IOSCO Recommends Hedge Fund Regulation as Part of Systemic Risk Oversight

The IOSCO technical committee has set forth recommendations for hedge fund regulation embodying a consistent global approach to addressing hedge fund risk. SEC Commissioner Kathleen Casey, Chair of the committee, noted that the financial crisis is not a hedge fund crisis, and that hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. But, she said that regulators are beginning to consider what role hedge funds played in amplifying the financial crises through trading strategy, reliance on leverage and the need to liquidate positions.

Dovetailing with recent G-20 recommendations, IOSCO urges risk-based regulatory oversight of hedge funds, focused particularly on systemically important and higher risk hedge fund managers, with a de-minimus cut-off. As part of this regulation, hedge fund managers should provide information to help regulators protect investors and monitor systemic risk and risks to hedge fund counterparties. Broadly, the information supplied through the registration process would provide adequate transparency into the business of the hedge fund manager and should also be made available to all prospective clients prior to the execution of the investment management agreement. More specifically, the disclosure should include assets under management, fees charged, investment strategies, risk tools employed, and conflicts of interest.

IOSCO also recommends that regulations require hedge fund managers to have comprehensive and independent risk management functions that measures risks across the whole of the business, including market, liquidity, credit and operational risks. Risk management should also inckude stringent stress testing of portfolios for market and liquidity risk. Appropriate disclosure regarding risk should also be made to investors.

Hedge funds should also implement a strong independent compliance function supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.

Valuation is also very important, said IOSCO, with valuation procedures embracing adequate segregation of responsibilities and thorough written policies. For example, the procedures must ensure that valuation principles are standardized, including disclosure about fair value measurements determined based on common market participant assumptions. In addition, robust verification of fund valuations can be achieved through independent third party providers or strong independent overview from the hedge fund‘s governing body.

Regulators must also ensure that hedge funds manage conflicts of interest and provide full disclosure and transparency about such conflicts of interest. IOSCO identified two categories of hedge fund conflicts of interest. The first category includes conflicts that affect the hedge fund manager as an institution, such as investment and brokerage allocation practices and undisclosed compensation arrangements with affiliates and counterparties. The second category includes individual conflicts, such as personal trading; personal investing; and personal or business relationships with issuers.

Regulatory concerns have been voiced about the role of off-shore financial centers where, for tax reasons, many of the underlying hedge funds are registered. First, IOSCO believes that all securities regulators, including those in the offshore financial centers, should ensure that appropriate information about the funds and its activities is maintained and properly audited for each fund registered in their jurisdiction. Regulatory cooperation, which IOSCO also calls for, would be further enhanced if all jurisdictions were able to collect key information items which could then be efficiently shared. But irrespective of where the underlying funds are established, hedge fund managers and prime brokers remain subject to regulatory jurisdiction, such as in the UK and US.

Given that circumstance, IOSCO believes that hedge fund managers should be able to obtain all the necessary information from their underlying funds irrespective of the location of those funds. Then, armed with this information, hedge fund managers will be able to evaluate the risks they are taking in their portfolio. If they cannot get the necessary information, said IOSCO, they should consider limiting the risks they are taking.