The UK’s financial regulator, the Financial Services Authority is concerned not to over-regulate the country’s flourishing hedge fund indust...

The UK’s financial regulator, the Financial Services Authority is concerned not to over-regulate the country’s flourishing hedge fund industry and banish it to an offshore jurisdiction. A senior FSA official told an invited audience at a round table discussion recently on the future of hedge funds that the regulator applies a cost/benefit analysis to extending its regulatory purview.

The FSA has initiated an industry consultation process that ends on 28 October and the regulator’s official urged the hedge funds industry to respond.

“The FSA don’t see it as a crime to get things wrong first time,” the official told the industry specialists gathered together by the UK's Centre For The Study of Financial Innovation. “Nothing is written in concrete, so now’s the time to influence our thinking,” she continued.

The FSA have made it their stated aim to concentrate their attention on up to 25 hedge funds that they believe could cause stress to the financial system through volume of trading, use of innovative products or operating in new or illiquid markets.

But according to FSA official the UK does not have one hedge fund that alone could do significant damage to the UK’s financial system, although if current growth continues this will not be the case for long.

The FSA’s big headache is that a cluster of medium-sized hedge funds following the same strategy could blow-up at the same time. And to make matters worse, the FSA doesn’t know what strategies hedge funds follow – the question is not asked on the regulatory return that all FSA-registered organisations are required to submit quarterly. When a potential hedge fund problem looms the only weapon at the FSA’s disposal to make some phone calls to get a sense of how many funds may be involved in the strategy in question.

The growing power of the fund of hedge funds may be the answer to the FSA’s dilemma. The overwhelming majority of hedge fund managers hope to get allocations from the fund of hedge funds who have a huge bank of data on the industry gathered through their extensive due diligence processes. If this information can be used by the FSA to get a sense of how committed the hedge fund sector is to a particular strategy, then so much the better.

It is only the FSA who can hope to get an over-arching picture of the market through the auspices of the fund of funds and the prime brokers who often act as the counterparties and administrators of the hedge funds, and in many cases make allocations to them.

But we should not forget that the FSA doesn’t operate a zero failure policy. If hedge funds fail and investors loose money, then surely caveat emptor should apply. After all hedge funds promise super-normal returns. Shouldn’t investors be expected to accept super-normal risks to achieve them?

It is only really when a fraud has been committed that the consumer has a reason to complain. Apparently many US funds of hedge funds turned their noses up at investing in the Bayou funds, the subject of the latest hedge fund fraud to grip the American market, because during the due diligence process it emerged that the promoters’ resumes were a pack of lies. And did these fund of funds say anything at the time? Did they have any concerns for investors who may not have had the resources for a full due diligence process?

And where does that leave regulation of hedge funds in the UK? If a fund of fund uncovers irregularities in the application of a hedge fund manager for an allocation of assets is it obliged by law to report it to the authorities? This very question was asked at the recent round table discussion, but not even the lawyers amongst us could answer it.