As evidenced by the draft amendment on local hedge funds and prime brokers that has recently been released for public review, Korea is on the verge of having its own homegrown hedge fund industry. Many of the overly restrictive regulations that had previously stifled the development of Korean hedge funds are set to be eliminated or eased, while other areas have been given greater clarity. Because of these positive steps, many industry participants are sanguine about the potential for the industry, but some of the optimism may be excessive. This article attempts to outline some potential pitfalls for the industry in its early stages and show how financial regulators and institutional investors must continue to play an important role in ensuring that the industry develops in a manner that is not only sustainable but that promotes financial system stability and investor protections.
New rules on hedge funds and prime brokers are scheduled for enactment
On June 20 2011, proposed revisions to an enforcement decree of the Financial Investment Services and Capital Markets Act (FSCMA) for the fostering of hedge funds and prime brokers in Korea were posted publicly in preparation for passage in October. These revisions were drafted by the financial authorities in response to concerns that the current form of the FSCMA is too restrictive and unable to achieve its stated objectives of promoting the development of Korea's capital markets and ‘financial investment’ (asset management and brokerage) industries. As the financial authorities have made it their goal to lay the groundwork for the launch of the first onshore Korean hedge fund by the end of 2011, these revisions were written to establish a road map for such a process. Supplementary details, such as specifics on required standards for prime brokers, were released on July 26. Now that relevant laws and standards have been established, we can soon expect to witness the launching of a homegrown hedge fund industry in Korea. Based on the current state of Korea's capital markets, however, it is unlikely that the process will be seamless. More likely, the hedge fund industry will go through a process of trial-and-error as it develops in a way that suits Korea's unique circumstances.
Hedge funds and prime brokers in Korea
Since the passage of the Financial Investment Services and Capital Markets Act in early 2009, offshore hedge funds have been sold to local investors, but there has been a distinct lack of onshore hedge funds. One reason is that, while the FSCMA permitted the establishment and management of onshore hedge funds, it prescribed overly restrictive conditions. For instance, it required onshore hedge funds to invest at least 50% of their assets in companies that are being restructured, and designated only financial institutions or pension funds as eligible investors.1 2 But under the recent revisions, the requirement that at least half of a hedge fund's assets be invested in companies undergoing restructuring was eliminated. Hedge fund assets can now be invested in a discretionary manner into securities, derivatives, real assets, or any other assets with economic value. In addition, individual investors (qualified general investors) are now permitted to invest in hedge funds as long as they invest ?500 million or more into one fund. With regard to funds of hedge funds (FOHFs), the financial authorities are planning to release guidelines in the third quarter that will cover minimum investment amounts, diversification requirements, etc.3 Moreover, to boost manager autonomy, the amendment proposes looser restrictions on hedge funds' use of short selling or leverage. For instance, it raises the ceiling on leverage from 300% of fund assets to 400%, and raises derivative position limits from the current 100% of fund assets to 400%.4
Asset management firms, securities firms and investment advisory firms will be allowed to manage hedge funds as long they satisfy certain requirements with regard to capitalisation, management track records, and relevant hedge fund experience of employees. This new type of onshore hedge fund will be allowed to invest in a wide variety of financial products and assets in a relatively unrestricted and discretionary manner. Moreover, the revisions establish a minimum capitalisation requirement at ?6 billion, based on consideration of expected costs for employee compensation and facilities, as well as a comparison with other fund categories within the asset management industry. Required hedge-fund management experience standards were set based on investment performance as well as capitalisation (in the case of securities firms), and funds under management (in the case of asset management firms).5 As for regulations on hedge-fund expertise, the rules require that each hedge fund be managed by at least three employees with relevant experience in either a domestic or overseas hedge fund. They also provide for additional educational/training programs through the Korea Financial Investment Association or other organisations in order to develop specialised personnel in a systematic manner.
In line with the global trend toward strengthened oversight of hedge funds, the revisions also strengthen requirements for reporting to the proper authorities in order to enhance investor protections and guard against systematic risk, without jeopardising the autonomy of the hedge fund manager. Hedge fund managers will be required to submit, on a quarterly basis, reports to the FSC on its major strategies, the types of assets it invests in, current leverage and derivatives positions, etc.
Finally, prime brokers, which provide comprehensive services to hedge funds and are an inseparable part of a thriving hedge fund industry, are defined by the enforcement decree as entities responsible for securities lending, financing, custody, clearing and reporting on investors. The revisions to the enforcement decree legally distinguish prime brokers from regular securities firms by creating a new category, ‘integrated financial investment provider’, otherwise known as an investment bank. Only these investment banks are granted permission to engage in the prime brokerage business.6 In order to become an investment bank under Korean law, a firm must: (1) be a corporation under commercial law, (2) be engaged in securities underwriting, (3) have at least ?3 trillion in paid-in-capital, and (4) possess adequate risk management and other capabilities.
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The hedge fund industry will probably start out smaller than expected
The size of the hedge fund industry will determine the number of asset management firms that enter the space as well as the extent of participation by prime brokers, whereas the extent of participation by capable and well-known prime brokers will also influence the scope of hedge fund activity. Analysis by certain brokerage firms concludes that Korea's hedge fund industry will grow to ?42 trillion within the first three years. Such analysis is based on the assumption that a certain portion of demand in the existing alternative investment industry in Korea - which includes regular private funds, PEF funds, wrap accounts, and discretionary management accounts - will migrate toward hedge funds.
