The Regulatory Focus On Hedge Funds

Industry must brace itself for imminent changes

Originally published in the February 2009 issue

Recent market turmoil has seen the regulatory spotlight focussed firmly on hedge funds, with the expectation that changes to the regulation of the hedge fund industry are imminent. As an example, in December 2008, the European Commission published a consultation on hedge funds which, according to the press release “will make an important contribution to European and international reflections on whether the approach to the regulation and supervision of hedge funds should be reassessed in light of the financial crisis”. The results of the consultation will form the basis for European input into the parallel reflections on hedge funds at international level by the G20. In addition, the FSA has, in recent years, published a number of papers relating to its regulatory approach to hedge funds.

This article looks at recent FSA pronouncements on hedge funds as well as the European Commission Consultation.

The FSA’s focus on hedge funds
Increased focus on the impact of short selling on the integrity of the financial markets has increased interest in hedge fund regulation. However, the FSA’s interest inhedge funds predates recent events and has been growing for a number of years.

In 2002, the FSA’s Discussion Paper 16, “Hedge Funds and the FSA” discussed how hedge fund managers were regulated and highlighted limitations on the FSA’s authority over their activities. This was followed in June 2005, by “Hedge Funds: A Discussion of Risk and Regulatory Engagement” , seeking views on further action the FSA could take to increase regulatory transparency. The paper set out the FSA’s view of the key risks posed by hedge funds, namely:

• the risk of serious market disruption and erosion of confidence as a result of the failure of a hedge fund;
• the difficulties in risk-managing multi-strategy portfolios;
• and the risk of hedge funds engaging in market abuse.

More recently, the FSA’s focus has been on the controls in place at hedge fund managers to mitigate the risk of market abuse. In Market Watch 24 (October 2007), the FSA published its review of market abuse risk mitigation controls in place at a variety of hedge fund managers and concluded that a significant number of those visited had inadequate controls.

Subsequently, the FSA conducted follow up visits to hedge fund managers and set out the findings in Market Watch 29 (October 2008).

Market Watch 24 and Market Watch 29 are essential reading for hedge fund managers as they set out details of the controls that the FSA expects to see in place. The areas of control that a hedge fund manager should consider to mitigate the risk of market abuse include:

• a strong compliance culture which recognises that the ultimate responsibility for compliance lies with senior management;
• building controls aimed at restricting or identifying market abuse into computer systems, for example by restricting access to system drives and the use of prompts which indicate if a trade is about to be executed in a security on a restricted list;
• independent monitoring of market abuse controls and procedures;
• independent monitoring of trading activity with a view to assessing whether market abuse has occurred;
• the provision of appropriate, regular and tailored training on market abuse to employees;
• the use of restricted/stop lists and Chinese walls with a view to limiting the flow of inside information;
• the implementation of policies which make employees aware of the need to maintain the confidentiality of price sensitive information;
• the use of long-term remuneration structures which are less likely to incentivise employees to engage in market abuse for short term gain;
• the use of taped telephone lines;
• operating personal account dealing policies and regular reviews of personal account dealing by employees.

Hedge fund managers who ignore the expectations as to appropriate controls set out in Market Watch 24 and 29 could find themselves facing enforcement action based on having inadequate systems and controls. This is likely to be the case regardless of whether the hedge fund manager in question was actually involved in market abuse.

Further insight into the FSA’s view of the hedge fund industry was provided by Hector Sants’s speech “The regulator’s view of hedge funds and hedge fund standards” given at the Hedge Conference in October 2008. Encouragingly, Mr Sants’s speech reiterated the FSA’s view that hedge funds were not the catalyst or driver of last summer’s market events. He also set out areas on which the FSA was focussing in respect of hedge funds namely: valuations, disclosure and market integrity.

In relation to valuations, Mr Sants stated that transparent and robust valuations are vital to the FSA’s supervisory approach. On the subject of disclosure, Mr Sants made specific reference to the FSA’s decision to implement a general disclosure regime for contracts for differences that will require the aggregation of CFDs and shares and the disclosure of those aggregated positions above 3%. According to Mr Sants, the FSA is committed to this policy but will work with the industry to ensure that the rules delivering this policy decision are framed in the most effective way. On market integrity, Mr Sants confirmed that tackling market abuse remains a regulatory priority and made specific mention of the fact that the FSA will continue its recent policy of using criminal prosecution for those it believes to have engaged in insider dealing.

The European Commission Consultation
The European Commission Consultation on hedge funds is part of the Commission’s comprehensive review of regulatory and supervisory arrangements for all market sectors in the European Union to be finalised in 2009, in line with the G-20 objective to “ensure that all financial market products and participants are regulated or subject to oversight, as appropriate to their circumstance”.

The consultation is of major importance to the hedge fund industry as it will inform the European Commission’s input into the G-20’s reflections on hedge funds regulation. The main areas on which the consultation seeks views and evidence are:

systemic risks: the consultation invites views on whether existing systems of macro-prudential oversight are sufficient to allow regulators to monitor and react to risks originating in the hedge fund sector and transmitted to the wider market through counterparties, including prime brokers, and through the impact on asset prices;
market integrity and efficiency: the consultation asks whether and under what circumstances the activities of hedge funds pose a threat to the efficiency and integrity of financial markets;
risk management: the consultation asks whether public authorities should concern themselves more with the way in which hedge funds manage the risks to which they and their investors are exposed, value their asset portfolios and manage any potential conflicts of interest; and
transparency towards investors and investor protection: the consultation invites views on whether hedge fund investors are adequately protected and receive the information required for sound investment decisions.

Clearly, regulatory authorities are very exercised about the challenges posed by hedge funds and are likely to develop new regulatory approaches. Against this backdrop it is essential that the hedge fund industry pays close attention to, and engages in, the regulatory debate so as to ensure that the views of the industry are properly represented and that any revised regulatory approaches which do emerge are workable and proportionate.