these proceedings on the Internet. We want them to understand what we are getting at.
In the United States, we were told that activity in the hedge fund sector is akin to the way things worked in wild-west times and that hedge funds are like junk bonds. Hedge fund operators say that although the sector can produce a high return, it is definitely high risk. If investors want a return of 33 per cent to 40 per cent, then they should see a hedge fund operator.
There has been a good track record, except for long-term capital and then the issue with Amaranth, which was touch-and-go. We are trying to make all of the information easily understood.
While your market is open all day, the operators of the ABC fund are putting that $1 million into buying, selling and looking for, I am told, volatile, not stable, situations. In that way, there is a better chance for them to make a good return. That is the nature of their business.
How risky is it? That is what this committee wants to understand. What you have told us thus far is reassuring: access to your trading markets is highly controlled, know-your-client rules are in place, and the dealers cannot willy- nilly pick up some not-so-savoury characters and start trading in your forum. Perhaps that will be the conclusion of this study, but before that can occur, we want to know whether there will be a huge run if the good times suddenly turn south. That is the kind of information we are looking for.
The Chairman: We are grappling with the inherent risk. Although we understand the need for liquidity and capital in Canada, we do not want to do anything that in any way, shape or form would put Canadian hedge fund managers at a disadvantage with either the English or the American marketplace. We are trying to strike a proper balance for a protective element. What is the proper regulatory balance that will give the markets their way while ensuring that the consumer and the economy are not detrimentally affected in the short-term or long-term downturn that we anticipate will happen? Every market that goes up also comes down. How do we hedge against that?
Senator Angus: There is the electronic exchange. You talked about exchange-traded derivatives, ETD, but we have heard about electronically-traded funds, ETF, as well. It is a whole new world. Should we be looking at those? We are senators, not rocket scientists, so we need your expertise to inform us. It is my sense that this is the replacement for junk bonds, et cetera, although you said that it is a welcome new product or financial capital measure. Junk bonds were more the old style of product. We needed something electronic in this new push-button world. Will this fill the existing void? Is that fair? Are we getting close to it?
Mr. Fotheringham: I would approach the question from a different angle. From the perspective of a market operator, what is the effect of a hedge fund in our market? As you say, markets go up and down and, inevitably, as much as we have good times, there will always be the opposite side of that coin.
One good thing that hedge funds provide is the other side of a market. In every purchase transaction there is a seller, and in every sell transaction there is a buyer for that security. The hedge fund, when it is in there, may be shorting a security that others have fallen in love with. There must be someone to facilitate that trade and a hedge fund manager will do that. Hedge funds provide liquidity to the market, often when others would not like to. That would be a disservice to our market makers that are in our market every day. Many of our participating organizations operate as market makers, who support the market on a daily basis with guaranteed minimum fills for our clients. I do not want to give a disservice to those participants because they fulfill a vital role for us and are important market participants. However, hedge funds also play a vital role by providing liquidity in times when others are unwilling to do so. They are the risk conduit that I talked about earlier such that when others are not willing to accept the risk, hedge fund managers are there to accept it. Another benefit, especially as it relates to shorting, is that they help with true price discovery. When markets get ahead of themselves, hedge funds will step in to help with that true price discovery, first acting in the market and then acting through their governance efforts.
We do find that hedge funds provide a vital role, which is my view as a market operator. I can step back to my role as a fund manager because I worked for a large Ontario pension fund before coming to TSX Group and I used hedge funds on a regular basis. We achieved the index through derivative contracts and used hedge funds to provide the alpha — the extra return or outperformance. Being on both the buy side and the service provider side, I see benefits to hedge funds.
Senator Angus: You said earlier that hedge funds are taking an active role in improving corporate governance, and you know of our interest in corporate governance as well. How do hedge funds tie into corporate governance?
Mr. Fotheringham: We have seen evidence of this not only in hedge funds but also in traditional funds and pension funds — those who for a long time had remained silent. In general terms, we are now seeing a more active governance approach by many investors. The investment community is getting more involved in how funds are run. To the extent that hedge funds are significant investors in a company, they can influence what is happening there. Again, that is outside the scope of my role as a market operator.
Senator Angus: Your point was that it is a risk mitigator in a sense, because to get registered and approved by the well-known CIBC Wood Gundy or Morgan Stanley or whoever, these ABC guys have to have good governance and they have to comply with the Sarbanes-Oxley measures. We are not necessarily big fans of Sarbanes-Oxley, but I use it as a generic term for governance. Is that correct?
Mr. Fotheringham: My view of the Canadian banking system is very positive. I think we have a very strong banking system with high-quality banks in Canada. They take risk management and measurement seriously. They have sophisticated systems and, as well, they want to know their clients. When someone is trading through them, they want to know who that client is and ensure that they are running their operations efficiently. I think the industry is applying ongoing efforts to this issue and it is constantly improving.
Senator Harb: Yesterday, a witness from the Office of the Superintendent of Financial Institutions appeared before the committee and indicated to us that the involvement of the banking and financial sector in hedge funds is in the vicinity of 2 per cent. Therefore, they concluded that there is nothing to be concerned about. From our perspective as a committee that was quite positive.
Has your organization done a breakdown of the players? Do you know which areas or sectors of the economy they are in and in what percentage of the hedge funds they participate?
Mr. Fotheringham: As a market operator we focus on our participating organizations. We have 116 participating organizations linked to our exchange; 10 of those are considered international participating organizations and they have to work through a Canadian conduit in order to access our exchange.
Those people are considered our direct clients. They are the people we know well and are the ones we focus on servicing. We have worked with them to have them secure approval to trade on our exchange. We have gone through the application process. In some cases, we have helped them secure their IDA membership; in other cases, they do it on their own.
In our efforts to promote general market awareness and general participation in our market, we also go out and talk to people about our market — the benefits of trading electronically, the benefits of trading in Canada, the focus on our product mix, which is very focused in mining, oil and gas. We can offer a number of structured products to investors.
We will talk in general terms about what we can offer to the marketplace and we get ideas from investors as well. Exchange traded funds were mentioned earlier; many people do not realize that Toronto was where those were discovered and developed — the TIPS, Toronto index participation shares, and HIPS you may be familiar with. That has grown into an incredibly successful global product, but that product came from talking to customers, talking to the marketplace, understanding what they need and developing products that satisfy them. That said, our focus is on the 116 participating organizations that are directly associated with our exchange.