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Rather than looking at the issue in this manner, however, it would probably be more accurate to forecast the potential size of Korea's hedge fund industry based on a comparison of the global hedge fund industry with the global mutual fund industry. Because the global mutual fund and hedge fund industries are very mature, their relative sizes have been relatively stable, even during periods of volatility such as the financial crisis. Between 2005 and 2010, the global hedge fund industry was 7 - 8% of the global mutual fund industry.7 If we apply this ratio to the domestic market, based on end-2010 numbers, we derive an expected size for the domestic hedge fund industry that is no more than ?18.5 trillion.8 Considering that Korea's capital markets and regulatory system are not as developed as those advanced economies where global hedge funds are most active, however, it appears likely that even this estimate may prove to be overly optimistic, especially for the early stages of Korea's hedge fund industry.
Though hedge funds are a potential new source of profit for securities firms and asset managers, it is not clear that the market will be large enough to support these firms' ambitions. Only the largest brokerage firms will be permitted to provide prime brokerage services, but hedge funds can only do business with prime brokers, so this may limit growth of the industry. Other factors that could limit growth of the industry include a potential dearth of prime brokers with the requisite skills and experience to meet hedge funds' needs, limits in the scope of hedge fund strategies that can be carried out in the domestic markets, and a shortage of experienced hedge fund professionals. In particular, Korea's capital-market conditions may restrict the ability of onshore hedge funds to carry out a variety of common hedge fund strategies, so they are likely to be limited to either equity long-short or CTA (managed futures) strategies. Furthermore, the cost of hiring experienced hedge fund professionals with the requisite overseas experience may be prohibitive, especially in the early stages of the industry, when there are no assurances of profitability.
In addition, while it is true that these revisions will probably improve many aspects of the FSCMA, there remain other policy and regulatory factors that could hamper development of the industry. For example, as we have seen during recent episodes of financial market turmoil, Korea's financial regulators are quick to ban short-selling. Such directives may appear to be effective in putting a floor under equity prices in the short-term, but such actions could damage the longer-term development not only of domestic capital market but also the domestic hedge fund industry. Also, the Financial Services Commission is currently in the process of imposing limits on the performance fees that can be charged by investment advisors and discretionary investment managers, another action that could potentially reduce incentives for hedge funds. Finally, current regulations require that short-sellers borrowing shares must put up collateral twice, an obstacle that may be removed later but that currently poses obstacles in carrying out equity long-short strategies.
Regulatory policy must be consistent, and institutional investors must play a crucial role in self-governance
Despite active efforts to set up a hedge fund industry, a number of impediments may keep the industry from growing as anticipated, particularly at the get-go. Thus, the financial authorities will have an important role to play in helping the industry get off the ground and on the proper path to growth. For example, they will need to be monitor against potential fraud or market-overheating, which could stymie longer-term growth. They will also need to enable fair and healthy competition through a consistent set of regulations and policies. They might also regulate prime brokers in such a way that is conducive to the management of potential systemic risk posed by hedge funds.
Over the longer term, the domestic hedge fund industry is likely to grow significantly, as Korea's capital markets continue to evolve. At that point, institutional investors will need to take on a greater role in helping the industry to self-regulate, rather than relying on regulatory authorities to guide its development. As we have seen with global hedge funds, the investor base has been steadily shifting from wealthy individuals to institutional investors. Such a trend is beneficial in that such institutions conduct more detailed due diligence and monitoring of hedge funds and demand greater transparency. In Korea as well, the high investment hurdle for individual investors makes it likely that institutional investors will play a much bigger role than individual investors, assuming the restrictions are not eased. Thus, institutional investors will have to play an important role in ensuring that those hedge funds with solid, consistent performance, and strong risk management capabilities, will be able to compete on merit.
Above all, policy will have to be consistent. As we saw recently, Korean regulators sometimes respond to market turmoil by banning short-selling. While such actions may seem necessary in the short term, they can also damage the integrity and attractiveness of Korea's equity market, particularly for hedge funds that rely on short sales as part of their strategies. To take another example, the financial regulator last year proposed measures to establish a ceiling on performance fees of investment advisors and discretionary investment managers. Such measures are likely to deter many qualified individuals from entering the Korean hedge fund industry.9 Thus, in order for Korea's hedge fund industry to grow successfully, in an environment built on trust, regulators will need to devise policies that reconcile the pursuit of growth with sound risk management, while ensuring that regulations are consistent, credible and conducive to sustainable, market-driven growth.
Warren Park and Seonghak Ahn are Senior Researchers in the Financial Industry Team of the Hana Institute of Finance. Mr. Park covers a variety of areas, including the global economy and financial markets. Mr. Ahn’s research is focused primarily on Korea’s securities industry and capital markets.
Established in 1986, the Hana Institute of Finance is a Seoul-based economic/financial research institute that leverages its quarter-century of experience to provide insightful and timely research and analysis on the rapidly evolving financial and economic landscape in Korea and abroad. In its dual role, it also serves as the ‘think tank’ for Hana Financial Group, providing it with analytical and strategic support to further its development into a major global financial services company.
This article first appeared in Hana Insight (3Q September 2011, Page 20 – 25). For more information, please visit www.hanaif.re.kr.