A mid fears that hedge funds have become a shadowy and unregulated yet powerful force in the capital markets, the hedge fund industry is beginning to embrace increased transparency as a way to deal with these concerns and, perhaps, to keep regulators at bay.

In mid-October, a group of London-based hedge funds published a paper proposing best practices for the industry, largely focusing on increased transparency. The group, comprising 14 leading hedge-fund managers, proposes standards for dealing with issues such as valuation, risk management, disclosure and fund governance. Interested parties have until Dec. 14 to submit comments on the consultation paper before the standards are finalized. A final report is expected in January 2008.

The standards it calls for include: that funds’ asset valuation methods be robust and transparent and that any conflicts are disclosed; that fund managers develop an approach to dealing with risk that ensures the funds’ liquidity; that they have procedures to deal with conflicts between managers and investors; that hedge funds develop proxy voting policies; and that managers vote only when they have an underlying economic interest in a company.

Additionally, the group calls on regulators to require that all inves-tors — not just hedge funds — disclose their derivative-style holdings, including contracts for difference.

Coming from the industry itself, the initiative is designed to ward off potential efforts from outside to impose tighter controls on the industry. The group was struck this past summer in direct response to demands for tougher oversight from various authorities, particularly in Europe.

This pressure is rooted in concerns that hedge funds are too powerful and secretive, making them a potentially destabilizing force in the global financial system, and that they have been disruptive in shaking up moribund companies in recent years.

In May, the G-8’s finance ministers endorsed a report from the Financial Stability Forum assessing market stability issues and the systemic risks posed by hedge funds. In the endorsement, the G-8 ministers note that while hedge funds and innovations such as credit derivatives have enhanced financial system efficiency: “The assessment of potential systemic and operational risks associated with these activities has become more complex and challenging.”

The G-8 ministers have also endorsed the FSF’s recommendations for regulators, investors and hedge fund counterparties, and also support the FSF’s call for the industry to review and enhance its existing standards.

At the same time, in Canada, the standing senate committee on banking, trade and commerce held hearings this year on the subject of hedge funds.

It indicated that its concerns involve how, if at all, these types of financial products should be regulated to protect consumers. It was also concerned about their impact on the systemic stability of the domestic and global financial markets. The committee has yet to release any recommendations of its own.

The new report from the hedge fund working group in London is intended to address these and other concerns about the hedge fund industry. It also aims to shore up confidence in the sector and head off any potentially onerous regulatory responses.

In addition to recommendations dealing with concerns such as valuation and governance, the report calls for hedge fund managers to disclose more information about themselves on their Web sites and to the public in general. It also recommends establishing a board to oversee these practice standards and to keep them current.

The report acknowledges that the group has not addressed all the concerns regarding hedge funds — given the current environment, it focuses on liquidity issues — but it allows that investor protection issues will also require some attention in the future, particularly as retail investors become increasingly exposed to the sector.

So far, the effort has been well received. German finance officials, who have been pushing for more scrutiny of hedge funds, are said to be pleased with the initial report. It also helps that hedge funds have hardly had a role in the ongoing credit crunch that has seized financial markets since mid-August.

Sir Andrew Large, a former deputy governor of the Bank of England who heads the hedge fund working group — he is now chairman of a British hedge fund — calls the initiative “a significant step.

“It shows that the industry recognizes its responsibilities as a significant force in the financial system,” he adds.

@page_break@Although developing standards may be seen as significant, it remains to be seen how widely they are actually adopted by the industry. Adherence to the recommended practices would be voluntary, as the group has no power to enforce them. The group proposes that firms either comply with the standards or explain why they have chosen not to.

Presumably, the 14 firms that make up the working group are willing to go along with this effort. In addition, a number of other prominent British fund managers have endorsed the group’s creation but didn’t participate in its work. The initiative is also supported by the industry’s trade association, the Alternative Investment Management Association.

Although the working group’s initiative is focused on funds in Britain, there is hope that its recommendations could evolve into a global industry standard.

“If the [British] industry accepts the standards, then pressure would be applied to other industry participants to meet the sound practice standards, including Canadian managers,” suggests Phil Schmitt, chairman of the AIMA’s Canadian chapter and president and CEO of Toronto-based Summerwood Group Inc.

This pressure to comply would probably come from both clients and regulators, Schmitt notes.

So far, Canadian authorities have shown less concern about the role of hedge funds in the market. A report by the Investment Dealers Association of Canada published in mid-2005 examines the state of the industry and details a number of issues. But most of these centre on how hedge funds are finding their way into the hands of ordinary retail investors via structured products such as principal-protected notes.

Moreover, in early 2006, David Wilson, chairman of the Ontario Securities Commission, indicated that Canadian securities regulators “have pretty much determined that hedge funds do not require their own separate regulatory regime.”

Instead, he stressed that regulators need to ensure that hedge funds are adhering to rules such as those related to referral
arrangements. IE