Senator Harb: The Investment Dealers Association commissioned the task force, and you stated earlier that you are not aware of their recommendations. In a nutshell, when it came to regulating hedge funds, they made a series of recommendations concerning the disclosure of fees, the relationship among the hedge fund managers, advisers and administrators, the issue of conflict of interest and so on.
You told us that the algorithms used by some hedge funds are a closely guarded secret, which is understandable. The strategies those hedge funds use for their investment will also be secret; is that correct?
Mr. Fotheringham: The execution techniques they use are secret, or the algorithm driving the execution techniques is secret. The stock they trade is fully transparent. It goes into our central limit order book and is fully displayed for the market. Retail investors, institutional investors or any participant in our market is able to access that order.
The algorithm that drives the execution is secret. It is proprietary; it is the edge they can provide to their client — the value-added. However, once it is delivered through an electronic medium to the exchange, it is fully displayed; anyone can participate in that. Clients do take priority. There is a price-time priority algorithm on our exchange to ensure first in gets serviced, best price gets serviced and customers get serviced first. The secrecy is in the development of the execution strategy, not in the execution.
Senator Harb: While they made all those recommendations, the committee said consideration should be given to the registration of hedge fund managers in order to ensure that there is an appropriate level of regulatory oversight of the activities of the manager, as well as the fund capitalization and governance procedure. In their report, when it came to these particular issues, they did not really take a firm stand on whether or not all these hedge funds should be registered and regulated.
The report has been public since October 2006. Have you or other members in the TSX had a chance to deliberate on its findings? Have you come to a conclusion regarding the registration of hedge funds? Is there a problem, although it looks as if everything is fine? If so, when do you think we as a committee will be able to know what is the overall position of the investment community on the stock exchange?
Mr. Fotheringham: We have reviewed the report and understood its content and we are in support of the recommendations. Speaking as a market operator, our goal is to have as many qualified participants available to the marketplace as possible.
We think the recommendations are positive. We also think that the culture we have adopted and nurtured in Canada would be supportive of these changes. As you talk to a number of fund managers and market participants, I believe you are getting the impression that people are open to this; they are not close-minded to the idea that this focus has been recommended. They are also conscious of the fact that the sector is being well managed today and that there are not significant risks in place in the marketplace. I think the general tone is that there is support.
Senator Harb: This is exactly my point, that they do not say whether or not you should do it. They say you should consider doing it. Have you considered that, and if you did, what have you decided? Whatever answer you give me — if it is yes, you have decided you want to do it — in your estimation is it best to be self-regulated through the exchange, or should regulation be done through government, by way of some regulatory procedures or laws?
Do you think anything needs to be done regarding registration for hedge funds? If so, who should do the registration and the enforcement of that mechanism?
Mr. Fotheringham: As I noted earlier, our role as a market operator is to facilitate the trade. We have made a decision to outsource the regulation to our regulation services, and we all operate under the observation of the provincial regulators where we happen to be domiciled.
Our view is that we will concentrate on our market activity. The facilities are in place to accommodate this. We do have a healthy community of open-minded people who are looking at this. The regulation services are focused on it. The Ontario Securities Commission and all the security commissions as well as the Office of the Superintendent of Financial Institutions and the Bank of Canada understand this. A number of people are focused on this industry and are interested in developing it.
From the perspective of TSX Group, we would not force regulation. We would leave that to the experts who understand that best and can apply it most efficiently.
Senator Harb: Who would that be? If the Investment Dealers Association, which represent a wide variety of organizations, said that consideration should be given to regulating, is it we who should look at that? Is it you? Who should do it? That is an important and relevant point in our deliberation. If it is up to me, I would say: ``if it's not broken, don't fix it; leave it alone. It seemed to be going all right.''
Following the committee's trip to New York, I was horrified to hear the stories and the different discussions that are taking place in Europe. Everyone seems to be saying there is a fire. We are quite relieved to find out here that things are going smoothly. As you can appreciate, we are concerned because we do not want someone at some future point saying, ``We warned you. We told you there was a problem.''
Given the fact that the task force did not take a firm position on this particular issue but rather left it to someone else, in your estimation, who should that someone else be? Is it we? You said you support the task force's recommendation. In their recommendation they talk about conflict of interest and disclosures and even, which puzzled me, the fact that they want hedge funds to describe their structure and their investment strategy. I think that is none of anyone's business. My strategy is my strategy. That is how forceful they were and how open they were in terms of their recommendation. I am intrigued by the recommendation that that consideration should be given. The question is by whom. Who should do that?
The Chairman: Mr. Fotheringham, I think Senator Harb sums up our dilemma in an interesting way. We know there are some problems. There is recognition of some problems. The question is who is to take responsibility for solving the problems and applying some regulatory oversight that is not presently there? It is like a game. The ball is in the middle. Everyone agrees the ball should be moved, but the ball is not moving; or is it? I think that is a way of putting it in common parlance.
Mr. Fotheringham: I speak as a market participant as opposed to as a market operator. As a TSX operator, we facilitate the trade and that is what we are focused on. As a market participant who is interested in the healthy operation of our markets, it is in our best interests to promote a healthy operation of the market. I would say that the current structure that supports self-regulatory organizations is a good one. I think that it is a matter of those organizations getting together and coordinating their efforts. While there is not a screaming problem today, I think it is always best to be looking forward. I agree with all of the assessments that the stability of the market is not at risk; however, we should be continuing to look at new ways to do things better.
Senator Goldstein: Your description of the manner in which trading is taking place today brings to mind a collateral issue, which is the simple, ordinary retail investor, Joe or Josephine Jones, some place in Canada, who has saved up a few dollars, wants to go in the market, has a bit of sophistication, looks at price earnings ratios and compares them to the general market in that industry, takes a look at the dividend records and the earnings records of the company and does all the diligent things that an ordinary, somewhat sophisticated investor would do rather than simply looking around for a tip and buying.
That retail investor, from what you describe, has become a cork in the ocean and he or she is bobbing as a function of what the mutual funds are doing, what the private investment people are doing and what the hedge funds are doing and she or he has absolutely no control over what is going on with his or her investment. That is a bit disturbing, unless you can find some way that the investor who wants to know what is happening in a particular industry or with a specific stock is able to find out via the transparency of those big traders. That is a contradiction in terms, because the big traders, the hedge funds, are not willing, for obvious and appropriate reasons, to divulge their proprietary algorithms. They are not interested in telling anyone, except perhaps every quarter or every half year or every year, what stocks they are in, not only stocks, but what investments they are in, to what extent they are in them or whether they are short or long on them.
What is happening to the ordinary retail person in all of this?
