Ever since they started entering the mainstream, hedge funds have become a popular target for calls of more regulation. Although these alternative investments are now better understood by more investors, they are still generally less regulated, less transparent, and perceived to be more susceptible to loopholes and irregularities.

It comes as no surprise, therefore, that in the latest report from US-based consulting firm Greenwich Associates, most of the large corporations and financial institutions it surveyed indicated that they want regulators to keep hedge funds on a tighter leash. In Asia, this may be unthinkable for some hedge funds in Singapore or Hong Kong that consider the current regulatory regime to be either just right or already too strict.

Almost three-quarters of the 84 Asian companies and financial institutions surveyed by Greenwich Associates say they favour stricter regulation of hedge funds. Those surveyed were among the 458 asset managers, companies and banks that participated in a Greenwich Market Pulse. Respondents were asked to rate their level of support for various regulatory reform proposals, to assess the appropriateness of the level of government intervention in markets around the world in combating the global crisis, and to predict the duration of the current economic recession.

Hedge funds were by no means singled out in the survey. More than two-thirds of Asian companies and financial institutions support the creation of so-called systemic regulators; between three-quarters and two-thirds of Asian respondents support reforms to global derivatives markets including shifting OTC trading to exchanges and centralising clearing;  70% of Asian companies and financial institutions would support mandatory separation of investment banking and commercial banking activities within financial service firms.

"Asian companies support many reform proposals because they believe strict financial regulation was effective in insulating Asia from the worst effects of the banking crisis that started in the West," says Greenwich Associates consultant Markus Ohlig.

Ohlig notes that the banking industry in most Asian countries has been tightly regulated since the 1997-1998 financial crisis, which was brought on by the collapse of the Thai baht. The survey results suggest that companies think this strict regulation prevented the build-up of the types of imbalances that brought on the banking crisis in the United States and Europe, he says.

This article focuses on the issue of hedge fund regulation, which always seems to be a sore spot no matter which side of the fence one sits on.

Peter Douglas, a Singapore-based council member for the Asia-Pacific region of the Alternative Investment Management Association (Aima), has very strong opinions on the issue.

Douglas notes that Aima has always believed in promoting sound practice in the hedge fund industry and this includes a belief that, generally, managers of hedge funds should be regulated.

While Aima doesn't believe that the industry necessarily needs further regulation, it has accepted the fact that this is most likely inevitable, and thus, focuses its efforts on the parameters and extent by which hedge funds should be regulated.

Australia, Hong Kong, and Singapore already have in place well thought out regulation, both for domestic fund managers including hedge funds, and also of distribution to domestic investors, including distribution of hedge funds. But Douglas concedes that in the light of global regulatory changes, "it would be unsurprising" if these jurisdictions are also reviewing their regulatory framework.  

When it comes to the benefits of further regulation, Douglas doesn't believe it will include better investor protection.

"The hedge fund industry is founded on extensive investor primary due diligence, and, historically, frauds have been found in regulated environments which may have caused investors to drop their guard," Douglas says.

Bernie Madoff in the US and Charles Schmitt in Hong Kong are good examples of Douglas's argument. Of course, Madoff is notorious for defrauding investors of billion of US dollars (estimated by US federal prosecutors at $65 billion) and has been convicted in the US and sentenced to serve 150 years in jail. Schmitt was banned for life by Hong Kong's Securities & Futures Commission (SFC) for misappropriating millions of US dollars in client assets and being convicted of false accounting in relation to the CSA Absolute Return Fund.

Not everyone is critical of hedge funds, Douglas points out, and this is in part reflected by the better performance figures reported by data provider Lipper across all hedge fund strategies in July.

"Most experienced investors that I speak to believe that hedge funds performed exceptionally well in 2008, mitigating typically 50% to 75% of potential market losses, against a backdrop of perhaps the worst financial crisis any of us will live through," Douglas says, adding he is confident that sooner rather than later, we will see a substantial reallocation of global investor assets to hedged and other alternative vehicles in recognition of their performance through the crisis.

In Europe, the EU Commission (EC) published the text of a draft directive on Alternative Investment Fund Managers (AIFM) in April. The directive applies primarily to any AIFM which is established in an EU member state and which provides management and administration services to one or more alternative investment funds. However, it will also apply to the marketing of alternative investment funds within the EU by AIFM which are established outside the EU. This is the strongest move post-financial crisis to tighten regulations for hedge funds and industry players worldwide are closely monitoring how this plays out.

Karl Hurst, Hong Kong-based managing director of hedge fund firm HT Capital Management, is of the belief that there is adequate regulation in place and "the mooted regulation coming out of Europe is seemingly Draconian without commensurate investor protection".

Hurst believes that investors would be better served if the regulators employ practitioners to undertake a meaningful and rigorous due diligence process.

"All types of investors would benefit by the regulators undertaking regular and thorough inspection of licensed fund management companies undertaken by qualified and skilled staff that actually know what questions to ask and, what to look for during onsite audits or inspections," Hurst says.

The Singapore branch of Aima has warned that the EC's draft directive on AIFM will make it unduly difficult for Singapore-based alternative investment managers to access the European market. The directive will also complicate the allocation of a global portfolio's fund management, making the delegation from Europe to Asia near impossible, the group says.

Under the directive, managers based outside of Europe will need to obtain a special marketing passport before being granted access to the European market, Aima points out, and the passport will not be available for three years after the introduction of the directive.

Michael Coleman, the chairman of the Singapore branch of Aima, believes the effect of the EC's draft directive "is highly protectionist". If it is left unchanged, he says it will have a major negative impact on the hedge fund industry in Singapore, which has a large European component to its investor base.

For its part, the International Organisation of Securities Commissions' (Iosco) technical committee published in June a hedge funds oversight report -- which followed an industry consultation - containing six principles expected to help regulators collectively address the risks posed by hedge funds in their own jurisdictions while supporting a globally consistent approach. The six high-level principles are:

  • Hedge funds/hedge fund managers/advisers should be subject to mandatory registration;
  • Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to organisational and operational standards, conflicts of interest and other conduct of business rules, disclosure to investors, and prudential regulation;
  • Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds;
  • Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks);
  • Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate;
  • Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

When the report was released, Kathleen Casey, chairman of Iosco's technical committee, noted that securities regulators recognise that the current crisis in financial markets is not a hedge fund driven event. She cited that hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. Nevertheless, she noted, the crisis has given regulators the opportunity to consider the systemic role hedge funds may play and the way in which we deal with the regulatory risks they may pose to the oversight of markets and protection of investors.