By James Hamilton, J.D., LL.M.
Regulators need to engage hedge fund managers and the brokers who service the funds in a number of critical areas without actually regulating the hedge funds themselves, in the view of Hector Sants, Managing Director of Institutional Markets at the UK Financial Services Authority. In remarks at an IOSCO meeting in Shanghai, he outlined five areas for regulatory attention: market disruption, insider trading, operations, valuation of illiquid instruments; and the preferential treatment of selected investors.
While the senior official assured that the FSA does not seek to regulate the funds themselves, he emphasized that risks can be mitigated through existing authority over hedge fund managers and firms providing prime brokerage services to the funds. With this in mind, the FSA set up a center of hedge fund expertise in October 2005, with a priority to enhance oversight of 31 of the largest UK hedge fund managers. The FSA is in regular contact with the firms and conducts periodic risk assessments to develop individual risk mitigation plans with them. Lower impact firms are subject to baseline monitoring through regulatory returns and other types of alerts.
Turning to the specific problem areas and the FSA’s response, the director noted that the failure of a highly exposed hedge fund could cause serious market disruption and erode confidence in other hedge funds and counterparties. In response to this threat, the FSA established a regular six month survey on the exposures to hedge funds of the London-based banks that provide prime brokerage services in order to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives.
The survey targets the largest prime brokers with two main data requests, with the first looking at their credit exposures to hedge funds, while the second focusing on the prime broker business. This effort has advanced regulatory discourse with firms with large risk exposures and encouraged the improvement of risk management systems in the prime brokers themselves. The FSA is also working with the banks on collateral and margin arrangements.