The UK’s Financial Services Authority says that hedge funds are an important part of the financial system, although it plans to enhance its supervisory focus in a couple of areas.

The FSA published its feedback on a discussion paper, which looked at the impact of hedge funds on the UK’s wholesale market. It notes that the FSA continues to view hedge funds as an important part of the financial services system providing a major source of liquidity and enhancing market efficiency.

However, the regulator says that in order to increase its understanding of the activities of hedge fund managers, it wants firms to identify their prime broker, third party administrator and the fund auditor in the reports they send to the FSA. It also plans to increase scrutiny of asset valuations, and possible preferential treatment of certain fund clients.

In terms of valuations, it says, “Hedge fund managers may be exposed to conflicts of interest as their remuneration is based on performance and assets under management. This may create an incentive to overstate the valuations it provides to administrators, who may not be able to challenge them.” It notes that regulatory visits are currently being carried out in this area and the findings will be known in the third quarter this year. Also, the FSA has also sponsored an IOSCO project on valuing complex and illiquid assets in hedge funds.

The regulator also warns that, “Failure by hedge fund managers to disclose that side letters have been granted to certain clients may result in some investors receiving more information and preferential treatment to other investors in the same share class. The FSA expects managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise.”

In a separate notice, the FSA also says that it will consider extending the range of retail investment products that are available, including authorized funds of hedge funds. The FSA plans to consult next year on widening the range of funds that can be marketed to retail investors to include new authorized funds of hedge funds. “This would enable retail investors, who are already gaining access to products with hedge-fund investment characteristics through a variety of means, to invest in products that would be subject to the FSA’s regime for authorised collective investment schemes,” it explains.

“The funds would be subject to structural and operational safeguards including the requirement to have an independent depositary. In addition, the fund of hedge funds managers will not be able to invest into all hedge funds – there will be liquidity criteria, for example, in respect of the underlying funds. This should enhance investor protection whilst allowing increased investor choice,” it adds.

“Retail investors can currently gain access to products with hedge-fund investment characteristics through a variety of means, including listed funds of hedge funds, funds offered on the internet from European jurisdictions, structured products linked to hedge fund indices. Given the reality of the contemporary retail market, it seems sensible to permit the marketing of funds of hedge funds through an authorised, onshore vehicle,” says Clive Briault, FSA managing director for Retail Markets. “These onshore funds of funds would benefit from the protections already in place for authorised funds. We also need to consider how we can help consumers to understand the features and risks associated with these products.”

The discussion paper on retail investment products identified three risks to consumers posed by the current suite of retail investment products. These were: lack of consumer understanding of newer products; confusion over the sales and distribution channels used; and possible detriment caused by marketing prohibitions on certain unregulated funds.

In addition to consulting on a possible extension of the range of authorised collective investment schemes the FSA proposes to focus on two additional areas of relevance to the wider range of investment products currently in the market: consumer education and awareness and product provider accountability.

The FSA will reinforce its existing consumer information and awareness work, stressing the increasing need for consumers to invest proportionately across a range of products, to read the disclosure material they receive, and to seek financial advice when necessary. And, it will examine the role that product providers and distributors play in ensuring customers are treated fairly, primarily through the provision and use of product information.