Hedge funds may be 'testing boundaries' of insider dealing

Some hedge funds may be "testing the boundaries" of insider trading laws, chief City watchdog the Financial Services Authority said yesterday.

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 banks' relationships with hedge funds have become so close that direct conflicts of interest are created.

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?
Two defining characteristics are short-selling and leverage. Short-selling is seeking to profit by betting that something will fall in value - it could be shares, commodities or bonds. Leverage is the industry's name for debt. For every £1 a hedge fund raises from investors, it might borrow another £5. The aim is to pump up the (hoped-for) investment profits.

Do they all follow the same strategies?
No. There are at least 10 major investment styles. Arbitrage funds seek to exploit price inefficiencies. Others are computer-driven programmes that try to follow price momentum.

Why are they all located in places like the Cayman Islands?
Offshore centres offer low taxes and light regulation - Bermuda and the British Virgin Islands are other favourites. But they are just the legal bases - the fund managers themselves stay onshore.

Are they regulated?
Not really. Hedge fund managers in the UK are authorised by the FSA. But the funds themselves are out of reach.

How many are there?
About 8,000 individual funds worldwide. The FSA thinks there are at least 50 in Europe managing over $1bn (£550m).

Is it profitable?
For the winners, very. Management fees are typically 2% of assets under management, plus performance fees equivalent to 20% of the investment gains, but about 10% of hedge funds go out of business every year.