Mr. Fotheringham: It is important to keep the retail investor in mind because the retail investor is a vital market participant and very important to our business as well as to the health of the Canadian capital market. I believe that the retail investor who has a firm view and is applying their strategies from a fundamental perspective, understanding the growth of the company and understanding their long-term objectives, is served by this market and is not harmed by the algorithmic trading. Given that they have different return objectives, different strategies, the retail investor tends to have a longer horizon, and a fundamental approach is much more appropriate to them.
Also, to the extent that they are working through an adviser who knows their client and can direct them to the right investments for them, intelligent investments for them, reconciled with their risk profile, I think the retail investor is served very well by this marketplace.
When algorithmic trading is applied to the market place, you not only get better liquidity, but also better price discovery, because the algorithms can act against the fundamentals for only so long. I think the retail investor is well served by the marketplace and is not hurt by these strategies.
Senator Goldstein: Is there any way one can respect the need of hedge funds to keep their strategies and the algorithms that reflect those strategies secret because they are proprietary, on the one hand, and on the other find a way that the retail investor can nevertheless get an understanding, if he or she so desires, of what kind of trading, not only generically but in terms of particular vehicles, the hedge funds are using? I am thinking, for instance, of some sort of delay technique where you cannot find out today what a hedge fund is doing today but you can find out three months hence what the hedge fund did. Would that be adverse to the interests of the hedge funds?
I am very concerned about the retail investor who has put money into the Canadian market and invested pension savings and life savings in the market having absolutely no knowledge of what is going on with his investment.
Mr. Fotheringham: It is important that retail investors reconcile their investment strategy with their personal objectives. Their personal objectives should drive their execution. On the institutional side, to link it to your question, agreements have often been developed where the actual executions will be divulged on a delayed basis. They could be exposed to the clients three months after the fact. It is random, but there are opportunities where that can be negotiated. I think it is better for the retail investor, if he is going to invest in a hedge fund, to understand the objectives of that fund and to understand the strategies that that fund will apply. In the case of exchange traded hedge funds, investors should understand the prospectus and be sure that it reconciles with their objective. The true test is the performance of that fund net of fee to ensure that it is satisfying the objective.
Senator Goldstein: Are you saying that, instead of buying CP, Bell or other household names with which he is comfortable from the long-range perspective because those are solid, sophisticated stocks that will not disappear from the scene, the retail investor is better off buying a mutual fund with objectives that appear to meet his objectives, or buying, if he can and if he qualifies, a hedge fund, to the extent that those are available given the limitations, and rely on the investment philosophy of the hedge fund or the mutual fund?
Mr. Fotheringham: It is very personal. When investment advisers sit down with individuals they must understand the clients' risk profile. It is right for some people but not for others. There are those who can devote the time, energy and intellectual capital to picking their own stock portfolio. Others are more focused on strategies, and that may be the individual who would suit a hedge fund. There are also those who buy and hold and go to the beach and who would rather look at another investment vehicle.
Investing is very individual and it comes down to knowing your client and ensuring that your investment profile fits your risk appetite and your long-term investment objectives.
Senator Goldstein: I know that brokers try very hard to follow the know-your-client rule. It is a wholesome rule, but sometimes individual investment advisers are prone to actions that do not necessarily comply with the needs of the investor; therefore, total reliance on one's broker is not necessarily a wise move.
Mr. Fotheringham: That is why regulatory bodies, which regulate sales techniques and the conduct of individual brokers in the investment community, have to step up and ensure that there is enforcement of the rules.
Senator Campbell: I am neither sophisticated nor knowledgeable in this area, but as I listen to you I have a vision of walking into a casino with various ways of gambling. The stock exchange provides that. It used to be a place to buy stock, but now it is derivatives, hedge funds and all the rest.
Are you familiar with the Alternative Investment Management Association?
Mr. Fotheringham: Yes.
Senator Campbell: They said that, in terms of regulation, Canadian security regulators appear to be coming to the conclusion that the current regulatory framework for the hedge fund industry in this country is appropriate and indeed is superior to that of many other jurisdictions. Do you agree with that statement?
Mr. Fotheringham: I agree with the direction, yes.
Senator Campbell: Then, having read an article on Amaranth, I come to the conclusion that everyone involved in this won, except for the investor. In fact, they will now start up new hedge funds. You lose billions of dollars and suddenly you are a success.
How does the stock exchange ensure that an investor going into a hedge fund will not get done like yesterday's dinner, like Amaranth?
Mr. Fotheringham: This gives me the opportunity to clarify. If I have left the impression that the TSX is a casino, I have done a terrible disservice to —
Senator Campbell: No, you didn't, and I did not say that. However, as someone who is not sophisticated, I know that blackjack, roulette and Texas hold'em each have a different risk level. I may be a great Texas hold'em player, but I am not that great at black jack. In my youth, the stock market was a place where one would invest in Bell Canada, for instance, because it is blue chip and it returns X amount. Now I can get into derivatives and many other things with the quick trade you are talking about. It scares me to think how many people are getting into this because of the opportunity for a huge return but not being aware of the downside. You can take a huge bath on money that you cannot afford to play with, that is for retirement or for your children's education.
Mr. Fotheringham: I must clarify that the hedge fund traders, the algorithmic traders, are participants on our exchange. They are one of many participants operating on a daily basis on our exchange. The key for the TSX is to attract good quality companies to list that are financially sound and represent the economy well. We have carved out a niche in mining, oil and gas. We have also been promoting structured products in ATS.
Our goal as a market operator is to get good quality companies. Once they are on the exchange, we ensure that they are traded efficiently and transparently so that all price discovery is out there and people can see the fair price. The retail investor can feel that they are fairly treated. They see the same price that the algorithmic trader sees.
Our goal is to develop liquid, transparent, quality markets regulated to the extent that we allow qualified individuals to trade and service the investment community. The investment strategies that are applied outside of that and may be articulated on our exchange are a different matter.
Senator Campbell: We are one of the largest oil and gas exchanges in the world.
Mr. Fotheringham: That is right.
Senator Campbell: Amaranth was mainly natural gas. You are looking into a crystal ball and trying to guess what will take place in March. How cold will it be? How much gas will be needed? If you win, you make a huge amount of money. If the trader loses, he does not lose anything. You get $75 million for producing a $1.26-billion profit. If you lost that, you don't lose any money, you just do not get your bonus. That is the part that bothers me. It is a crap shoot.
