The Financial Services Authority (FSA) has today published its feedback to Discussion Paper 05/4 Hedge Funds: A Discussion of Risk and Regulatory Engagement, which looked at the impact of hedge funds on the UK's wholesale market.
The FSA continues to view hedge funds as an important part of the financial services system providing a major source of liquidity and enhancing market efficiency. In DP05/4 the FSA identified what it saw as the risks posed to its objectives by hedge funds and outlined the steps it had taken to mitigate them and a number of further ways in which it could address those risks.
In order to increase its understanding of the activities of those asset managers using hedge fund techniques, the FSA proposes 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 FSA.
Additionally, two specific areas are the subject of supervisory focus. These are:
- Asset Valuations: 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. Themed visits are currently being carried out in this area and the findings will be known in the third quarter this year. The FSA has also sponsored an IOSCO project on valuing complex and illiquid assets in hedge funds; and
- Side Letters: the failure by hedge fund managers to disclose that side letters have been granted to certain clients may result in some investors receiving more information and preferential treatment to other investors in the same share class. The FSA expects managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise.
Hector Sants, FSA Managing Director of Wholesale Business, said:
"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.
"We are pleased that both the formal responses and our wider discussions confirmed that the risks we had identified from hedge funds to our objectives were the correct ones. As we have previously made clear our response is only a modest change in our regulatory approach.
"There are two principal areas of focus to our current supervisory work. Firstly, we will seek additional information from the hedge fund managers we regulate to enhance our understanding of their activities, which will better inform our supervisory approach. Secondly, we continue to urge firms to focus on the risks posed by asset valuations and side letters, which will remain an area of supervisory focus."
A feedback statement to the accompanying Discussion Paper 05/3 Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World has also been published today.
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