I was long puzzled by one question that supposedly well informed hedge fund clients kept asking over recent months: have we seen the worst yet? It took a while for the penny to drop as to what was really being asked – not the direction of the markets but a clue from an insider exposed to the practices of hedge funds as to the scale of unknown horrors that may be lurking. Not even a hefty dose of aspirin helped the instant headache that developed when I explored the question with my crystal ball.

Three interwoven features leapt to mind: the largely unregulated nature of hedge funds; the poor quality valuation information available to investors; and the absence of any real system of control over hedge funds’ operating practices before disaster struck.

Largely unregulated: The very essence of a hedge fund is its unregulated nature. Historically, the avoidance of restrictions on selling practices has been an important driver but two features have become much more important: first, the absence of any requirement for disclosure at any time of a fund’s investments or investment strategy – this has been critical for funds hoping to make returns by betting against the market; secondly, the absence of any effective restriction on what funds may do – the only restrictions are found in the funds’ contractual documents and these are toothless because what has occurred only ever comes to light post-disaster.

The pedantic may say that funds are not unregulated. The Cayman Islands and the British Virgin Islands both have statutory regulatory systems. The regulation may be conscientious but its “light touch” is easily demonstrated. Cayman (according to the CIMA, its regulator) had 10,037 funds in June 2008 but apparently a total staff of only 24. BVI (according to the FSC, its regulator) had 2,781 funds in March 2008 and about 10 staff in its Investment Business division. These numbers require caution because lawyers or other professionals from other departments might be called upon for enforcement action but my own view is that the implications are clear.

Valuation problems: Valuations (usually by the fund administrator without responsibility for anything but its own fraud or deliberate default) are the only information that investors will have on which to base investment decisions. Valuations will determine entry and exit prices. They rarely contain any information except as to total fund value and the consequent value per share.

Experience of funds in difficulty suggests that valuations often bear no relationship to the reality of what positions were worth if realised within a reasonable time. Controversy surrounds the pricing models of funds. Is there any necessity to mark to market positions that are illiquid or difficult to value (ie the vast majority of most funds’ portfolios) rather than marking them to model (ie the investment manager’s expectation of how positions should perform at that moment)?

The debate itself demonstrates that some funds’ measure of performance is not realistic. The true extent of the problem is pure speculation for there are no statistics. My speculation that the problem is widespread is jaundiced by seeing the disasters.

Lack of effective control systems: Every fund ought to have risk control systems but the well known disasters illustrate the dangers of the systems being operated by the very people burdened by acute conflicts of interest: the investment managers’ future as well as their remuneration is based on delivery of positive results. There are rarely, if ever, outsiders involved who have access to information in real time.

Even when problems start to emerge with funds, experience is that the funds’ directors are neither suitable nor willing to exercise their independent judgment or such limited muscle as is left with them by the fund management agreements. The recipe is all too familiar to those of us whose professional careers have covered cases like the BCCI collapse and the Maxwell scandals. I have been shocked to learn of the exposure of UK pension funds to hedge funds. When that is added to the mix the reach of hedge fund problems may be far wider than appreciated.

Any UK or EU regulation of these offshore entities needs care if it is to work but I will finish on two thoughts. First, the only obvious path of domestic regulation is to limit access to financial markets to those who comply with acceptable standards, even if regulated offshore. Secondly, a statutory presumption should be that anyone marking to model is guilty of creating a false market in securities, unless he shows the contrary.

Lawrence Cohen QC is a member of the Chancery Bar Association