The UK's Financial Services Authority (FSA) has opened up a debate about the hedge fund industry, with the publication in June of a comprehensive discussion paper on the sector. The report, which identifies the key risks posed by hedge funds, raises the prospect of enhanced supervisory oversight of those 'high impact' funds domiciled in the UK.
"We view hedge funds as a significant, useful and growing asset class through their role in providing market liquidity and diversification options for investors," says Hector Sants, managing director, wholesale markets and institutions, at the FSA in London. "However, the activities of hedge funds do pose risks to the UK's financial markets and the work of the FSA, and it is right that we fully understand them."
The paper identifies a number of key risks, in particular the potential for serious market disruption and loss of investor confidence if a large and high leveraged hedge fund, or a group of medium-sized hedge funds with concentrated exposures, was to fail. The regulator also identifies potential liquidity problems that could occur if a group of hedge funds, which are invested in illiquid assets, are faced with mass investor redemptions. However, a lack of information means regulators are unable to identify areas of concentration and make informed decisions about risk, the FSA says.
The report also identifies operational risk issues posed by late trade confirmations and non-notified trade assignments, weaknesses in asset valuation methodologies and challenges posed by the risk management of multi-strategy portfolios. The regulator also states that acts of market abuse, particularly among event-driven and convertible arbitrage funds, "are testing the boundaries of acceptable practice concerning insider trading and market manipulation".
In response, the FSA moots a number of potential actions. The regulator has already increased its dialogue with the hedge fund industry, in particular increasing its data collection from prime brokers. However, while recognising that its ability to supervise the predominantly offshore domiciled hedge fund industry is limited, the FSA does suggest a number of additional risk mitigation actions. For a start, it plans to create a 'centre of hedge fund expertise' to manage relationships with high-impact funds and to increase its market surveillance with respect to issues of market conduct. It also proposes the collection of additional data from hedge funds to support enhanced supervisory oversight. However, the FSA is wary of pushing the disclosure requirements too far.
"In opening this discussion, we are mindful of the danger of regulatory arbitrage, and have no desire to cause the hedge fund management industry to migrate to more lightly regulated offshore centres as a result of regulatory actions," says Sants.
The consultation paper is open for comment until October 28, but the London-based Alternative Investment Management Association has already provided a preliminary response, in which it states that the regulator has misunderstood certain aspects of the hedge fund industry. "We don't think there was enough acknowledgement of developments in the industry. There has been a lot of progress in the competency of risk management since 1998," says Emma Mugridge, director of the association.