How do you ensure that the TSX does not have an Amaranth like we had a Bre-X? How can investors be confident that they are being looked after when this ongoing industry, at least in natural gas, is really just trying to guess what will happen in the future?
Mr. Fotheringham: There is a legitimate need for speculators or liquidity providers; they are necessary in the marketplace. As I noted earlier, if everyone were on one side of the trade the market would be one-directional and that is not healthy.
TSX focuses on the 116 participating organizations to ensure they are quality organizations and have passed the test in order to be become members of our exchange or participating organizations on our exchange.
Senator Campbell: I do not disagree that you need liquidity providers, but should they not be the sophisticated investors, the people prepared to go out there and take the risks? They should not unsophisticated investors or people who simply want to have a portfolio where they get an 8 per cent or 9 per cent return.
Mr. Fotheringham: This goes back to the know-your-client rule and to making sure that your investment advisor puts you in a fund or a vehicle that articulates your risk profile and investment objective properly. We cannot regulate bad judgment.
Senator Campbell: I do not think you can because the bad judgment is based on greed. If someone says, ``I can get you 30 per cent,'' I will be on it like a rash. If it does not happen, who is to blame? Me. I was greedy and I wanted to go out there and do that.
The Chairman: Senator Campbell, there is a guideline between sophisticated and unsophisticated investors. Previously in the committee we debated how large the quantum of the investor should be. The benchmark used to be $150,000 or $125,000 in Canada to become a sophisticated investor. Now they are talking about $2.5 million. There is an active debate on where you draw the line between unsophisticated and sophisticated.
Senator Campbell: That would mean, then, that everyone involved in Amaranth who lost their money all had $2.5 million and they were all sophisticated investors?
The Chairman: Most of them in Amaranth in the U.S. were sophisticated investors.
Senator Campbell: How many hedge funds are not using that basis?
The Chairman: Hopefully, senator, this will be the subject matter of our own considerations of what our recommendations will be.
Senator Campbell: I want to make clear that I was not suggesting in any way, shape or form that the TSX was involved in fraud here. I used Bre-X because it was an example of a company that was able to keep everyone outside of it. I was not suggesting that the TSX is in any way a fraud. I think the TSX is a great organization and they should be commended for what they are doing and for being able to be in the top five in the world. My concern is strictly for the investor.
Mr. Fotheringham: I appreciate the clarification, because I do have to go back to work tomorrow.
The Chairman: You have heard a great commendation for the TSX from Senator Campbell, a former mayor of the City of Vancouver.
We have talked about transparency and about liquidity, in which we are interested. I am curious about one of your comments about governance. As Senator Angus pointed out, governance issues are a concern to us as they relate to the economy. We are concerned about the disparity between what workers make now and what CEOs make. The disparity in Canada is great but not as great as in the United States where it is out of sight. We are concerned about that issue and we may be addressing that.
An article appeared in the last ten days about leveraged buyouts and where brokerage companies — and I use these words carefully — where hedge funds and brokers got together with respect to buying or taking over a leveraged buyout company and the share owners' votes were lent for the purposes of takeover. That is a serious problem, because we in this committee and in Canada believe there is shareholder democracy. If you buy a share you are entitled to know what is happening and you are entitled to vote those shares.
Are you familiar with what happened in the United States? It was on the front page of The Wall Street Journal within the last 10 days. It was a shock to us because we had been to New York and had not uncovered the practice of lending votes without the knowledge or the ascent of the shareholder to a leverage buyout. A person buys shares in a company and through a leverage fund invests in the company. Then that company buys shares. That is all methodology to which we do not object. Then — I do not like to use the word ``conspire''; it is not appropriate — they agree for value to take a fee in order to lend those votes for the purpose of a takeover. That strikes me as being contrary to our entire theory of corporate democracy.
Do you have comments about that?
Mr. Fotheringham: I will speak as someone who is involved in the market as a portfolio manager as opposed to as a representative of the TSX. At TSX we are trading the securities and do not lend or borrow. We facilitate the trade.
As a fund manager, securities lending was an important part of our business. It allowed those who wanted to go short to facilitate that trade. For a fee they could borrow to facilitate the trade. Those who were lending were able to add incremental income, especially those who were pension funds and had long-term horizons, a five- or ten-year investment horizon.
To the extent that securities lending is used in that way, it is a healthy function. It helps facilitate trade and it is a more efficient operation of the market. That is the perspective I can speak on.
The Chairman: Do you find the practice offensive to our general principles of shareholder democracy and transparency?
As an example, there is a leverage buyout and a company is taken over. If the company that is taken over or merged is not aware that the shareholdings that can determine its fate are now loaned and not in transparent hands and therefore cannot counteract by having a fair response to votes that will go a different way, that does not pass my smell test.
You may be right. The market is working efficiently and quickly and sometimes the market working effectively does not necessarily mean it is consistent with shareholder democracy. That is my issue. An unfair takeover may have taken place without those shareholders' being able to defend their corporate entity against an unfair takeover. Those are rules in the marketplace. Do you have comment about that? I ask you from a market side.
Mr. Fotheringham: Having been a market participant prior to joining TSX, my view is that you should be allowed to purchase or sell shares to articulate your view. As an investor, you should be allowed to participate in the corporate governance through your share ownership.
In order to facilitate liquidity in the marketplace and efficient trading, borrowing and lending must take place. Again, reaching back before I joined TSX, a personal opinion is that that may not be the intent or it certainly is not the desired outcome for the market to borrow shares in order to manipulate.
The Chairman: Thank you for your evidence. Obviously you can see that the committee is very interested in the subject matter and I wish to thank you very much for your knowledge and expertise and that of your organization.
Mr. Fotheringham: Thank you for having me. It was a terrific opportunity. I appreciate it.
The Chairman: I will ask our next witnesses to come to the table. Gentlemen, you can see that the committee is deeply engaged in this issue. As I mentioned earlier, the Standing Senate Committee on Banking, Trade and Commerce was in New York last October to discuss a number of issues that we are now considering within our mandate, which is the hedge funds, a sector then valued at $1.1 trillion in assets globally. We now understand from your evidence that those funds are now $1.4 trillion. The sector is growing like Topsy. We know the Canadian market has gone from a low of $25 million or $26 million up to $40 million depending on how you count it.
There is no question at all we are into a growth market for this new methodology of investing in funds. Given the scope and size of our trading relationship with the United States and the integrated nature of our economies, we think priority must be given to financial global stability. It is imperative that we as policy-makers, regulators and investors in Canada understand what is happening both in Canada and in the United States at the same time. Therefore, we are delighted now to welcome our witnesses from the Alternative Investment Management Association, AIMA.
