IOSCO Issues Principles for Hedge Fund Regulation as Legislation Looms

With the US and EU readying legislation to regulate hedge funds, IOSCO has set forth six high level principles for hedge fund regulation driven by disclosure and international coordination. IOSCO calls for the mandatory registration of hedge fund advisers under a prudential regulatory regime emphasizing disclosure and the elimination of conflicts of interest. In addition, prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration and should have to implement risk management systems to monitor their counterparty credit risk exposures to hedge funds.

SEC Commissioner Kathleen Casey, Chair of the IOSCO Technical Committee, said that the collective application of the principles can provide regulators with the tools to obtain relevant information in order to address the systemic risks posed by hedge funds. While securities regulators recognize that the current crisis is not a hedge fund driven event, she noted, the crisis did reveal the systemic role hedge funds may play and the way in which regulators deal with the risks they may pose to the oversight of markets and protection of investors.

Anticipating the passage of systemic risk legislation, IOSCO recommends that hedge fund advisers and prime brokers be required to give their relevant regulators information for systemic risk purposes, including the identification, analysis and mitigation of systemic risks.

Also, regulators should have the authority to co-operate and share information with each other in order to facilitate effective oversight of globally active hedge fund advisers and funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating cross-border risks.

Disclosure is a key element of the regulation. Hedge fund managers, like other fund managers, are subject to significant conflicts of interest. IOSCO urges them to provide full disclosure and transparency about such conflicts of interest and how they manage them.

Hedge fund managers should ensure that there is proper disclosure to investors on the risks incurred, the conditions for redemption, the existence and conditions of any side letters and gating structures, the fund‘s strategy and performance, including audited financial statements. As part of these ongoing requirements, regulators should have the power to inspect the fund managers and their records.

In addition, hedge fund managers should provide to regulators information on their prime brokers, custodian, and background information on the persons managing the assets, as well as information on the hedge fund manager‘s larger funds including, the net asset value, predominant strategy, and performance. The disclosure should also include data on leverage and risk, including concentration risk of the hedge fund manager‘s larger funds. Importantly, regulators should be told counterparty risk; and assets and liability information for the hedge fund manager‘s larger funds. Moreover, there should be disclosure of product exposure for all of the hedge fund manager assets, such as structured and securitized credit.

Under the IOSCO principles, prime brokers should provide on-going information on hedge funds to their regulators so as to gauge risk appetite and identify the emergence of large and highly leveraged funds. The data will also help assess banks’ ability to aggregate counterparty exposure across business lines and build a prime brokerage network.

IOSCO also urges regulatory standards on the operational conduct of hedge fund managers, including the valuation techniques they employ. As part of operations, there should be an independent risk management function appropriate to the size, complexity and risk profile of the hedge fund manager. There should be a similar independent compliance function. The nine previously announced IOSCO principles on valuation remain valid and should be incorporated into operations.

First, documented policies and procedures should be established for the valuation of financial instruments held by a hedge fund. Second, the policies should identify the methodologies used for valuing all of the financial instruments held by the hedge fund. The third and fourth principles are that the financial instruments held by hedge funds should be consistently valued according to the policies and the policies should be reviewed periodically. The fifth principle is that independence should be embedded into the valuation processes by using third-party pricing services.

The sixth principle is that the valuation policies should ensure that an appropriate level of independent review is undertaken of the individual values that are generated by the policies. The seventh principle is that a hedge fund’s policies should describe the process for handling and documenting price overrides, including the review by an independent party. The eighth principle is that initial and periodic due diligence should be conducted on third parties appointed to perform valuation services. The ninth principle is that the valuation arrangements must be transparent to investors.