Big Brother is watching you but he does not want to drive you out of business. That is the clear message to hedge funds from the latest paper from the Financial Services Authority, the UK regulator.

The paper, snappily entitled “Hedge Funds: A discussion of risk and regulatory engagement”, will reassure those in the sector who feared that the FSA might pursue a heavy-handed regulatory approach. A separate paper: “A wider range of retail investments: consumer protection in a rapidly changing world” suggests that hedge funds may become more accessible for private investors.

The FSA clearly indicates that it is worried about the impact of excessive regulation on the industry and that the appearance of oversight might also create moral hazard in the minds of investors. As the regulator points out, it does not directly authorise hedge funds, nor indeed does it regulate administrators, who are typically located offshore. It does regulate fund managers, but in their general role, not specifically in relation to their hedge fund activities.

“There is a risk that our regulatory activities in respect of hedge fund managers could create a false set of expectations in stakeholders about the extent of our influence over the hedge fund industry” the paper says.

Furthermore, would regulating hedge funds pass a cost-benefit analysis test? As the paper remarks: “It is difficult to justify mitigating fraud in hedge funds as a priority for the FSA from our consumer protection objective as current UK investors in hedge funds are generally sophisticated and consciously choose to invest in an offshore fund rather than an onshore regulated fund so they should be aware of the attendant risks.”

But the FSA still worries about a whole host of factors that might lead to hedge funds disrupting markets or to investors losing out. So it is suggesting that it may monitor the hedge fund industry more closely, particularly the select group of funds which it deems to have a significant market impact.

The paper lists a series of potential risks arising from the existence of hedge funds: serious market disruption and erosion of confidence; liquidity disruption leading to disorderly markets; insufficient information to inform regulatory action; control issues; operational risk; risk management; valuation weaknesses; market abuse; fraud; money laundering and conflicts of interest.

The market disruption issue will be familiar to anyone who recalls the near-collapse of Long-Term Capital Management in 1998. On this point, the FSA is reassuring.

“In our view, at the time of publishing this paper, the probability of an event on a scale that could significantly affect UK financial stability is relatively low. Our judgment is that the risk of an individual hedge fund posing a threat to the financial system on the scale of the LTCM episode, or even approaching it, has significantly diminished since 1998.”

The FSA’s recent survey of financial institutions suggested there were no hedge funds using leverage on the scale attempted by LTCM. Furthermore, the industry seems to have learned its lessons from that episode. “We believe that, in general, risk management standards have improved, both in respect of the larger hedge funds managing their portfolios and of the banks which are monitoring their counterparty risks” the paper says.

But the position needs monitoring. Back in May, the FSA issued a discussion paper on the subject of stress-testing and intends to follow that up with a conference in the third quarter of this year. The Authority says it “may consider involving the most significant hedge fund managers in this event.” There are other potential dangers. One is that the multiplicity of relationships between hedge funds and financial institutions means that some lenders may not be aware of a counterparty’s full positions.

“The increasing incidence of multiple prime brokerage relationships and multiple trading relationships mean there may still be cases where credit providers do not have an accurate picture of the risk profile of the fund as a whole. Although each prime broker may have margin arrangements which look adequate for their own exposure, these could in the future prove insufficient if a large illiquid position has been split by the hedge fund between prime brokers but the prime brokers are unaware of this” the paper says.

Furthermore, an FSA survey on hedge funds as counterparties found that competition may be applying pressure on brokers’ margins. “Some newer entrants may be offering more flexible credit and applying less stringent risk measurement” the paper says.

The survey found that leverage was not very high in historical terms. Of 100 counterparty names, only 19 appeared more than once, indicating that the business is not overly concentrated. But the FSA intends to repeat the data collection exercise on a six monthly basis.

