New dawn heralds bright future for hedge funds

As new hedge fund business surges, Guernsey is reviewing its regulatory approach to open-ended hedge funds to strengthen its position as an important world centre for the industry.

Guernsey's hedge fund stakeholders are actively engaged in discussions aimed at ensuring the island's regulatory environment continues to actively support the development of this rapidly expanding sector.

The Guernsey Financial Services Commission (GFSC) is considering responses to a consultation paper which explores a number of wide-ranging issues. These include the role of the prime broker and custodian, asset segregation and net asset value and share price estimation.

The review has been triggered by significant growth in the number of hedge funds and funds of hedge funds domiciled in Guernsey. Inflows are estimated to be as high as £2.5bn during the past six months.

Hedge funds and funds of hedge funds comprised £10.6bn of the record £20.6bn of open-ended funds in Guernsey recorded at the end of the third quarter of 2003. Of open-ended funds incorporated in Guernsey, 35% are now either hedge funds or funds of hedge funds. Growth in hedge funds and funds of hedge funds also contributed to closed-end investment funds reaching a new peak of £19.5bn over the same period.

Why Guernsey?

Guernsey has traditionally maintained a flexible and innovative approach to the hedge fund industry. The island has specific fund rules which are able to accommodate a variety of hedge fund styles. This is supported by a depth of specialist third-party administration expertise which tailors its approach to suit the specific requirements of hedge fund managers. Hedge funds may be listed on the Guernsey-based Channel Islands Stock Exchange (CISX) which enjoys wide recognition by financial authorities including the UK Inland Revenue and the US Securities and Exchange Commission. The CISX rules are flexible and can accommodate hedge funds.

The review, which is limited to open-ended hedge funds, embraces issues relating to the Protection of Investors (Bailiwick of Guernsey) Law 1987, as amended (PoI). GFSC deputy director of investment business Carl Rosumek reports: "The outcome of discussions will provide a clear summary of Guernsey's capability and a pragmatic framework for the future. New rulings may flow along with detailed guidance aimed at clarifying the GFSC's position to a range of current hedge fund issues." The GFSC expects to issue its conclusions during the first quarter of 2004.

Custodians and prime brokers

The custodian's responsibilities for the prime broker is a key focus. Under existing practice, the custodian appoints the prime broker, which typically holds all of the fund assets, often as collateral for lending by the broker to the fund. It remains the custodian's responsibility to monitor prime broker activities and protect the fund's property.

Due to the nature of some hedge fund strategies, this can be impractical. Under the PoI law, the GFSC has no authority to set the requirement for a designated custodian aside. However, the GFSC notes in its consultation paper The Regulatory Framework for Hedge Funds in Guernsey, that it "may conclude that the custodian's duty to take control of fund property is not essential, or even appropriate, to the proper operation of a hedge fund,'' although the custodian would remain responsible for oversight of the manager's operation of the fund.

My own view is that addressing this issue would enhance Guernsey's reputation as an attractive hedge fund centre, placing it on an even regulatory footing with Europe's leading hedge fund jurisdictions.

This issue has also prompted discussion about how prime brokers should address client asset segregation.

Net asset value

The GFSC review also encompasses the use of estimated net asset value and share price estimation. Under the existing regulatory infrastructure, there is an expectation that the net asset value (NAV) will be calculated frequently with investors' subscription money only available to the fund manager for a known quantity of shares. However, hedge fund managers often need to be able to use subscription money to make new investments before NAV and share price have been determined. The industry has been asked if the use of estimated NAVs and share prices should be considered for calculating hedge fund transactions; and if so, what risk warnings should be given to investors.

The bottom line

The Guernsey fund industry believes the consultation process will help consolidate and further enhance the island's status as an important international hedge fund jurisdiction for both Guernsey domiciled and non-Guernsey domiciled funds.

Key Points

Guernsey is reviewing the regulatory framework for hedge funds as it enjoys record levels of hedge fund business

The aim is to address a number of specific hedge fund issues through a pragmatic and flexible approach