FSA Publishes Feedback On Hedge Fund Risks

by Robert Lee, for LawAndTax-News.com, London

27 March 2006

The Financial Services Authority (FSA) has published its feedback to a discussion paper on the risk and regulatory impact of hedge funds on the UK's wholesale markets.

Upon publication of the feedback paper, the FSA stated that it continues to view hedge funds as "an important part of the financial services system providing a major source of liquidity and enhancing market efficiency". However, the regulator also raised several concerns over the way hedge funds operate.

According to the FSA, two specific areas are the subject of supervisory focus: asset valuations by hedge fund managers; and disclosure by hedge fund managers of side letters.

On the first point, the authority is wary that hedge fund managers may be exposed to conflicts of interest, as their remuneration is based on performance and assets under management.

"This may create an incentive to overstate the valuations it provides to administrators, who may not be able to challenge them," it warned.

The FSA said that "themed visits" are currently being carried out in this area, and the findings will be known in the third quarter this year. The authority has also sponsored an IOSCO project on valuing complex and illiquid assets in hedge funds.

On the seond issue, the authority fears hedge fund managers are failing to fully disclose that side letters have been granted to certain clients which could result in some investors receiving more information and preferential treatment than other investors in the same share class.

The FSA has proposed to include additional questions to identify the firm's prime broker, third party administrator and the fund auditor in the Integrated Regulatory Returns that firms send to the regulator, in order to increase its understanding of the activities of those asset managers using hedge fund techniques.

Commenting on the feedback paper, Hector Sants, FSA Managing Director of Wholesale Business noted that:

"We continue to view hedge funds as a vital segment of the financial services industry. In particular they play a fundamental role in the efficient reallocation of capital and risk, and remain an important source of liquidity and innovation in today's markets."

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