Sunday, November 12, 2006

UK Official Details Hedge Risks and FSA Response

By James Hamilton, J.D., LL.M.

The UK Financial Services Authority has identified six primary risks posed by hedge funds and is acting to defuse them. FSA Director of Retail Policy Dan Waters details the risks as market disruption, market abuse, operational, retailization, incorrect valuation of illiquid instruments, and transparency failures. In remarks at the recent AsiaHedge seminar in Hong Kong, he outlined the FSA’s response to these risks.

For example the failure or significant distress of a large and highly exposed hedge fund could cause serious market disruption. To counter this, the FSA established a regular six month surveys on the exposures to hedge funds of the main London-based banks that provide prime brokerage services. The aim of the survey is to enhance the FSA’s understanding of prime brokerage and to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives.

With regard to the valuation of complex illiquid instruments, the director mentioned that IOSCO is developing good practice valuation policies and pricing procedures for hedge fund managers. There is a mandate to develop a single set of valuation principles with a reasonable level of granularity. IOSCO will be focusing on the existence of robust, written policies and procedures, the effective day-to-day operation of them, the role of the hedge fund manager, the role of independent parties in producing and/or verifying prices, and the adequacy of disclosure to investors.