Regulation of Hedge Funds (3/3)

In Mar 2006, IOSCO released a survey report which studied the global regulatory environment for hedge funds, covering a number of jurisdictions (including HK). There are 4 significant conclusions:

1. No member country had adopted a formal, legal definition of "hedge fund".
2. Hedge fund managers were regulated in most of the jurisdictions.
3. Few jurisdictions reported any significant "retailization" of hedge funds.
4. There had been some incidents of fraud relating to hedge funds.

According to a testimony of SEC, there are 3 principal areas of regulatory concern over hedge funds:

• Fiduciary obligations
• Market abuse
• Risks to broker-dealers

Fiduciary Obligations

SEC has handled many enforcement against hedge fund managers, which involve:

• misappropriation of fund assets
• "portfolio pumping" (i.e. bidding up the value of a fund's holdings right before the quarter-end)
• side letter agreements (i.e. hedge fund managers give certain investors more favorable privileges than others receive, e.g. liquidity preferences or more portfolio information)
• improper valuation of fund assets in order to hide losses or boost performance

Market Abuse

The market abuse activities include insider dealing, illegal short selling, market manipulation, late trading and fraudulent market timing. We still remember how hedge funds attacked the Asian financial markets during 1997-1998. Such manipulative activities were facilitated by investment banks and prime brokers.

Risks to Broker-Dealers

One core service prime brokers offer their hedge fund clients is margin financing. Under the competitive business environment, some prime brokers may be tempted to relax their risk management and credit policy, thus creating unduly large exposure to hedge fund risks. Derivative is a 2-side sword. Amarthan was killed by natural gas futures. A recent article of Forbes alerted investors to the potential disaster of hedge funds for trading in credit derivatives. Nevertheless, Donald Tsang still mentioned in his policy address that the government would study for the development of a commodity futures market in HK. Is it an idea to attract more hedge funds to HK, or provide one more gambling tool to retail investors?

Hedge fund is definitely a growing business but the global regulators are still sorting out the best regulatory model for such a mix of devil and angel. While we are concerned about systemic risk and investor protection, we can't deny that hedge funds contribute substantially to market efficiency, price discovery, liquidity and financial innovation.