Some participants in South Korea's nascent alternative-investment market have grown pessimistic over the ability of incoming legislation to support the development of an onshore hedge funds industry.

The Capital Markets Consolidation Act will become effective in February. It is a sweeping attempt to give Korea a securities law akin to those in the United Kingdom or Australia, in which financial services are regulated by function rather than by business license, and in which most types of businesses will be thrown open to all kinds of financial institutions. It will allow the development of a universal bank and plenty of cross-selling.

As part of this, the Financial Supervisory Service has been keen to encourage the development of an onshore hedge funds industry. There are a growing number of Korea-focused hedge funds, but nearly all of them operate offshore, in Singapore, Hong Kong or the United States. The government wants to position Seoul as a financial hub for northeast Asia, and has seen how hedge funds have become a vital and welcome part of the milieu in places like Singapore.

The Consolidation Act makes no mention of hedge funds, however, and industry players have lobbied the Ministry of Strategy and Planning (what they call the Ministry of Economy and Finance these days) to address this. The government has responded by floating an amendment to the Consolidation Act that is expected to go before the National Assembly, probably in October. This amendment specifically addresses the ability of onshore fund managers to employ leverage.

But significant obstacles remain before hedge funds will want to obtain an onshore license, says David Bennett, director of the hedge fund practice at Hana Daetoo Securities in Seoul, which is setting up an alternative investments platform in Singapore and advises local investors such as Korea Post on hedge fund strategy.

ôI give the government a lot of credit for realising it needs to do something, and for trying to address it, but this amendment won't really change things,ö says Bennett, who is working with the local chapter of the Alternative Investment Management Association to raise awareness of these issues.

The biggest obstacle, which is outside the remit of the Consolidation Act, remains tax. Locally domiciled asset managers with offshore funds that cater to local investors are subject to withholding taxes. And a foreign-domiciled fund that is managed onshore will also be subject to tax. This situation is akin to Japan's. Japanese hedge funds have fled to Singapore and Hong Kong to escape 'Permanent Establishment' issues. Japanese regulators have become more proactive about easing tax concerns and Korea's must do the same, Bennett suggests.

Right now even just having a research office in Korea can potentially open a fund to 'transfer pricing' policies, in which tax authorities can investigate whether there is a difference between onshore revenues and the numbers reported by the manager's headquarters overseas. The threat alone of such an investigation has prompted some hedge funds to leave Korea, say industry participants.

Tax lies outside of the Consolidation Act, but other, more directly relevant factors also have yet to be addressed. Paid-up capital requirements remain too high for start ups. Ambiguity remains regarding ease of shorting stock or using an offshore prime broker, and shorting amounts remain limited to $50 million per fund and requires that collateral be posted with the local depository. There is no mention of who counts as a qualified investor for hedge funds, which has been left to presidential decree once the Consolidation Act comes into force.

ôA lot of people, including even prime brokers, are under the illusion that the Consolidation Act will lead to an onshore hedge fund industry and even retail access to hedge funds,ö Bennett says. ôBut the Act as it now stands won't change things.ö