Regulators worldwide have been busy over the last few months taking emergency measures to address the financial crisis. New thinking is emerging in the wake of the financial crisis:  

  • Adair Turner, the Chairman of the FSA, has queried whether institutions, such as hedge funds, which behave like banks should be treated as banks and regulated in a similar way; and  
  • the G30 report recommends that regulators should have the authority to require funds to provide certain information and, where funds are above a certain size, that regulators should be able to set standards for capital, liquidity and risk management.  

Rosali Pretorius and Emma Radmore look at current regulatory concerns.  

The European Commission consulted on hedge funds. It will use the results in its discussions with the G20 on potential changes to hedge fund regulation and supervision.  

Until now, the Commission was satisfied that various EU and national measures and industry codes have combined to give the right safeguards against significant risks hedge funds present. Also, EU entities servicing offshore hedge funds, such as fund managers, administrators or prime brokers are regulated.  

The Commission now asks whether a European regime for regulating hedge funds would be appropriate in the light of risks associated with hedge funds to the financial system.  

The Commission asks for feedback on:  

  • Systemic risks: Do regulators have the mechanics to monitor and react to risks originating in the hedge fund sector?  
  • Market integrity and efficiency: Do the activities of hedge funds threaten the efficiency and integrity of financial markets?  
  • Risk management: Should authorities worry about the way hedge funds manage the risks to which they and their investors are exposed, value their asset portfolios and manage any potential conflicts of interest?  
  • Transparency and investor protection: Are hedge fund investors adequately protected and do they get the information they need?  

The UK regulators have responded in some detail to the Commission’s questions. Treasury and FSA have sent a joint reply. They stress the importance to the UK of the hedge fund industry and how high-profile political debate should not obscure fundamental issues. That said, they admit regulators could do more to oversee all entities, including hedge funds, that might contribute to macro prudential risk.  

The Investment Management Association supports the substance over form tenet of the UK Government. IMA feels the hedge fund product is not one that needs fixing and that there is no such thing as the “unregulated European hedge fund” the Commission is looking to tackle, because EU-based hedge funds’ service providers tend to be regulated. It feels a good pan-European private placement structure is critical for the future. The Hedge Fund Standards Board similarly feels existing regulation is strong.  

Other developments affecting hedge funds

Major concerns for the UK hedge fund industry come from Lord Turner’s recent speech, his forthcoming report on bank regulation and FSA’s current business plan. The move is towards looking at the effects of institutional behaviour and regulating the economic effects in the same way, regardless of the classification of the institution in question. This could potentially bring not only investment banks but also the most influential hedge funds under a similar regulatory banner to deposit-taking banks.  

Although it is likely that hedge funds will see more UK regulation rather than less in future, the UK Government listened to hedge fund industry concerns following the Lehman collapse. Hedge funds complain vehemently that the administrators failed to distribute at least some client money and assets early. Court challenges failed. But section 233 of the new Banking Act 2009 gives Treasury power to make rules about “investment banks” (defined to capture any broker dealers who hold client money). This could pave the way for a protection scheme for funds posting client money and custody assets with prime brokers.  

Conclusion  

This is an uncertain time in the regulation of hedge funds. The regulators must strike a balance between regulating those who could cause damage to the financial system if left unchecked and allowing businesses to prosper in onshore environments. The US has recently proposed laws that, if passed, would increase the supervision of hedge funds, venture capital and private equity funds and similar vehicles. Hedge funds should be prepared to act quickly to respond to these regulatory changes. A key plank of this will be to review contracts with service providers, especially prime brokers.