Knuckling down

The political climate in the US may have shifted in favour of Christopher Cox, chairman of the Securities and Exchange Commission (SEC) and a leading advocate of closer oversight of the lightly regulated hedge fund industry. In mid-December, the SEC board voted to propose a rule raising the minimum personal wealth for hedge fund investors from $1 million to $2.5 million, reducing the universe of eligible clients for hedge funds.

This comes six months after the District of Columbia appeals court ruled that the SEC had no power to force US hedge fund advisers to register for supervision - a regulation that had been introduced in February last year. That rule required all advisers with more than $30 million in assets and 15 clients to submit audits and keep records on their clients. However, the appeals court ruled that this requirement was discriminatory. In the face of this setback, Cox gave up his efforts to compel registration, although he continued to condemn existing regulations as inadequate.

Then came Amaranth Advisors. The Connecticut-based hedge fund collapsed in September, losing around $6 billion after its natural gas trading strategy went wrong (Risk October 2006, page 8).

Since then, a chorus of voices have called for greater regulation of the hedge fund sector. Chuck Grassley, outgoing chairman of the Senate finance committee, warned US treasury secretary Henry Paulson in a letter sent on October 16 that hedge funds were endangering US pension schemes. And Richard Blumenthal, attorney general of Connecticut (where many US hedge funds are based), wrote in a letter to the SEC on September 19: "I strongly urge the commission to take additional stronger regulatory measures to combat market abuses and to protect investors, particularly in the still effectively unregulated field of hedge funds."

Blumenthal supports the increase in the wealth threshold, and has called for the minimum income required for hedge fund investors to be raised as well, from its current level of $200,000 to $500,000.

Not surprisingly, fund managers are wary of tighter regulation. Larry Goldstein, chief executive of the Californian asset management firm Santa Monica Partners, warns: "Anything that the government or government agencies do is another nail in the administrative coffin... and it takes time away from my primary job of finding investments."

The new SEC rules on minimum personal wealth are aimed at ensuring hedge fund investors are sophisticated and have previous experience in the markets. The commission has also reiterated to advisers and managers that enticing investors with false or misleading statements will be treated as fraud. While this is not a change in the law, it represents an assertion that, despite its defeat in court, the SEC still has the power to act in defence of hedge fund investors.

The change in tone may not translate into a significantly less friendly regulatory environment. The minimum personal wealth threshold has remained unchanged since its inception in 1982 - arguably, the increase simply brings it back into line with inflation. However, US market analysis company Wolters Klouwer estimates that the net effect will be to cut the number of eligible US hedge fund investors by 88%.

Timothy Spangler, a London-based partner at law firm Kaye Scholer, says: "Everything is relative - it depends where you start from. And there is no market in the world more liberal for hedge funds than the US - it is amazingly simple and straightforward." He adds that, despite this, the increased threshold may mean the US regulators "have a sense that too many people are getting access to hedge funds".

In Europe, meanwhile, hedge funds are facing a significantly more hostile climate. The European Central Bank (ECB) has long been wary of the sector - in its semi-annual Financial Stability Review, issued in June last year, it described them as a major risk to global financial stability for which there are no obvious remedies, and warned that the collapse of a key hedge fund or a cluster of smaller funds could trigger a market-wide disruption.

In December, ECB vice-president Lucas Papademos described what he called a "triangle of vulnerability" - hedge funds, credit derivatives and declining credit quality - that presented the highest risk of a market crisis. The solution, he said, was central registration of hedge funds. This idea was also explored in the latest ECB Financial Stability Review, published in December. "The information disclosed to regulated counterparties by a hedge fund must be sufficient to allow them to monitor their risks effectively. A key concern in applying this approach is that banks are often not informed in a sufficiently detailed and timely fashion on the entire portfolio held by individual hedge funds," the ECB said.

The best solution, albeit the most complex and expensive, the bank said, is to establish an international register of positions held by hedge funds and other highly leveraged investors. A register is the only way of ensuring prime brokers and other hedge funds have up-to-date and complete information about the risks associated with a client's or counterparty's entire portfolio.

But this proposal would create new problems, the bank admits - not least that of moral hazard. If hedge fund managers knew their positions were being scrutinised by regulators, they would be more willing to take risky positions in the knowledge that stabilising action would be more certain, the bank warns. In addition, collecting the data - most of it proprietary and highly sensitive - would be problematic. A leak could damage participating institutions by betraying their trading strategies, and could destroy their confidence in the regulatory authorities.

Furthermore, the sheer volume of data - which would need to be collected and analysed as frequently as possible, perhaps daily or even intraday - would require significant infrastructure to handle it.

The registration Papademos favours is different to that attempted by the SEC last February. The SEC tried and failed to enforce registry of the fund managers, while Papademos has backed a more intrusive regulatory register of open positions held by the funds themselves. The ECB's proposal will be discussed at the G-8 meetings in Germany in June 2007.

But enforcing such a register could be difficult. Callum McCarthy, chairman of the UK Financial Services Authority (FSA), pointed out in a speech to the European Money and Finance Forum on December 7 that most hedge funds in the UK are registered in tax-efficient offshore jurisdictions beyond the reach of UK regulators. UK-based hedge fund managers are already regulated.

And, he added, a register of positions could actually be harmful: "We do not seek, nor would we find it useful, to have information about specific large positions of individual funds or their managers. I do not see what the FSA - or, indeed, any other regulatory organisation - would do with such information if it were made available; and I see very considerable moral hazard in regulators seeking and holding information that is not used, but is known to be collected."

He said that it was not obvious how such a register would help ensure stability, adding that unless the ECB made it clear what information it wanted and why, the demand for transparency would be an empty requirement.

In general, the FSA is attempting to be more welcoming to hedge funds. McCarthy promised action to relax the rules that block UK retail investors from funds of hedge funds, with a consultation exercise due early in 2007.

The authority is also moving to relax rules on listing of investment companies - in particular, rules that have restricted hedge fund-like activity. In a consultation document released in December, the FSA said it planned to encourage the listing of investment entities that pursue a wider range of investment strategies, including those employed by hedge funds - for instance, taking controlling stakes in other companies, currently prohibited by rules on investment entities.

This is in contrast to a change in German law in May 2006, which reduced the maximum stake that could be held by investors without disclosure from 5% to 3%, effectively making it more difficult for hedge funds (and other asset managers) to acquire controlling or influential stakes in traded companies.

London already dominates the European hedge fund industry - all of the top 10 European hedge fund management companies are London-based. And this split is likely to continue while attitudes remain unchanged, Kaye Scholer's Spangler believes.

"You have the US and the UK on one side and Europe on the other when it comes to the role of hedge funds," he says. "The Anglo-American consensus is that hedge funds are just participants in the market, and the risks they give rise to are the same as the risks associated with the market in general." By contrast, European regulators and governments tend to regard hedge funds, private equity companies and other active asset managers with suspicion, he says. The FSA's approach means UK fund management companies are likely to benefit, Spangler believes: "It is odd to have so many managers and such a small market - in other countries there is roughly parity. The new rules mean more investors will be brought in to the hedge fund sector."