Hong Kong's Securities and Futures Commission is expected to release draft rules next week that will require hedge funds marketing their product to local retail investors to disclose information about their operations.

According to sources familiar with the situation, the draft envisages a high degree of regulation - one that is alien to the hedge fund community globally.

The implications of this have led some market participants to wonder why Hong Kong's regulators would take a radical step. This view speculates that disclosure rules for hedge funds may be a trial balloon for heightened regulation of the traditional mutual fund market in Hong Kong.

Hong Kong is a small jurisdiction. Regulators here tend to benchmark themselves against the United Kingdom or the United States, but rarely see the need or advantage in extending the regulatory regime further. Therefore taking a bold step on hedge funds raises the question of motive.

This assumes that the draft rules are indeed radical. So far they have only been distributed to six European hedge fund managers that have applied to the SFC to market their products here. Comments from the financial community have so far been made in the dark.

"It is quite a difficult process for the SFC and the industry because there is no common practice," says Rory Gallaher, partner at law firm Deacons. "The SFC feels that greater disclosure is required in the fund's narrative but at what level of detail I am not sure. It is hard to know the appropriate level; reports by mutual funds are impenetrable for most of us, so a clear-language requirement would be helpful."

The hedge fund managers in Hong Kong interviewed for this story agree that transparency is good, but wonder how helpful any disclosure requirements will really be. There is no template for this: jurisdictions such as Britain and America do not allow the retail sale of hedge funds, so the issue of public disclosure doesn't arise.

Henry Lee, managing director at Hendale Asia, hasn't seen the draft rules but thinks they should mirror disclosure requirements for mutual funds, such as listing the fund's top 10 positions and its geographic spread, and maybe include net leverage. He thinks including information such as what companies a fund is shorting will be too sensitive.

Even that much could be problematic, says George Long, managing director at Long Investment Management, not because it is a burden but because investors won't be able to use that information in a meaningful way. For example, saying a convertible arbitrage fund is leveraged eight times is totally different than saying a long-short equity strategy is leveraged eight times. Moreover, degrees of leverage that may seem extreme in one market condition may be appropriate in others.

Long does add, however, that he thinks the SFC is right to do this. "I applaud the SFC for dealing with this," he says. "More disclosure is better, but interpretation is difficult." The problem is simply that few investors in Hong Kong are savvy enough to use such information well, even in traditional, long-only funds. Long notes that a mutual fund can be leveraged up to 25%, and funds covering GEM stocks or small caps in Hong Kong or regional markets are riskier than many hedge funds û and perfectly accessible to retail investors.

Therein may lie the rub.

The SFC is more than aware that many mutual funds are risky and that investor education levels are too low. It wants to improve disclosure and not just tag along what the US and the UK do, but be part of the international trends in regulation.

So it is going to insist that hedge fund managers that want to play in this market will have to disclose a lot more than just their top-10 holdings. They will have to provide detailed information about Sharpe ratios and drawdowns. Moreover they will have to use international accounting standards (IAS), not US generally accepted accounting principles (GAAP). The standards are not compatible, so even though most of the hedge fund industry follows GAAP rules, they will have to change or launch a separate product to operate in Hong Kong.

This seems like too much to ask. The regulator is said to want to do this because it wants to be able to compare hedge fund accounts with those pooled funds used in the Mandatory Provident Fund system.

Interestingly, mutual funds registered in Dublin use GAAP. This implies that once this new disclosure is put in place, the SFC will then seek to require Dublin-listed funds also report using IAS û or quit the market.

The logical conclusion is that all pooled asset vehicles in Hong Kong will have to comply with the same level of disclosure and accounting principles as will be applied to hedge funds. At some point this will leave Hong Kong with a possibly smaller but more advanced asset management regime, one that is progressive and well-regulated û to the point, say some, that it will be considered by mainland authorities as a safe staging ground for introducing offshore mutual funds to China.

The SFC is in for a long autumn. It is going to be accused of being regressive or reckless. It is going to be accused of abandoning free enterprise. It is going to be accused of being China's errand boy. Critics will say these rules will only make business a chore, not easier, and that Singapore will be the beneficiary. This, combined with an outstanding controversy about taxing the funds industry, will make small Hong Kong too difficult to be worth the bother.

The SFC will argue that it has long wanted to standardize performance data, and that it will be the first in Asia to do so. It will assert that these gradual moves will bolster public confidence in the funds industry. It will claim these moves are part of a global trend and are not regressive, and are not designed to please Beijing or upend the industry, but to make Hong Kong the Asia-Pacific's most advanced market for asset management.

The stakes are massive, the risk is high. The first step begins next week with hedge fund draft disclosure rules. The topic will dominate the headlines for months to come.