The FSA has also picked up on a threat previously mentioned by the Bank of England; the use of leverage by funds of funds. “A newer contagion risk relates to the additional debt leverage of some funds of funds” the paper says. “The failure of one hedge fund may lead a fund of funds to breach its banking covenants, prompting it to withdraw capital from underlying funds, potentially causing them to fail. Enhanced liquidity sometimes granted by hedge funds to fund of funds investors may allow such a situation to develop rapidly. If these failures caused other leveraged funds to breach their banking covenants, then a domino effect could ensue.”

In examining the market impact of hedge funds, the FSA paper notes that funds are often characterised by high transaction volume; concentration in less liquid markets; concentrations in innovative/complex products; concentrations in high profile corporate events /market movements; and the use of risk-augmenting financial techniques such as leverage.

The paper notes that the market impact of hedge funds is arguably as significant as that of the proprietary trading desks of investment banks although hedge funds are subject to far less regulatory scrutiny.

The FSA cites industry sources as suggesting hedge funds represent more than 50 per cent of trading volumes in many asset classes. “When they are following similar strategies and/or using similar risk management models, there is a risk they will enter or exit a market collectively and in so doing disturb liquidity.” Such comments may provoke a wry smile from convertible arbitrage managers, who saw a mass rush for the exits this spring.

Even though the FSA does not believe hedge funds pose a systemic risk at the moment, that does not means that individual market segments might not be affected. The paper refers to some of the difficulties faced by hedge funds over the last 18 months in the face of compressed spreads, reduced volatility and the massive inflows of new money that may have competed away many arbitrage opportunities.

The FSA says managers do not appear to have responded by increasing leverage; instead they have moved into new areas. “Structured credit – particularly funds investing in collateralised debt obligations (CDOs), collateralised loan obligations (CLOs) and asset-backed securities (ABS) – seems to be the current principal focus for strategy development.” However, the FSA notes that “many new instruments embody a degree of leverage (and potential for high volatility) within themselves.”

These investments are not only complex, they are illiquid. This raises a number of concerns in the FSA’s mind. “Overall liquidity risk in hedge funds would appear to be medium and growing, with a potential mis-match developing between the increasingly illiquid investment made by the funds and the increasing liquidity offered to hedge fund investors.” On this point, the FSA is referring to the tendency for hedge funds to offer special liquidity terms to some large investors, in an attempt to attract their cash. Bringing one of these investors on board, of course, can make all the difference between success and failure.

“The existence of an increasing number of managed accounts and side letters granting enhanced investors liquidity may be increasing liquidity risk. This is because money could be withdrawn more rapidly, forcing liquidation of assets” the paper says. The FSA points out such letters could be detrimental to the interests of smaller investors who could find that, by the time they are able to liquidate, prices will have moved very sharply against them.

Another area of concern is how well risk is monitored, by prime brokers, investors and the hedge funds themselves. There are some deficiencies at each stage. In terms of brokers, the paper says that: “As part of the initial credit assessment, some firms do not conduct on-site visits for all hedge fund counterparties before taking them on, placing too much reliance on the track record of individual managers. As part of the on-going assessment, there is heavy reliance on investor newsletters.” This does not seem sufficiently sophisticated, to put it mildly.

The same lack of sophistication can apply to investors. “Our impression was that investors are focused on just two high-level metrics, irrespective of strategy. A fund’s experienced loss levels for month, year-to date and drawdown from the previous high watermark and performance against an annualised volatility target.” For the hedge funds themselves, there are clearly incentives to cheat. The rewards for success are enormous, as newspaper reports on manager salaries often show.

The paper says that: “The asymmetrical pay-off for a hedge fund manager could, at least in theory, cause them to take unreasonable risks with investors’ money. In practice, the principal moderating influence on such behaviour is a desire to remain in business (and maintain a good standing in the industry) and so limit the use of unduly risky strategies. This constraint has been seen to erode rapidly, however, in circumstances of market difficulty where the opportunity of improving poor fund performance is possible only by taking on very high risks.”

