UK regulators are reviewing hedge funds and alternative retail investments with a view to imposing new restrictions that could curtail growth in the sector, writes Michael Imeson.

What’s proposed?

More green twine on hedge fund managers and their products, with two aims: to safeguard the wholesale markets, and to protect consumers.

Who dreamed it up?

The UK’s Financial Services Authority, who else? It has come out of the wholesale markets and institutions division, which presumably can’t sleep at night for worrying about monster hedge funds of leylandii proportions growing out of control.

The FSA set out its dream of controllable hedges in two discussion papers published in June. One looks at the impact of hedge funds on the UK’s wholesale markets and how they can be better supervised and controlled (DPO5/4. Hedge Funds: A Discussion of Risk and Regulatory Engagement). The other looks at regulating currently unregulated sophisticated retail investment products, including hedge funds (DP05/3. Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World). Interested parties had until October to respond. The FSA will issue its feedback in early 2006 before bringing in specific measures.

What are the main proposals?

To encourage the sector to make greater use of stress-testing in their risk management; to require hedge fund firms and prime brokers (who provide them with specialist services) to get FSA permission to undertake their activities; to force the industry to divulge more data; to set standards for valuing hedge funds; to develop a hedge fund code of conduct; and to create a new category of sophisticated retail products where the increased risks have to be flagged. The FSA has already beefed up its supervision: in September it announced the creation of a unit to supervise 25 hedge fund firms deemed to have a “high impact” on the financial markets. In the preceding months it had increased data collection from hedge fund managers and prime brokers. To be fair, on the retail investments side, the FSA is considering a “no-change option” and even an element of deregulation.

What’s in the small print?

The FSA is considering “any global or European regulatory initiative that could helpfully raise standards in the hedge fund industry”.

What does the industry say?

The Alternative Investment Management Association (AIMA) assembled the largest working group of members ever to look at the proposals. They objected to most of them in their response to DPO5/4. The AIMA does not want firms to have to seek permission to engage in hedge fund business, nor does it want a code of conduct forced on it. “No evidence has been offered to suggest that hedge fund managers are likely to cause any more disruption to the market than other players,” it says.

How much will it cost?

The AIMA says the requirement to supply additional data to the FSA would put practitioners to “perhaps significant additional time and cost”.

What do the regulators say?

That stricter regulation is inevitable. The FSA accepts that hedge funds are a beneficial component of the financial system, but says that they also pose risks to the stability of the financial markets. The authority’s proposals are simply part of a global trend to impose more regulation, it argues.

The law of unintended consequences

FSA managing director of the wholesale markets and institutions division Hector Sants says he is “mindful of the danger of regulatory arbitrage and [has] no desire to cause the hedge fund management industry to migrate to more lightly regulated offshore centres as a result of regulatory action”. Trouble is, the law of unintended consequences is, by definition, unpredictable. So regulatory arbitrage may be a consequence. And the consequences could be great because of the size of the UK hedge fund sector. London has more than 75% of Europe’s hedge fund assets under management, and the European market is second only to the US.

Could we live without it?

Yes, but regulators have to do something about hedge funds – or face huge criticism the next time one blows up.

Rating: 4

Rating scale: 5 = Essential and costly 4 = Useful (and costly) 3 = Neutral (and costly) 2 = Unnecessary (and costly) 1 = Waste of time (and costly) 0 = Commercially damaging (and costly)

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