Basel II: Hedge Funds Risk...

Hedge Funds Managing Partners have been looking in the rear view mirror as they see the regulators following their every move. Oversight is not just a phenomenon here in the U.S. with the SEC and our own legislators. There is another international wave of change on the horizon:

Japanese banks may be forced to cut back their investments in hedge funds to comply with a global risk regulation.

Banks, pension funds, and insurers are among the largest Japanese investors in hedge funds. Japanese investors have quadrupled their hedge fund holdings during the past five years, to $35 billion.

The March 2007 deadline for Japanese banks to comply with Basel II, a regulation that will alter the capital reserve requirements for financial institutions, is what is causing the concern. The regulation could be especially problematic for smaller Japanese institutions, which manage more than one third of the country's $6.7 trillion of assets. Those institutions may be "incapable" of managing the associated risk under the new rules, one banking executive told Bloomberg News at a conference this week.

In some cases, banks will have to hold $1 in reserve for every $1 invested. Japanese regulators have yet to announce any guidance for complying with Basel II.

Here in the United States the pressure is building to develop more systematic compliance for hedge funds to address the growing corruption and fraud schemes.

Senate Judiciary Committee Chairman Arlen Specter, a Pennsylvania Republican, is circulating draft legislation that would require hedge funds accepting pension money to register with federal regulators. Hedge funds would also be forced to set up ethics codes and compliance programs, and allow the U.S. attorney general to reward private citizens for helping in insider trading cases.

Why all of the talk about regulation and oversight? With over 8000 hedge funds now controlling over $1 Trillion in assets it won't be long before the marketing gets pushed down to just the "high net worth" individuals. Having a place for pension fund managers to get some portfolio exposure on the other end of a risk spectrum is one thing. To move the access to these investment vehicles closer to the average consumer is now the concern.

The hedge fund industry has shown few signs of major fraud, but cases of wrongdoing may rise if more of these investment vehicles are sold to mass-market savers, international financial regulators said on Monday.

The sector does not appear to have high levels of dishonesty, but some national watchdogs fear risks of fraud could rise if these funds were to become more available to retail investors, the International Organisation of Securities Commissions (IOSCO) said in a report.

Hedge funds, traditionally a secretive industry domiciled in offshore tax havens such as the Cayman Islands, have come under growing scrutiny from central banks and regulators concerned about the sector's potential impact on financial stability.

Traditionally, hedge funds have been used only by wealthy individuals or institutions such as pension funds.

"The extent of fraud relating to hedge funds varies in the member jurisdictions ... the absolute number of fraud complaints is presently not high, although some regulators perceive a risk of greater fraud in the future as further retailisation occurs," the report said.