Regulation and Best Practice

How many more best practice initiatives do we need?

Originally published in the June 2008 issue

Many corners of the hedge fund industry in the US and Europe are beginning to voice concerns about the apparently never-ending stream of initiatives which are designed to help the industry conform to common standards of operation and to provide greater assurance for investors and regulators. Since 2000 the MFA, AIMA, IOSCO, the FSA and the SEC have all provided their own brand of guidance on hedge funds practice in one form or another.

Right now the industry is faced with two further initiatives: in the UK, The Hedge Funds Standards Board’s Best Practice Standards (the “HF Standards”), which were published at the end of January 2008; and in the US, the Asset Managers Committee (AMC) and the Investors’ Committee (IC) of The Presidents Working Group which have separately published their own consultation documents on ‘Best Practices for the Hedge Funds Industry’ in April 2008.

It is indisputable that the hedge fund industry has grown substantially in size, influence and complexity over the past three decades and that the investor base has become increasingly diverse. Such developments carry with them parallel responsibilities to reduce systemic risk and to foster investor protection.

Government intervention

It is widely believed that if the industry is not seen to take its responsibilities seriously then regulators will need to act in a more prescriptive way than they have done previously. Such intervention could, quite conceivably, be extremely damaging to the hedge fund industries in both the US and Europe.

The new industry-led standards initiatives on both sides of the Atlantic are the latest attempts by the industry to offset this threat. Managers are understandably debating the merits of each initiative and many that have transatlantic interests are considering the implications of having to sign up to both sets of standards in addition to their existing responsibilities and activities. For some managers reaching compliance with the standards will be costly and resource intensive.

The good news is that both sets of standards, along with much of the guidance that precedes them, have consistent objectives and are thus very similar in nature.

Therefore, in theory, if you comply with one then you will also meet most requirements of the other. There are several points of detail which differ between the two and it will be key for managers that seek to comply with both sets of standards to plan well to achieve efficiencies.

The devil is in the detail

So what’s different about the two sets of standards? As previously mentioned there are several points of detail which are consistent, but there are also some fundamental differences which include:

  • The HFSB was initiated by the UK hedge funds industry itself and is comprised of representatives from fourteen of the largest Hedge Fund managers in the UK. In contrast, in the US, The President’s Working Group (PWG) is sponsored by the US Department of the Treasury. The AMC and the IC which issued the recent reports on best practices are part of this US government sponsored group.
  • There is a clear process in place for signing-up to the HF Standards but no process is yet in place for how hedge fund managers will sign up to the PWG standards.
  • The respective standards reflect the differences in market practices between the US and UK, in particular, the widespread use of third-party administrators in Europe compared to the US. Consequently, the HF Standards place more emphasis on the risk of outsourcing administration than in the PWG proposals.

“The industry needs to act in order to protect the freedom that it currently enjoys from imposed regulation”

Neither the HFSB nor the PWG has yet indicated with any degree of clarity how the standards will be effectively policed. Signatories to the HF Standards are required to self certify their compliance, however, the HFSB has no power of law to enforce it. It is also unclear the degree to which the HFSB will scrutinise applications from signatories. Indeed, more sceptical observers might claim there is something of a conflict of interest since the HFSB is clearly motivated to encourage widespread adoption, which may only be achieved if compliance is not excessively onerous.

Act now to protect hedge fund freedom

In the US, while the proposals are still out for consultation, there is also concern about how the standards will be policed once they are finalised. It is also unclear whether the standards will become de-facto regulatory standards which are enforced on all managers by regulators, or purely on those that choose to sign up. Past experience of voluntary industry standards indicate that whilst regulators stop short of formally endorsing such standards, they take a firm stance against false claims of compliance on the basis of market misrepresentation. For example, the issue around the integrity of investment performance reporting has remained in the SEC’s top ten list of hot topics for a number of years. Herein, false claims of compliance with Global Investment Performance Standards (GIPS), have resulted in publicised regulatory sanctions for guilty parties. It is also unclear at this stage, who will be the guardian of the PWG standards once they are finalised. Currently, there is no dedicated custodian who will be responsible for the ongoing upkeep and enforcement of the standards.

In conclusion, the industry itself needs to act in order to protect the freedom that it currently enjoys from imposed regulation. The world is watching. If managers don’t sign up to the standards, then stakeholders will ultimately want to know why. Both sets of standards are therefore sensible initiatives in principle. The reality of compliance is more complex. There are still plenty of sceptics of the standards amongst managers and they might be shooting themselves in the foot unless they either adopt the standards; speedily come up with a better alternative which satisfies their stakeholders; or seek regulatory arbitrage and move overseas.

The frustration for many managers, who operate in a global marketplace, is that they cannot currently adopt one set of standards that is acceptable in all jurisdictions. It means the process of conducting their business becomes more bureaucratic – an environment in which few hedge fund managers thrive. However, the standards are extremely similar and the challenge for managers is to achieve efficiencies in signing up to both if they seek to comply on both sides of the Atlantic.



David Yim is a director in KPMG LLP’s advisory practice and is a specialist in operational risk and controls for the investment management sector.


Tim Fundell is the Business Development Manager for KPMG LLP’s European Hedge Funds Practice.