European Commission Launches Review of Hedge Fund Regulation in Light of Financial Crisis
The European Commission has launched a wide-ranging consultation on the regulation of hedge funds in light of the financial crisis. The consultation will examine issues dealing with transparency, market integrity, risk management at the hedge funds, and any systemic risks that the funds may impose. Public comment is invited until Jan. 31, 2009.
The consultation invites views on whether existing systems of macro-prudential oversight are sufficient to allow regulators to monitor and react to risks originating in the hedge fund sector and transmitted to the wider market through counterparties, including prime brokers, and through the impact on asset prices. The consultation will also examine whether regulators should concern themselves more with the way in which hedge funds manage the risks to which they and their investors are exposed, value their asset portfolios and manage any potential conflicts of interest. The consultation invites views on whether hedge fund investors are adequately protected and receive the information required for sound investment decisions.
Hedge funds have not traditionally been considered to be of systemic relevance, noted the EC, since losses incurred by hedge funds and their risk of failure are borne directly by investors and their immediate counterparties. Recent developments have demonstrated that hedge funds may impact wider market dynamics in other ways. By virtue of their volume and the frequency of their trading, hedge funds may pose risks to the stability of the financial system through the pro-cyclical effect of their activities on asset markets.
Traditionally, regulators have not concerned themselves with overseeing the risk management and asset valuation processes of hedge funds to the same degree as for retail investment funds. The investor base for hedge funds has typically comprised institutional investors and high net worth investors deemed sufficiently savvy to understand the higher risk of capital loss associated with hedge fund investing and whose investment portfolios were sufficiently large to absorb the losses of the occasional hedge fund failure.
However, recent large scale redemption demands by hedge fund investors have demonstrated that hedge funds, particularly funds of hedge funds, are not immune from liquidity risk. In addition, the rescue or failure of important prime brokers and other market counterparties have underscored that hedge funds are exposed to important counterparty, custodian and settlement risks. Their risk-management processes and back-office administration must keep pace with the increasing demands of a more complex market.
The Financial Stability Forum has previously called on the hedge fund industry to deliver improvements with respect to risk management processes and valuation techniques. In response, self-regulatory codes have been developed recommending best practice. But the Commission noted that it is not yet clear whether these have had a material impact on the robustness of the internal processes of hedge funds, particularly in stressed conditions.
Regarding transparency, all investors, even sophisticated ones, require information on the nature and the risks of the investment into which they are entering. The appropriate content and form of this information will vary according to the degree of sophistication of the investor. When, as is typically the case, hedge funds are distributed directly to professional investors, disclosure practice is driven largely by contractual arrangements between the funds and their investors. Investors request information to serve as the basis for their due diligence and to ensure compliance with their own investment constraints. In some jurisdictions, certain information obligations have been codified through self-regulatory standards, such as those overseen by the Hedge Fund Standards Board in the United Kingdom.
The Commission is concerned that hedge funds do not always provide sufficient information on a pre-contractual and ongoing basis to allow investors to assess the risks of their investments. For example, information on investment policies or risk management procedures may be incomplete or infrequently updated.