Hedge funds prepare for legal crackdown

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Harsh new regulation of the hedge fund industry is widely expected in the wake of the financial meltdown last year and the Madoff affair. Crackdowns have been threatened on everything from short selling and the use of derivatives to leverage and capital requirements.

This is not the first time such threats have been issued. As Meredith Jones, managing director of US-based PerTrac Financial Solutions, says: “In 1998, we had LTCM and the industry made the trip to Congress to testify. Then in the high-tech downturn of 2000-2002 it was asserted that hedge funds had taken down the Nasdaq and we had a similar process.”

Ms Jones is not convinced that the current threats will be carried through. After the problems in 1998 and 2000-2002 there was little substantial change, she says. “What did change, however, was oversight by investors. Before 1998, few hedge funds reported numbers and there was zero transparency. Afterwards most provided information on holdings, exposure and returns.”

Nevertheless, Ms Jones accepts that the current environment is of a different order of magnitude and regulation is more likely to result.

The larger US hedge funds are likely to choose to be regulated to avoid closer scrutiny down the line, believes Carmel Peters, an Asian equities specialist at RWC, a multi-strategy hedge fund firm based in London. “The SEC may register more firms and more firms will voluntarily choose to do so,” she says.

Leverage, widely perceived to have exacerbated systemic financial problems, is a potential target area for rule-makers. But Ms Peters argues against new rules in this area, arguing that leverage will reduce naturally as the structure of prime broking changes. “There appears little reason to legislate. Funds will still lever, of course, but less so.”

And RMF, a Switzerland-based seeding firm and fund of hedge funds company, points out that leverage, at least in the short term, will not be necessary for many funds to make money, given market volatility and distressed asset prices.

Hans Hurschler, head of RMF Hedge Fund Ventures, says: “There is ample opportunity for funds to make excellent unlevered returns in this environment.”

New rules on the use of credit derivatives, widely viewed as the root of recent problems, are most likely of all. Moves to regulate the $30,000bn (£22,000bn, €23,000bn) credit default swaps market escalated at the end of last year, with New York state planning to bring parts of the sector under the control of its insurance supervisors from January.

Market manipulation is a further area of contact for legislators. Fidessa LatentZero, a hedge fund technology provider says, unlike in the US, measures should be unnecessary in Europe where trade reporting rules have already been tightened under Mifid (the markets in financial instruments directive). “Smaller funds delegate this to their prime brokers,” says Richard Jones, chief executive of Fidessa LatentZero. This should not be an issue for most hedge funds.”

However, the greatest likelihood of regulatory action exists in capital requirement rules. The European parliament’s economic and monetary committee has passed a resolution calling on the Commission to make “all relevant actors and financial market participants, including hedge funds and private equity” subject to mandatory capital requirements. In response, the Alternative Investment Management Association (Aima) in October updated guidance to its members on how to implement an internal capital adequacy assessment process.

Andrew Baker, Aima’s deputy chief executive, says: “The hedge fund industry has embraced the capital adequacy debate proactively.”

Yet all the putative measures can appear a somewhat desperate response by policymakers and Tom Brown, head of investment management at KPMG, is sceptical about the potential benefits. “What we need is more supervision and enforcement of the existing regulations, not new rules,” he says.

PerTrac’s Ms Jones agrees. “It is not very useful to impose industry-wide sanctions on an industry that is so diverse. They could put restrictions on leverage but 30 per cent of hedge funds don’t use leverage. There is no panacea from a government point of view.”

Nevertheless, regulators are starting to gather the firepower to enforce existing regulation, according to Fidessa LatentZero’s Mr Jones.

“Regulators will be able to recruit a higher calibre of person than in the past with the job losses in the financial services markets.”

Whether existing regulations are tightened or new ones introduced, it is clear that the industry needs to act to protect itself. Says PerTrac’s Ms Jones: “The introduction of additional real regulation will depend on how well the industry responds and educates people. Hedge funds must get out and dispel the myths. That is the only way they can avoid knee-jerk official reaction.”

There has already been a marked trend towards greater transparency – the main concern of politicians and rulemakers – with most hedge fund managers providing weekly or even daily numbers, she says. But there are technical difficulties involved in providing the numbers that not all hedge fund managers had yet overcome. Ms Jones says: “We still see many hedge fund managers provide a pdf of the information to investors, who then have to go through it and type in the relevant bits and then do their analysis. Many hedge funds have the information but don’t have the ability to share it with a large group of investors.”

And the more complicated the strategy, the more challenging the reporting requirements become. Exotic instruments aside, there is even complexity with plain fixed income funds, which tend to use plenty of leverage to magnify small movements in prices. “Reporting on the leverage and explaining counterparty risk is no easy matter,” says Ms Jones.

Indeed, counterparty risk rose to the top of the agenda for hedge funds following the collapse of Lehman Brothers, and is now an essential part of the risk jigsaw alongside operational controls, performance measurement, compliance and order flow control. “If you are a single prime-broker hedge fund, you are much more likely to run into trouble,” says Mr Jones.

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