Tris Lett, Deputy Chair, Alternative Investment Management Association (AIMA): First, I would like to say that our chairman, Phil Schmitt, who would love to have been here today, is in the U.K. with our headquarters. They are having their global council meeting so he sends his regrets and apologizes for not being here personally.
Since you have the information about what we do, there is not much we can add. We are in the business of educating any entities that are investing or considering investing in or considering operating in the hedge fund business. We assist in the advocacy of those groups who are in the business, both from the investor side and from the service-provider side. We also deal with the regulators and we try to promulgate best practices through the information we publish and make available to our members and to all those who are concerned about what hedge funds are.
In a nutshell, that is what AIMA Canada is about. You can go to our website and find this information. It is free of charge and available to everyone.
We have heard reference today to the study done by the Canadian Securities Administrators. I do not think we need to run through that either. You have read it. Let us just go to the questions. It seems to me you have a real appetite to know what is happening in this business. Mr. Burns will give you the regulation side and I can give you the macroeconomic risk side.
The Chairman: I am unfair to you in a way because your organization is an important organization. As I understand, it is the Canadian chapter of an international organization started back in 1990. Essentially, as your heading says, it is a forum for hedge funds, managed futures and managed currencies. It is a not-for-profit organization to help in the education about and understanding of these new investment vehicles. We understand now that these chapters are growing like Topsy. There are 110 corporate members in 47 countries, so obviously this is a growth sector and you are on the cutting edge of that.
Mr. Lett: We have 1,100 corporate members now, with chapters globally.
The Chairman: Obviously the appetite and the interest are great, and we want to thank you for that.
Senator Angus: Welcome, gentlemen, it is good to see you here. I noted that you were in the room during all of the evidence of Mr. Fotheringham, so I may want to make reference to that in some questions.
First, to clarify: There is a relatively new exchange in London, England, called AIMS or AIM. Are you the same people? What is your connection with that?
Mr. Lett: We have no relationship to them.
Senator Angus: None at all. That is what I thought.
Michael Burns, Legal Counsel, Alternative Investment Management Association (AIMA): AIM is a junior stock exchange similar to the TSX Venture Exchange. It lists developmental and start-up companies. It has absolutely no affiliation with AIMA.
Senator Angus: As you know, it has been popular as a competitor to exchanges, not only in New York but in Toronto, because they allegedly are not sticklers on Sarbanes-Oxley type restrictions, as are exchanges and regulators over here. Also, the access is less costly, I understand. Therefore, there has been quite a flight of capital over to there; I am told it is a new and quite exciting source of funds for start-ups to get in without being bankrupted before they get started with all the costs of getting organized.
There is an indirect relationship to the hedge fund industry, which is what we are interested in.
Having heard our questioning and Mr. Fotheringham's responses, is there anything you would like to take issue with or supplement?
Mr. Burns: First, I would like to say that I am happy to be here today. It is an honour to appear before this committee, and I applaud the work that you are doing. We at AIMA Canada are willing to do anything we can to foster greater public awareness of hedge funds and their activities and structures, as well as provide support on an ongoing basis.
On a personal note, it is an honour indeed for a boy from the Miramichi in New Brunswick to appear before a Senate committee.
Judging from the conversations with the prior witness and from previous testimony before this committee, I take exception to the notions that, first, hedge funds as a group are a riskier investment than other types of investment classes and, second, investors will give a hedge fund manager their money and then have absolutely no idea what the hedge fund manager will do with it.
In my experience as a securities lawyer who acts with a number of hedge funds, most hedge funds that are offered via a private placement are offered through an offering memorandum. The offering memorandum contains disclosure concerning the investment strategy.
The Chairman: Mr. Burns, stop there. We heard evidence earlier about the differentiation between those that are offered and those that are not offered through an offering. We heard the gentleman who came to us and said only a small proportion of the hedge funds go through the listing process.
Senator Angus: I do not think these offering memorandums are listed.
Senator Goldstein: They are not the same.
The Chairman: I am talking about the question of discretion versus disclosure, the management, and if there is an offering memorandum, you have some idea of what you are about to invest in.
Give us the demarcation between those that are regulated in that fashion and those that are not. Many of them are pure private placements, other than a private offering memorandum versus a publicly registered offering memorandum.
Mr. Burns: Are you referring to the differentiation between a prospectus and an offering memorandum?
The Chairman: Yes, I am.
Mr. Burns: The majority of hedge funds are sold on a private placement basis to accredited investors. It depends on the hedge fund manager, but most will use an offering memorandum for the purpose of introducing their fund to potential investors. Under current securities legislation there is no prescribed form of offering memorandum that must be used and no prescribed content for that type of offering memorandum.
There is in certain Canadian jurisdictions an offering memorandum exemption that does contain a prescribed form for that type of document. If you are selling to accredited investors, you do not have to use an offering memorandum, but if you choose to do so, you will tend to describe in that offering memorandum the investment strategy that you intend to use.
The Chairman: We understand that. We now have 2,200 hedge funds, and we are trying to grasp what proportion of the entire marketplace of hedge funds — the universe of hedge funds — is under which degree of regulation — A, B, or C, where C is nothing other than raising some money, pure and clear, with no offering memorandum, just ``Give me $2 million,'' or ``Here is $10 million.''
Mr. Burns: That category would be in the minority.
The Chairman: What percentage of the total would it be?
Mr. Burns: I would guess roughly 5 per cent of the hedge fund universe would be offered without any offering documents.
The Chairman: Are you saying that the bulk would be done through a private offering memorandum?
Mr. Burns: Right; that would be 80 per cent to 85 per cent.
The Chairman: The other portion would be through a public offering.
Mr. Burns: Yes. Those are usually organized as a closed-end trust, and they are listed on the TSX and offered under a prospectus.
The Chairman: For the bulk of them, in terms of public information, there is no regulation regarding how must disclosure the offering memorandum must give. Based on the offering memorandum, the investor chooses whether he is prepared to give the manager the level of discretion required, which is a lot of discretion based on a certain formula.
Mr. Burns: There is one important caveat: if an offering memorandum is provided to potential investors, securities law requires statutory contractual rights of action for rescission of the contract also be provided, so you can get out of the trade or damages, if you suffered damages, in the event that the offering memorandum contains a misrepresentation. The misrepresentation standard is not thought to be the equivalent of the full, true and plain disclosure standard required of prospectuses. However, that has never been tested in a court of law.
The Chairman: Has there been any litigation on that?
