Hedge funds may be 'testing boundaries' of insider dealing

Hedge funds may be 'testing boundaries' of insider dealing

The warning was made in a detailed discussion of the risks and regulatory problems posed by the hedge fund boom.

These sophisticated investment funds - mostly based in offshore tax havens - are thought to number 8,000 worldwide and can account for half the daily activity on the London Stock Exchange.

However, the FSA also floated the idea that retail investors could be allowed to invest directly in some hedge funds. At the moment, access is confined mostly to wealthy individuals and financial institutions.

A second discussion paper asked whether a new category of "sophisticated products" could be created in which the increased risks of hedge funds are flagged up. Already, hedge fund-style products are creeping into the retail arena. In May, Merrill Lynch launched a unit trust in which managers have the ability to short-sell shares.

However, despite the FSA's recognition of hedge funds as "an important part of the financial markets", its warning about the potential risks will reverberate in the City.

In April, John Sunderland, president of the employers' body the CBI, attacked hedge funds' lack of openness and accountability, and one German politician called them the "locusts" of international capitalism because of their short-term focus.

There have also been con cerns that investment.....continued below

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The FSA made a barely disguised reference to these "prime broking" arrangements whereby banks provide comprehensive services to hedge funds such as stock-lending and research.

The regulator said: "Given their payment of significant commissions and close relations with counterparties, [hedge funds] may create incentives for others to commit market abuse."

The regulator plans to establish a "centre of hedge fund expertise" which will monitor what it called "high impact" firms. It also plans to increase surveillance of potential abuse of insider dealing rules.

Among a list of 10 major risks, the FSA also mentioned "market disruption and erosion of confidence" if a large hedge fund, or a cluster of small ones, collapsed.

Such fears have regularly surfaced since Long-Term Capital Management (LTCM) had to be rescued by a Wall Street bailout in 1997. The industry usually argues that modern hedge funds do not employ LTCM's extreme levels of leverage, or borrowing, and so are fundamentally more stable.

However, the FSA hinted it does not think the point has been proved. "Insufficient reliable and comparable data is available to regulators, which limits our ability to make informed decisions about risk and take proportionate regulatory action to mitigate that risk," it said.

The fundamentals

What is a hedge fund?

Hedge funds come in many guises but almost all pursue so-called absolute returns. They don't measure themselves against any index or benchmark, but simply try to generate gains consistently.

How do they try to do it?