Supervision Approach

Because of the LTCM case and several smaller national events, questions about regulation and supervision of hedge funds are being discussed. The main shortcomings and unsolved questions are.

• The possible macroeconomic costs of a hedge fund’s failure
• Disclosure, leading to more transparency and market discipline
• Up to now information is only given on a bilateral basis
• Accurate portfolio evaluation

Apart from disclosure requirements possible starting points for supervision or regulation could be either the sound practices of the hedge fund managers and corporate governance regulations or the product itself. Drafting a concept of supervision/regulation is complicated on the one hand by the global character of hedge funds. A national approach can be very easily avoided if the hedge fund or its manager is not located within the jurisdiction of the supervising rules.

On the other hand, hedge funds are currently changing and developing. Risk profiles are changing and risk measuring methods have to be adapted. Systemic risks are not easy to discover. There is only little transparency and the retail market is growing more sophisticated. These issues must be taken into account if supervision of hedge funds is considered.

A supervisory approach linked directly to the product must bear in mind the nature of the transactions. Event driven or arbitrage strategies, for instance, make use of certain developments not yet commonly known, respectively not yet fully anticipated by the market. By combining this information with the certain knowledge or experience of the fund manager the investment can benefit from certain market conditions that would quickly disappear if all facts were publicly disclosed. This demonstrates the hedge funds need confidentiality by their nature.

Upon the request from the G7 Finance Ministers, the Financial Stability Forum (FSF) has updated its 2000 report on Highly Leveraged Institutions which was published in the wake of the Asian financial crisis and the turbulence following the LTCM collapse. The update contains five recommendations to supervisors and the hedge fund industry.

Recommendations by the Financial Stability Forum.

• Supervisors should act so that core intermediaries continue to strengthen their counterparty risk management practices.
• Supervisors should work with core intermediaries to further improve their robustness to the potential erosion of market liquidity.
• Supervisors should explore and evaluate the extent to which developing more systematic and consistent data on core intermediaries’ consolidated counterparty exposures to hedge funds would be an effective complement to existing supervisory efforts.
• Counterparties and investors should act to strengthen the effectiveness of market discipline, including by obtaining accurate and timely portfolio valuations and risk information.
• The global hedge fund industry should review and enhance existing sound practice benchmarks for hedge fund managers in the light of expectations for improved practices set out by the official and private sectors.

As a reaction to these recommendations the Alternative Investment Association (AIMA) and the Managed Funds Association (MFA) both issued recommendations in this respect. As regards the possible regulatory approaches, a wide spectrum is available ranging from no regulation at all to full direct regulation, with various alternatives in between. These alternatives include self-regulation, e.g. through codes of conduct by the industry, indirect regulation through interaction of hedge funds with regulated counterparties and soft direct regulation, e.g. by regulating certain aspects, such as disclosure.