Mr. Burns: Not to my knowledge. A misrepresentation is defined in the securities legislation not only as getting something wrong or misstating a material fact but also as the omission of a material fact that would be relevant for a purchaser in making an investment decision. When they are crafting an offering memorandum in the context of the offering of hedge fund securities, the legal team and the managers take great care to ensure that that document contains sufficient disclosure in order for people to make an informed investment decision.
Senator Angus: The witnesses were just in the process of answering my general question about whether they took issue with anything.
Mr. Burns, you were saying that you took issue with our suggestion that these hedge funds, whilst an interesting new product and a useful new source of capital and so forth, are risky. I suggested earlier that they have fairly good records of return on investment, 20-plus per cent and even above 30 per cent. Is that not a fact? We may have that wrong. Our understanding was that it was a high return. The risks are higher. It is like the junk bond analogy.
Mr. Burns: The returns can be high. I like to quote the first line from Tolstoy's Anna Karenina: ``Happy families are all alike; every unhappy family is unhappy in its own way.''
It is the same with hedge funds. There are a multitude of different strategies and risk profiles in the hedge fund universe. To classify all hedge funds as inherently risky is not accurate. That was my basic supposition or objection to that characterization. It has been picked up in the media as well. The media view hedge funds as inherently risky, which is not always the case.
There have been occurrences of the returns being at the 20 per cent or 30 per cent level, but the global hedge fund returns over the last couple of years have not been near that level. In large part that is because all the markets have been moving in the same direction, and hedge funds tend to thrive in turmoil when there are choppy directions and you cannot tell which way the market is going. In rising markets, hedge funds tend not to perform as well as they do in more volatile markets.
Mr. Lett: It is very difficult to generalize this business.
Senator Angus: It is also dangerous.
Mr. Lett: You must be extremely careful when you are talking about it. I can see that people in New York and other places you may have visited have given you the headlines, but they have not told you where all the action is, which is that 50 per cent of hedge funds invest in stocks only. They have portfolios that are long and short stocks, and some are market neutral, so they have no exposure to the market. They have cancelled that out completely through hedging. Those portfolios are totally transparent. If you want to know what is happening in your portfolio, the strategy may be complicated and difficult to explain, but it is not a risky strategy.
You must look at hedge funds more like an individual stock. If you want to hold one stock portfolio, you can get individual stocks that can give you fabulously high returns and ones that will give you fabulously low returns. If you want to embark on investing in this business, you should be thinking in a portfolio context wherein you diversify across a number of hedge funds of different styles, and so on. There are lots of styles from which to pick. I heard an enumeration at the beginning. For example, the Amaranth bet was really on hurricanes. They believed that they would have the same incident of hurricanes this year as they had last year. As it turned out, we have had hardly any. That was an incorrect bet. You cannot generalize these things; they are as heterogeneous as you can imagine.
Senator Angus: That is helpful.
The Chairman: It is helpful, but I think we did understand that. We are trying to break down the categories to see where the risk is, where the lines should be drawn and what the nature of the oversight should be.
Senator Goldstein: Gentlemen, thank you for your exposé and for being patient here while your predecessor was speaking with us.
Your organization, which is a voluntary not-for-profit organization, now has 90 members, as indicated in the literature that you were kind enough to provide. We heard that there are 200 hedge funds in Canada. Are you making any effort to get the other 110 hedge funds on board?
Mr. Lett: Our membership is not exclusively hedge funds. Any corporate member could have 10 hedge funds in their stable. It is difficult to make a judgment of what our coverage is. We have almost all the important ones.
Senator Goldstein: There was a paragraph in your presentation that caught my attention. It spoke about the Canadian Securities Administrators' six suggestions in its January 12 report. You were generally supportive, with a proviso. I would like you to expand upon that. You stated that you agree with the course of action as it relates to hedge fund regulation, ``provided that any proposed new rules are implemented in a manner which ensures a `level playing field' between hedge funds and other investment products available to Canadians.''
That raises two issues. The first is the implication in that paragraph that at the moment there is not a level playing field between hedge funds and other investment products. I would like to hear more about that. The second is how those six recommendations would assure a level playing field between hedge funds and other investments products available in Canada. I am reading from your paper, but I am not sure I understand. I do not know the answers to those two questions.
Mr. Burns: Regarding the level playing field, our point was that we would not want to see an additional regulatory burden put on hedge fund managers as compared to other types of investment managers, for example mutual fund managers or private equity managers. We would not want hedge fund managers to be subject to a level of regulation to which other managers doing essentially the same thing were not.
We at AIMA Canada generally are supportive of regulation, provided it is thoughtful. We always want to try to have input into it to assist regulators in understanding the unique environment that hedge fund managers face in conducting their business.
Senator Goldstein: Amaranth was not based in Canada and therefore would not have been subject to Canadian regulations. Yet, Canadian pension funds and others had positions in Amaranth. The bulk of the worldwide hedge fund industry is not situated in Canada but elsewhere, frequently in tax havens and frequently in non-regulatory havens.
How does one go about dealing with the kind of gentle regulation that the CSA has recommended, when a grand total of 200 hedge funds are susceptible to regulation in Canada but thousands of hedge funds worldwide are selling into Canada?
Mr. Burns: I can answer at least part of that question. Hedge fund managers based offshore who would like to sell their product to Canadians have only a limited ability to do so currently under Canadian securities laws. They must be offering their fund primarily abroad; they can offer it to Canadian investors in only two ways: first, on a private placement basis — that is, to accredited investors; and, second, through registered dealers. If they do not do that, or if they make a targeted offering to Canadians, then they are obligated to register as investment counsel portfolio managers with the applicable jurisdictions in Canada.
Senator Goldstein: The accreditation criteria in Canada are at the moment relatively nominal. You are aware that the United States is about to raise its thresholds to $2.5 million and a variety of other variations that are inconsistent with what we in Canada are doing so far.
Would you suggest a variation of the Canadian thresholds for accredited investors?
Mr. Burns: This goes back to the level playing field argument. Would the threshold change for all types of private placement? In other words, would someone buying a private placement in a mining company be forced to meet the same accredited investor standard as someone buying hedge funds? I think it is worthy of study.
I believe the U.S. Securities and Exchange Commission, SEC, decided to change the accredited investor standard because the value of one's home was included in the test. With the startling increase in the value of real estate in the United States, and with their general population growth and growth in incomes, the $1 million threshold for becoming an accredited investor was irrelevant. Many people were suddenly becoming accredited investors almost solely by the value of their real estate holdings or principle residence.
