UK - Direct regulation of hedge funds is not "appropriate" as they "do not pose a systemic risk to financial stability", the UK Financial Services Authority (FSA) has claimed.

In a speech to a European Parliament committee hearing on hedge funds and private equity, Dan Waters, sector leader for asset management at the FSA, revealed the organisation's regulation of hedge funds focuses on the managers themselves and the banks which finance and support the strategies.

However, he claimed it was not the role of the FSA to "second-guess" hedge fund investment strategies, or prevent "those who invest in them from losing money", as the "vast majority" of investors in hedge funds are institutional or sophisticated investors with access to portfolio investment advice.

"We expect investors of this nature to exercise a substantial degree of responsibility for their investment decisions and to bear the risks of high rewards and significant losses that can occur," he added.

As a result, the FSA said it "fully agreed" with the conclusions of the European Parliament's recent report on hedge funds and financial stability, which were "direct regulation of hedge funds did not seem to be appropriate".

Instead, Waters concurred "indirect oversight of hedge fund activities through active regulation of banks (brokers and creditors) and hedge fund managers was the better approach".

He said the FSA believed hedge funds are "neither the catalyst nor the drivers of the current financial market turmoil", as like other institutional investors they "have shared in the pain" resulting from serious failures in the US sub-prime mortgage market and securitisations backed by such assets.

That said, Waters admitted the FSA also shared the European Parliament's opinion which officials argue the main risk to financial stability "resides in hedge fund failures that may bring down a bank and thereby also endanger the stability of other banks and the payment system".

To combat this, Waters confirmed the FSA's regulatory efforts are "focused less on the question of whether particular hedge funds may or may not be losing money and more on the interaction of hedge funds with the banking sector which finances their activities and which itself is central to the sound, safe and efficient operation of the financial system".

He claimed the FSA's approach to regulating hedge fund managers and managing systemic risk is "robust and appropriate", as demonstrated by the relatively small losses experienced by banks after hedge fund failures in the current market turmoil.

Waters said the FSA disagreed with the findings of a Working Paper issued by the European Parliament at the end of 2007, claiming hedge funds "operate in the shadows" and use investment techniques which are "largely unregulated", as he highlighted the vast majority of financial instruments are traded on regulated investment exchanges or transacted with regulated counterparties such as investment banks.

He also suggested the rationale behind having lightly or unregulated pools of capital, such as hedge funds, alongside tightly regulated institutions such as pension funds, insurance companies and banks, is hedge funds "do not pose a systemic risk to stability".

Waters pointed out, in contrast, banks and insurance companies need to be highly regulated as they are "critical to the economic infrastructure", and as pension funds represent the long-term financial future of millions of relatively unsophisticated retail investors, they are "important enough to merit direct regulatory grip in the interest of protecting the underlying members".

However, he claimed: "The evidence on hedge funds, on the other hand, is that they do not pose a systemic risk to stability; hence their regulation may be expected to differ significantly from that applied to banks.

"Moreover, hedge fund investors are overwhelmingly institutional or sophisticated individual investors, who are in a position to assess the risks involved and bear responsibility for their decisions, profitable or not," he added.

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