FSA publishes feedback on hedge fund risks

The Financial Services Authority (FSA) has published its feedback to discussion paper 05/4 Hedge Funds: A Discussion of Risk and Regulatory Engagement, which looked at the impact of hedge funds on the UK's wholesale market.

In DP05/4 the FSA identified what it saw as the risks posed to its objectives by hedge funds, and outlined the steps it had taken to mitigate them, plus a number of further ways in which it could address those risks.

To increase its understanding of the activities of those asset managers using hedge fund techniques, the FSA proposes to include additional questions to identify the firm's prime broker, third-party administrator and the fund auditor in the integrated regulatory returns firms send to the FSA.

Two specific areas are the subject of supervisory focus:

•Asset valuations: hedge fund managers may be exposed to conflicts of interest as their remuneration is based on performance and assets under management. This may create an incentive to overstate the valuations it provides to administrators, who may not be able to challenge them. Themed visits are currently being carried out in this area, and the findings will be known in the third quarter this year. The FSA has also sponsored an International Organisation of Securities Commission (Iosco) project on valuing complex and illiquid assets in hedge funds; and

• Side letters: the failure by hedge fund managers to disclose that side letters have been granted to certain clients may result in some investors receiving more information and preferential treatment to other investors in the same share class. The FSA expects managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise.

Hector Sants, FSA managing director of wholesale business, said: "We are pleased that both the formal responses and our wider discussions confirmed that the risks we had identified from hedge funds to our objectives were the correct ones. As we have previously made clear our response is only a modest change in our regulatory approach.”

Click here for a copy of the feedback on the FSA’s website.