The Swiss Federal Banking Commission, the country's financial services regulator, has concluded in a report that Switzerland would become a more popular location for the establishment of hedge funds if its tax laws were more similar to those of leading industry centres.
The report spotlights various issues relating to the hedge fund business including systemic stability, market integrity, investor protection and business location, and examines the regulatory and tax environment in Switzerland.
The SFBC has dealt with hedge fund-related issues regularly in recent years, ands the report summarises its work by describing the nature of the sector, its development and risks, as well as the regulatory and supervisory approach adopted by the commission.
The report notes that the current financial market turmoil and resulting illiquidity in some markets illustrates how important it is for financial stability that investment banks keep a very close eye on counterparty risk in their dealings with hedge funds. The SFBC says it accords great importance to constant monitoring of globally active Swiss banks.
Switzerland may be a major market for the placement of hedge fund products, but to date it has been far less significant as a location for hedge fund managers and as a domicile for funds. The SFBC supports efforts to create incentives for hedge fund managers to base themselves in Switzerland by improving their operating environment.
The report notes that compared with other types of investments, hedge funds are generally subject to fewer restrictions on the types of investments they can make. The activities of hedge funds and other market participants such as private equity firms and investment banks have increasingly come to overlap, it says.
By international standards, Switzerland has played only a minor role as a location for hedge fund managers and domicile for funds. However, it is an important market for hedge fund investment, which accounts for more than 5 per cent of the assets invested in the country.
The report says hedge funds contribute substantially to efficient capital and risk allocation, enhance market liquidity and promote efficient price formation. The total size of the hedge fund industry remains modest by comparison with other industry segments like investment funds, but their influence on the financial markets is harder to ascertain.
Noting that investment banks extend credit to hedge funds, which exposes them to counterparty credit risk, the report says the collapse of a large hedge fund could have a serious impact on the functioning of the financial system, particularly if it were associated with a significant deterioration in market liquidity.
The SFBC supports international co-ordination of measures to boost financial stability and improve risk management. The Swiss regulator believes that indirect regulation of funds through their dealings with banks is the best way to prevent a crisis arising at a hedge fund spreading to the rest of the financial system.
The report finds no proof that hedge funds are more prone to market abuses than other market participants and in greater need of regulation. In Switzerland, the same market behaviour rules apply to hedge funds as to other market participants, although the regulator says that if hedge funds were able to build up stakes in listed firms, it could allow them to manipulate prices.
Diverging interests among investors, lenders and managers of hedge funds could create incentives for an overvaluation of complex financial instruments and positions in less liquid markets. The SFBC says it supports international efforts to introduce more concrete requirements for transparency and independence in the valuation of fund portfolios.
In recent years, the report notes, financial investors including hedge funds have tried to use non-controlling interests to influence strategic company decisions as a means of achieving short-term profits. This type of shareholder activism is not exclusive to hedge funds, and short-term investment strategies need not run counter to a company's long-term interests, but the report says sufficient transparency regarding share ownership patterns and the eligibility to exercise share voting rights must be ensured.
Investing in hedge funds affords the opportunity for pension funds, insurance companies and even retail investors to diversify risks, but also carries its own risk. In contrast to some other countries, investor safeguards in Switzerland are not administered through a ban on sales to small investors but instead through broad informational requirements pertaining to the characteristics and risks of the product.
The country's new Collective Investment Act offers a flexible legal framework with a number of different corporate forms for hedge fund activities in Switzerland. However, the regulator says, it's hard for managers of foreign hedge funds seek the supervision of the SFBC.
Making it easier for hedger fund managers to be licensed and supervised could enhance Switzerland's attractiveness as a location for hedge funds, since a number of investors such as pension funds only invest in assets managed by managers under official oversight. The SFBC supports a revision of the Collective Investment Act that would improve regulatory incentives for hedge fund managers to establish themselves in Switzerland.
The SFBC also argues that hedge fund managers choose a domicile for their funds primarily according to tax-based considerations. Aligning the currently unfavourable tax regime in Switzerland with those of leading hedge fund centres abroad could change managers' negative attitudes toward Switzerland, the commission says, but any decision will rest with the country's political authorities, who may have to take into account other considerations.