Hedge Fund regulation – step up or step away

Before the recent downturn in the market, the hedge fund industry had the luxury of being positioned in a lightly regulated market with minimal reporting requirements and transparency.  This liberal mindset has allowed hedge funds to keep their investment strategies and the levels of their risk exposure under wraps, reports Lise Baril, manager – Enterprise Risk Services at Deloitte.

Market turmoil and a number of related financial blunders have, however, changed the landscape and also investors’ confidence in the marketplace. Hedge fund executives, investors and regulators around the world have been taken by surprise at the extent and scale of financial losses which resulted from the market meltdown and credit crunch. Not to mention the number of fiduciary trust violations.
 
Increased regulation, scrutiny and transparency are on the horizon for the hedge fund industry. Regulators are beginning to demand aggressive improvements in areas such as executive oversight, risk management and internal control. The aforementioned have typically been overlooked by hedge fund regulators and are gaining increased attention that will subject them to comprehensive independent third party reviews and examinations in the near future.
 
Akshaya Bhargava, chief executive officer at Butterfield Fulcrum, says increased regulation is inevitable.
 
“Regulators will likely require more frequent and detailed transparency reporting from hedge funds and administrators will become more necessary (and be held accountable by their clients) for the production of these reports,” he stated [Hedge Fund Review, 10 April 2010 – Margie Lindsay, Braced for Impact.]
 
On 30 December, 2009, the Securities and Exchange Commission finalised amendments to the custody requirements of Rule 206(4)-2 under the Investment Advisers Act of 1940 and related forms. The SEC explained that the amendments had been designed to increase the protection and security for investors who entrust their funds and securities to registered investment advisers. According to the changes, all SEC registered investment advisers with “custody” of clients’ assets will now be required to have an independent accounting firm conduct an annual surprise examination of those assets to verify client funds and securities. Additionally, if the investment adviser or a related person acts as the qualified custodian of client assets, the adviser must obtain an internal control report (i.e., Statement on Auditing Standards 70 Type II) that includes an assessment of controls relating to custody of client assets.
 
Developed by the American Institute of Certified Public Accountants, SAS 70 is a widely accepted auditing standard that has been used by hedge fund managers and fund administrators for some time. This standard enables service organisations to disclose their control activities and processes in a standardised reporting format. They can then issue this report to their user organisations (i.e., clients or customers, such as investors) and their auditors thus supporting that the organisation’s controls have been examined by an independent auditing firm. There are two types of service auditor’s reports issued for SAS 70 examinations. A Type I report examines the service provider’s description of controls at a specific point in time, while a Type II report also involves testing of controls over a minimum six-month period, which is updated annually.
 
SAS 70 is recognised as the global standard for reporting on controls at a service organisation and is quickly becoming the industry norm. Not only are auditors of the user organisations requesting an SAS 70 examination report to support their audits, but both existing and prospective clients are expecting an SAS 70 from their service providers.  An SAS 70 report gives users transparency into the service organisation’s control environment and control processes. In addition, an SAS 70 examination also serves as a risk management tool for both the service organisation and the user organisation by providing management with information to assist with their oversight responsibilities. Many service organisations are finding that, especially in today’s market, those that do not have SAS 70 examinations can be at a competitive disadvantage, sometimes getting passed over when trying to gain new business. In addition, investors are becoming more cautious and are frequently requesting SAS 70 reports for third party asset managers as part of their initial selection and ongoing monitoring. Sound governance will be a focus as clients and investors alike will want comfort that service organisations have effective policies, procedures and controls in place.
 
“Investors are demanding independent valuations and are increasingly looking towards larger, more established fund administrators that can provide robust controls, defined processes and transparency by way of risk compliance as well as traditional net asset value reporting,” advises Citi’s Richard Ernesti.
 
“Investors will demand greater sharing of information regarding investment options, underlying risk and operational procedures,” he adds [Hedge Fund Review, 10 April 2010 – Margie Lindsay, Power Shifts to Investors].
 
As the market evolves, investors and regulators will continue to call for greater assurance that investments are not exposed to potential failures in risk management or governance. Members of the hedge fund industry, from asset managers through to technology service providers alike, will need to meet those needs in order to gain the competitive advantage.

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Lise Baril, manager – Enterprise Risk Services, Deloitte

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