Comment; The Question of Hedge Funds: Timothy Spangler, Berwin Leighton Paisner, London

Comment; The Question of Hedge Funds: Timothy Spangler, Berwin Leighton Paisner, London

Tue, 26/07/2005 - 08:00

Timothy Spangler outlines the key points and significance of the UK FSA's discussion papers on hedge funds and retail investment products.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />


 


At a time when hedge funds are more widely reported and discussed in the general and financial press than ever before, the Financial Services Authority has recently released two new discussion papers addressing a number of important issues related to their structure and operation.


 


In "Hedge Funds: A Discussion of Risk and Regulatory Engagement" (Discussion Paper 05/04), the FSA seeks views on what further actions should be taken to increase regulatory transparency and improve regulatory effectiveness with regards to hedge funds, in light of their growing importance to the UK and international financial systems.  In regards to systemic issues, the FSA discusses the risks posed by hedge funds in relation to:-



  • financial stability and market confidence;

  • market cleanliness;

  • financial crime; and

  • consumer protection.

Importantly, the FSA is establishing a dedicated centre of hedge fund expertise to focus on these issues.


 


In "Wider <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World" (Discussion Paper 05/03), the FSA examines the regulatory regime that currently applies to sophisticated investment products and the inconsistencies that arise from this product-oriented approach.  In particular, the Discussion Paper addresses three areas of potential risk:-



  • consumers and companies that may not fully understand these products;

  • consumers who may be confused by different forms and distribution channels of a wider range of products, resulting in mis-buying or mis-selling; and

  • consumers who may miss out on investment opportunities because of the current restrictions on the marketing of unregulated products. 

The FSA raises several possible courses of action including:


 


(i)                   whether a new category of sophisticated products which highlight more effectively these risks should be developed,  and


(ii)                 (ii) whether the marketing restrictions on unregulated funds should be lifted.


 


Having consulted at some lengths in 2002 on the manner in which hedge fund managers were regulated, the FSA's willingness to re-examine these questions now demonstrates the encouraging open-mindness necessary to ensure that the UK remains the pre-eminent investment management jurisdiction in Europe.


 


Hedge funds play an important role in financial markets, providing much needed liquidity to other market participants and portfolio diversification for investors.  Such involvement, however, raises risks of potential market disruption and liquidity mismatches.  In the past, the effectiveness of onshore regulators have been limited because of lack of current, detailed information about the activity of hedge funds, both individually and in aggregate.


 


Of particular interest to the FSA is the susceptibility of hedge funds to commit market abuse, due to their traditionally close (and highly profitable) relationships with prime brokers and other key counter parties.  The FSA will now focus more closely on examining current hedge fund practices in relation to trading on non-public information as well as market manipulation.


 


In addition to the relationship between hedge funds and other market participants, the FSA is also asking fundamental questions regarding what exposure investors (and, ultimately, retail consumers) should have to these products.  Fortunately, these queries are being phrased in non-judgemental, open-ended terms, rather than the conclusion-driven jargon that is too frequently used.


 


Interestingly, the FSA begins its analysis not with hedge funds per se, but rather with the changes to authorised funds brought by the EU's so-called "UCITS III" Directive that was adopted a few years ago.  Under the new passporting rules, UCITS-qualifying funds may now make greater use of derivative instruments.  Consumers, however, may not fully understand the practical consequences of these changes, which will significantly increase the range of strategies that such funds may implement.  In addition, the risk controls mandated by UCITS III as a condition of increased investment latitude may not be fully implemented by all management companies.


 


The current product-based regulatory segmentation is then questioned, acknowledging that retail consumers may already gain access to certain high-risk investment strategies depending upon how such strategies are delivered to them.  The FSA poses the question of whether prohibiting access to investment strategies based on the legal status of a fund - rather than the strategies underlying risk profile - is the best course of action.  The FSA then raises the possibility of a regulatory regime that primarily distinguishes between the nature and riskiness of the underlying strategy, with issues of consumer protection addressed by enhanced disclosure to draw investors's attention to the additional risks involved.  Other approaches for investor protection could include some form of product regulation, conduct of business requirements and/or marketing criteria.


 

Hedge funds have become a permanent feature of the financial landscape.  Industry and financial regulators must regularly revisit and re-examine the legal and regulatory framework in which these funds operate.  The FSA's recent discussion papers layout a wide array of opportunities for managers, distributors and investors.  A full and vibrant debate by all such parties would be in everyone's best interest.

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