In Canada, we have different tests under the accredited investor standard. Your residence would come into play only if you had net assets of $5 million currently. That is the only time you can include the value of your residence in the accredited investor standard. The other two tests under which you can qualify are net financial assets, which are liquid stocks, bonds and securities having a net value of $1 million, and the income test, which is $200,000 of net income in the last two years, $300,000 together with your spouse, and a reasonable expectation of meeting that level in the current year.
Given our population relative to the United States and the relative income disbursement in Canada, it could be relevant to study whether it is worthwhile to bump up the accredited investor threshold at this point, but I would not be able to comment now whether I would support that.
Senator Goldstein: Do you see a value in having a different test for people investing in a mining company, to use your example, which has an offering memorandum and is subject to some regulatory control because it is a Canadian mining company, as compared to a hedge fund which does not have any significant regulatory supervision? Do you see any value in different thresholds for different investment vehicles?
Mr. Burns: Personally, I would not. In fact, in those two examples, the hedge fund would be more highly regulated than the mining company, because the investment adviser to that hedge fund would be registered with a provincial securities commission as an investment counsel portfolio manager. In Ontario they would also have a limited-market dealer registration, which obligates them to follow the know-your-client rule and perform suitability analysis if they are selling directly to an investor. Neither of those safeguards would be in place with the mining company. I would not support a different standard for hedge funds vis-à-vis other investments.
The Chairman: We want to welcome back Senator Tkachuk from his great travels across the country on our behalf.
Senator Tkachuk: I cannot help but note that the hurricane warnings were predicted by the climatologists, who said there would be global warming and therefore more hurricanes. They are the same people who predicted that in the West this year we would have a warm winter and in the East it would be a cold winter. In both cases, they were completely wrong.
Mr. Lett: When I hear of weather forecasts like that, I go the opposite way; I hedge it.
Senator Tkachuk: That is exactly right. The people at Amaranth should never have listened to those people. It caused many people a lot of grief.
Senator Angus: We are all wearing green ribbons today.
Senator Tkachuk: I am not.
The Chairman: There is a little political debate going on in the country about environmental policies and so on, but it has nothing to do with this question.
Senator Tkachuk: We find hedge funds difficult to understand, and anything difficult to understand seems more risky than something that you think you understand, even though you may not.
Is there really a difference between the risk taken by people on the TSX in venture funds and with hedge funds or any of the other market exchanges that any retail investor can get into, buying penny stock here or in Vancouver buying diamond mines? That goes on, and at the same time, we do not have limits on the amount of money that one can spend on stock.
Mr. Lett: That is a wholesome question. Probably more money was lost by Canadians' betting on one stock, Nortel, than anything else. I cannot imagine what regulation could have been put in place to stop people from putting 100 per cent of their RRSP into the stock. Risks are everywhere, and one must be intelligent about how one takes those risks.
With Nortel, people really did not know what was happening in the company. The story is out now, but in those days we did not know the real story, how the company was operated and why the stock kept going up.
Hedge funds have two degrees of freedom that mutual funds or long-only investments do not have. One is that they can go short and the other is that they can borrow money or use leverage with financial instruments to magnify their exposure.
Investors must learn the proper use of these instruments. Certainly from AIMA Canada's and AIMA's point of view, education is a massive part of our mandate. We have just released a paper on leverage, which is available on our website. It is one of the finest papers I have read on the subject, because it clarifies exactly what leverage is.
The Chairman: Could you make that paper available for our committee? Any recent documents you have would help put this subject in the proper context. For instance, leverage is an important issue with which we are grappling.
Mr. Lett: If you start looking at this in the macroeconomic sense, leverage can magnify its way through the banking system. You also have to worry about that. I am sure Governor Dodge has spent many hours examining that question. In Canada, and I think in general, the prime brokerage system which lends money to the hedge fund industry to magnify positions in various issues is careful about the limits they put on those hedge funds. They do not let them run off and go crazy with this leverage.
Senator Tkachuk: Even if you are an individual small investor with your own trading account of $100,000, the bank will be more than happy to give you another $75,000 to buy more stock, to buy options, and perform all kinds of rather risky manoeuvres. You could go down to the TSX Venture Exchange with that amount of money and borrow another 75 per cent of your total asset value in that account and blow it all on five or six little companies in the hope of becoming a millionaire. That is totally unregulated. No one is asking questions. Anyone can take that risk, whether they are playing with their pension plan, as Mr. Burns was concerned about, or with their children's education or their home, because they could easily do that too. The banks would be more than happy to lend you money to buy stocks so you can write off the interest on your income.
How much can a hedge fund leverage? Seventy-five per cent or 100 per cent?
Mr. Lett: How much they leverage is related to the entity that is lending them the money. They perform careful analyses and monitor religiously. The banks see all the transactions going through their prime broker desk. They can see how much risk is in every position and they will start asking investors to pare back if they feel it is too risky.
The Chairman: Earlier, Mr. Fotheringham said that generally hedge funds are less leveraged in Canada. We did not get a chance to explore that notion with him. Are hedge funds less leveraged here because of the ability of the broker- dealers and the banks to limit the amount of risk they are prepared to allow hedge funds to incur based on their investing formulae?
Mr. Lett: I was interested in Mr. Fotheringham's remark. I was unaware of that, and I will ask him where he got that information.
The Chairman: I have just asked our researcher to search that out for us.
Mr. Lett: In general, I do not believe that hedge funds leverage over two and a half times for the industry as a whole, globally. It has come way down from the Long-Term Capital Management days that Senator Angus referred to earlier.
The second part of the equation is short selling, which is an additional degree of freedom. Most people think short selling is the opposite of buying long. It is not the opposite of buying long. They have different risk profiles. In buying long, all you can do is lose all the money you invested. With short selling, you can lose much more than you invested. It has a different type of risk profile and it is a more difficult strategy to implement, because you have to find someone who will lend you those securities.
I want to get to the point that Senator Grafstein raised on democracy and securities lending. Disclosure is a difficult issue for hedge funds that are shorting, because they do not want people to know that they have got a large short position in anything in particular. The first thing that happens is that people will start to arbitrage that and put on a short squeeze. The cost of that short goes up and then they have forced sales, which cause liquidity crises, which in turn cause blow-ups. Those are the situations we do not want to have. A certain amount of non-transparency or stale transparency is probably something that you should contemplate.
We can deal with your other issue in a minute, Senator Grafstein.
Senator Campbell: You said that 50 per cent of the hedge funds deal in stocks. Is that growing or not?