The FSA is also concerned about valuations. Hedge funds normally use a third party administrator to value their positions. But FSA insiders say there is no requirement in law for hedge funds to use an administrator that is authorised by a regulatory body; many of them are based offshore. When it comes to complex assets, these administrators have a problem. They are usually forced to rely on a combination of counterparty quotes, valuation models (often developed by the fund manager itself) or direct valuations from the fund manager.

This approach raises concerns. The hedge fund valuations involve an obvious conflict of interest but so does the counterparty approach. As the FSA paper says “they might have an incentive to misprice the deal for their own internal purposes.” Indeed, the administrator could also be the fund’s counterparty, or its prime broker.

The FSA suggests the best way of dealing with this issue may be a global, voluntary and co-operative exercise, such as was developed by IOSCO in relation to credit derivatives.

A further issue of concern for the FSA was the potential for market abuse. FSA insiders say some funds are strategically concentrated in areas of the market that are particularly information-sensitive, for example, event-driven firms focusing on mergers and acquisitions or companies emerging from bankruptcy. Given the trading approach of hedge funds, which often involve high commissions, there are “incentives for others to pass inside information to them or show bias in allocations in the hope of being rewarded.”

The FSA also raises a question mark over the recent enthusiasm for pension funds to invest in hedge funds. “Conflicts of interest may arise from the role of pension fund consultants advising trustees to allocate some of the scheme’s assets to hedge fund investments. Some consultants are setting up hedge fund-of-funds advisers and receive regular fees from funds of hedge funds.” The FSA points out that advising pension funds on asset allocation is not a regulated activity.

In the face of all these risks, what is the FSA going to do? The encouraging answer (from the industry’s point of view) is – not much. The action points include a lot of dialogue, thematic reviews and encouragement of industry initiatives, but the level of concrete action is fairly restricted.

The paper points out that no distinction between conventional fund managers and hedge fund managers exists in the current regulatory regime. The paper suggests two possible mechanisms for making this distinction.

The first would be to create a new and distinct hedge fund management related activity, obliging firms to seek separate permission before doing so. However, such a change would require “A significant amount of time and resource (both from the public and private sector) to draft, improve, agree and implement legislative amendments.” The second would be to make hedge fund management a “notifiable event”, simply requiring fund managers to let the FSA know they were doing so. This would clearly be a lower cost option and the tone of the paper appears to favour this route.

In terms of oversight, the FSA thinks it could be logical to increase supervision “just in relation to those hedge fund managers whose funds and business model have a significant market impact.” The FSA says its current estimate of the number of hedge fund managers is around 15 to 25.

To help monitor such funds, the FSA is creating a centre of hedge fund expertise within its wholesale business unit. This centre will be responsible for relationship management with high impact hedge fund managers and developing thematic work, studying issues such as leverage in the structured credit markets.”

To help it monitor the industry, the FSA is considering a trial data collection exercise. Amongst the data the FSA is thinking about collecting are: the prospectus and marketing pack; the strategy buckets; the valuation; gross long and short exposures; profit and loss volatility targets; monthly returns; performance fees; management fees; number and value of transaction in the reporting period; and total commission paid. The agreed data would probably be subject to monthly collection. Funds judged to be in the high impact category might be required to produce additional data.

All this extra information seems to be designed to help the FSA deal with any trouble in the sector. “The improved regulatory data would allow us to more accurately identify firms with a significant market impact and target our supervisory resources accordingly” the paper says. “It would allow us to respond more effectively to any crisis, using our enhanced knowledge of who might be active in a particular market and therefore might have exposures or expertise that could be of relevance in managing or mitigating the impact of the crisis.”

But the FSA is keen to play down expectations, pointing out it does not have the same level of resources available to analyse hedge funds as might be available to market participants.

What happens next? Interested parties have until October 28 to respond to the FSA paper and once those responses have been analysed, the FSA will issue a further paper early in 2006.

Philip Coggan is Investment Editor of the Financial Times