Gatekeeper Approach

Regulation of hedge funds remains a controversial issue. Since investors of hedge funds are typically at non-retail level, direct regulation of hedge funds may not be appropriate. However, no regulation is also not desirable as hedge funds pose systemic risk to the markets.

Hennessee Group, an adviser to hedge fund investors, released its opinion recently on how to improve hedge fund investors’ protection and reduce systemic risk related to hedge funds. It supports recent SEC action to increase the accredited investor level and recommends further considerations related to “gatekeepers”.

Despite the recent decision not to directly regulate hedge funds, proactive indirect monitoring through coordination with “gatekeepers”, including prime brokers, accountants, administrators, investment banks and commercial banks (many of which are already under regulatory oversight or influence), can be a cost-effective alternative.

According to Hennessee Group research:

• The largest 100 hedge funds account for more than 50% of the industry’s total assets and pose the greatest threat to systemic risk.
• Over 90% of U.S. hedge funds currently utilize one of 10 prime brokers who are registered broker dealers and regulated by the SEC and NASD. Information about leverage and concentration can be gathered from this source.
• Over 90% of all U.S. hedge funds use one of six accounting firms to perform annual financial audits, and more than half of U.S. offshore hedge funds currently use one of the top five administrators. The uncertainties about the size of the hedge fund industry (in assets and leverage) can be answered by polling these accounting firms.

Hennessee Group concluded that by capturing information from the gatekeepers, regulatory authorities and government agencies can gain transparency into the hedge fund industry in a cost-effective and timely manner without inhibiting the entrepreneurial spirit of the industry that provides liquidity, contrarian research and pricing efficiency to the markets.

However, when hedge funds are distributed at retail level, a mix of direct supervision and gatekeeper approach would become necessary. Yesterday FSA set out proposals that would allow UK retail consumers to invest in funds of hedge funds and other alternative investments sold by firms authorised in UK. A key element in FSA's approach is its expectation that the fund manager will operate with "due diligence". FSA has accompanied the Consultation Paper with a case study illustrating the respective responsibilities of providers and distributors of these products.