Regulatory oversight of hedge funds may be costly

To hedge, or not, is a question which US regulators have decided to answer by bringing hedge funds under the lens to regulate the $1,500b industry. Hedge funds that straddle multiple definitions, whose dealings are well-regulated, unregulated, or at the best quasi-regulated, will be subjected to new guidelines. Investors and creditors will have to tighten up due diligence before extending credit to a private pool of capital.

These guidelines include the role of counterparties in managing their hedge fund exposures and spell out rules for hedge fund managers, investors, supervisors and regulators. Treasury officials have emphasised that relying on counterparties to manage risk does not take into account the inter-relationships between these parties. Creditors will have to undertake “stress testing” to quantify the impact of “adverse market events”.

Henry Paulson, treasury secretary and former Goldman Sachs banker, said that while the growth of hedge funds had been beneficial and had helped spread risk, they presented “certain challenges”, including the use of some over-the-counter derivatives.

Others share a different view. “Some people — when they talk about this — want to regulate them out of existence, as they don’t want shareholder activism,” Charlie McCreevy, EU internal market commissioner said.

Sebi had called a meeting of FIIs to discuss the issue and need for using participatory notes (PN) for investing in the equity market. Sebi plans to provide a direct entry into hedge funds to operate through the FII route and not through PN to avoid ambiguity about their origin.

As per RBI, there needs to be an assessment of risks involved in flows through hedge funds, PN, sub-accounts, etc. Strict adherence to know-your-investor principle, especially with regard to flows from tax havens, including beneficial ownership, would enhance quality of such flows, it has said.