The UK's FSA stressed that the launch of its wide-ranging discussion paper on hedge funds is not an attempt to shackle UK's booming hedge fund industry.
The FSA's Discussion Paper (DP) "Hedge funds: A Discussion of Risk and Regulatory Engagement" was launched at the end of last week, together with a related DP on retail investment products.
The DP on hedge funds is the culmination of a programme of work designed to further the FSA's understanding of the risks posed by the hedge funds sector, which has included a series of recent visits to hedge fund managers and advisers, including prime brokers.
Hector Sants, Managing Director of the FSA's Wholesale Markets and Institutions Managing Director, said: "We view hedge funds as a significant, useful and growing asset class through their role in providing market liquidity and diversification options for investors. However the activities of hedge funds do pose risks to the UK's financial markets and the work of the FSA, and it is right that we fully understand them."
"We intend to make certain changes in how we engage with the hedge fund industry in the UK and seek feedback on these changes and other potential changes which we have identified as meriting consideration."
"In relation to retail investment funds we want to open a wider debate on three important issues: first, how we can bring greater coherence to the current regime for retail investment products, given the changing environment we are operating in? Second, should we seek to encourage or to discourage wider access to hedge funds investment techniques by on-shore providers? Third, should we consider lifting the marketing restrictions on offshore, unregulated CIS? Any debate on lifting the marketing restrictions needs to reflect that the FSA would not be regulating these products and so the risks to consumers are likely to be greater than for on-shore products."
"In opening this discussion we are mindful of the danger of regulatory arbitrage and have no desire to cause the hedge fund management industry to migrate to more lightly regulated offshore centres as a result of regulatory action."
The two "separate but related" papers look, respectively, at the impact of hedge funds on the UK's wholesale markets - 'Hedge Funds: A Discussion of Risk and Regulatory Engagement' - and at the regulatory regime that applies to retail investment products - 'Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World'.
Hedge Funds: A Discussion of Risk and Regulatory Engagement
The FSA views hedge funds as a growing and beneficial component of the financial system. Not withstanding that, it says they do pose risks to the FSA's statutory objectives which this discussion paper seeks to identify. It also sets out current and potential future mitigating actions.
Reflecting the growth in importance of hedge funds, the FSA has already increased its engagement with the industry and, in the last twelve months in particular, has increased data collection both from prime brokers and, to a lesser extent, hedge funds. It has also engaged in increased proactive market surveillance.
Going forward, the FSA is establishing a dedicated centre of hedge fund expertise and will continue to develop a more proactive supervisory relationship with high impact firms.
The paper, however, seeks views on further actions the FSA could take in a proportionate manner to increase regulatory transparency and thus improve the effectiveness of its regulatory engagement. In particular it seeks views on the costs and benefits of the FSA requiring the industry to provide it with certain additional data.
Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World
This paper looks at the regulatory regime that applies to sophisticated investment products. In recent years there has been an increase in the quantity and range of such products that utilise techniques similar to those used by unregulated collective investment schemes (CIS) including hedge funds. This paper is intended to stimulate discussion of issues arising from this development.
It identifies three risks: first, that consumers and companies may not fully understand these products; second, that consumers may be confused by different forms and distribution channels of wider range products, resulting in mis-buying or mis-selling; and third, that consumers may be missing out on investment opportunities because of the current restrictions on the marketing of unregulated products. The FSA puts forward a number of options including asking whether a new category of sophisticated products which flag up these increased risks should be developed.
Views are also sought on whether the marketing restrictions on unregulated CIS should be lifted. The paper recognises that the investment techniques used by some off-shore CIS may in fact offer lower risk investments than some of the more widely marketable vehicles.
It also recognises, though, that as these products are based offshore there would be considerable challenges in ensuring adequate levels of consumer protection. The paper also discusses the consequence of adopting a no-change option.
The FSA is seeking industry and investor feedback on the issues raised in these papers and will be actively engaging with key market participants, including those who contributed to its thematic reviews.
It also seeks views from the industry and interested parties on what products should be marketed to retail investors.
The FSA believes that hedge funds and their investment strategies are an important part of the financial markets. In particular it recognises their increasingly significant role in the provision of market liquidity. It also recognises that it would not be beneficial if regulatory action in the UK caused the hedge fund industry to move to jurisdictions where there was little or no regulation.
It is, though, keen to engage the industry in a debate about the risks this sector poses and achieve a consensus on which risks are significant and do therefore merit some further regulatory engagement.
The FSA would like to receive comments by 28 October 2005. It intends to review these comments and issue a feedback statement early in 2006.
The complete pdf versions of both discussion papers can be viewed and downloaded at http://www.hedgeweek.com/hwreports.asp