Mr. Lett: The percentage is declining.
Senator Campbell: Are they getting out of stocks?
Mr. Lett: Newer hedge funds are getting into more complicated areas of the market, for example the collateralized debt obligations and the collateralized loan obligations market. This is a relatively new market — not well understood so not well priced — so there are opportunities there for hedge funds to make money.
Senator Campbell: I agree with the senator from Saskatchewan, which is rare.
Senator Tkachuk: We always agree.
Senator Campbell: I had a breakdown in communication. Much of this issue has to do with people's greed and perhaps not so much with being a sophisticated investor, because you can start playing on the venture exchange and find yourself in a lot of trouble. There are no controls on that. It is gambling.
Mr. Burns: That is where the relationship between the client and the financial adviser becomes very important. AIMA Canada has published a list of 10 questions that investors should ask their adviser before they invest in a hedge fund. We can supply that list to the committee. If your adviser cannot answer those questions, I would advise you to get another adviser. Those questions will reveal how much due diligence your adviser has done on a hedge fund product and how well they understand the product. That is what it comes down to at the end of the day — a sufficient level of knowledge to be able to make an informed investment decision about the products. That tracks through the advisor channel all the way back to the manufacturers of these products to ensure that information is provided. That is published on our website at www.AIMA-Canada.org, but we would be happy to provide it to the committee as well.
The Chairman: In your text, you say that the Canadian Securities Administrators determined that while an appropriate securities framework exists for hedge funds in Canada, which is what you have said this morning, certain areas can be improved. Their review identified areas for improvement, including issues with principal protected notes, referral arrangements, distribution, disclosure, and registration of fund managers. I assume that if our committee decided, as we looked at each issue, that it was appropriate to make recommendations about improving regulatory oversight, depending on how deep and pervasive those were, as a question of policy you would be in agreement.
Mr. Lett: Yes.
Mr. Burns: Yes.
The Chairman: We are trying to find appropriate guidelines without suffocating this growing industry. We are sensitive to your needs.
Do you have a response to my question to Mr. Fotheringham about what I consider to be a problem, at least on the surface, with shareholder democracy? Someone can make a fee for lending a vote without the shareholder's knowing that his vote is being used and without the corporation's having any knowledge that this is taking place so it cannot respond properly in the marketplace.
Mr. Lett: Each of us has a response to that. This is part of a much broader issue. In fact, if you leave any security in a broker account, you basically do not have control over that security. If you have cash in that broker account and that broker goes up the flue, your cash is gone. From a broad context, that is a problem.
At my firm, we are aware of the issues associated with the lending of securities and the lending of the votes simultaneously, and we do not let our prime brokers vote our shares, even when they loan them. The democracy is because you can control that. The issue is whether you know you can control that. Did you even know they were doing this? No. I think the publicity on this event recently has been of great educational value. Educating is part of what we do at AIMA. When you are aware of these things, you can do something about them.
The Chairman: Do you agree, then, that it is not fair to allow a company to be subject to a takeover bid and have votes against that it did not even know were being used in a shareholder takeover?
Mr. Lett: You certainly have been taken advantage of by the fact that you did not know. Would you have done that had you known? It does smack of unfairness.
Senator Angus: The company should have known from the shareholders' register where the stock is. They may not know it is being held at the broker's office, but if they are soliciting votes for a takeover bid, they will be doing the due diligence and go to the fellow and ask for the proxy.
The Chairman: There is an issue of disclosure. We are concerned about a level playing field. As I understand it, if you are about to take over a company, you can go in and buy shares in that particular company and use those shares as well to go forward and seek the majority of shares necessary to take over the company. That has to be disclosed. Someone who seeks to do that acquires those shares, and that is regulated and he had to come up to a certain amount. They have to be disclosed. The company knows who they are, and that is regulated. All of a sudden there is a gap where funds are now in hedge fund accounts or brokers' accounts, and the leverage buyout artist in effect goes and pays a fee to acquire the votes of those particular shares in addition to the votes that are openly held, therefore putting the opposing elements at a disadvantage because they just did not know the votes were gone. It is not a question of sending out circulars to convince then. They have already been pre-bought. The discretion is gone.
It strikes me as an unfair application of brokers or hedge funds unless they publicly declare that this is what they are doing. I have no problem with it if they publicly say, ``We are into this and here is the way we are going to vote our shares,'' and put their shareholders on notice. To do otherwise strikes me as stealthy and unfair. That is just an impression. If the hedge funds, which are lightly regulated, are abusing this process, people concerned with governance should look at it.
That is as far as I will go, because we do not know the full implications of all of this. I am looking for your reactions as a regulatory lawyer. Does it pass your smell test?
Mr. Burns: Not in the way you portray it. I would echo Mr. Lett's comments. If this is being done without the knowledge of the people who are putting their shares into a brokerage account, I do not like the sound of that, and I do not like the appearance at all, because it would smack of being an end run around the proxy solicitation rules. The normal way to effect a change at a corporate governance level is to send out a circular to the people from whom you want to solicit votes to explain what you are doing and to solicit their support.
If these people are acquiring the shares, I would add that we do have an early warning system in Canada when it comes to takeover bids. Once you acquire beneficial control or direction of 10 per cent or more of the securities of the public issuer, you are obligated to file a report, notify the market and issue a new release.
The Chairman: As I understand the difference, although I may be wrong because I have not looked at it carefully, it is one thing to acquire the equity. You acquire it, so you have to disclose. However, if you are borrowing shares, you do not have the same requirement. You are just borrowing for the purposes of a vote. The regulations may not specify that that, in effect, is ownership.
Mr. Burns: If you have acquired control or direction over the voting shares, that would be included in the report.
The Chairman: You are lending the vote for a particular purpose at a particular moment in time.
Mr. Burns: The legislation is crafted very broadly; it is intended to capture any type of agreement or arrangement by which you may vote the securities. If that hedge fund were in Canada —
The Chairman: There are American examples.
Mr. Burns: In the U.S., they have an even lower threshold, 5 per cent, for voting.
The Chairman: It still applies.
Mr. Burns: You would have to include those shares in your report and file a news release saying you have acquired those shares.
The Chairman: We will continue to look at this question. Thank you both for helping our committee on this issue. We are becoming more familiar with the intricacies. We do not want to overstep our bounds. We do not want to simplify. We want to understand this. If we are to make recommendations, they should be appropriate recommendations that will not inhibit the marketplace but make it work more transparently and effectively. Stay tuned.
The committee adjourned.