In last month's article, we looked at the background to, and an update on, the UK Inland Revenue's taxation of offshore funds.  Alongside the Inland Revenue's review in August, 2002, the UK's Financial Services Authority (FSA) issued a consultative paper on the regulation of hedge funds. The consultation closed at the end of November, 2002.

This consultation has undoubtedly been inspired by the increasing interest in hedge funds and the potential threat posed by other juris- ictions whose approach to regulation of hedge funds is more sympathetic than the current regime in the UK. It also has to be seen in the context of an overall review of regulation of funds scheduled for early 2003 and the UCITS Directive on which FSA issued a consultative paper in January, 2002.

Hedge funds are classified as unregulated collective investment schemes, whatever their structure, and they cannot be made freely available to retail investors. They can only be made available to regu-lated entities, professional and institutional investors, companies and high net worth individuals (classified under FSA rules as market counterparties and intermediate cus-tomers).

Retail investors (classified under FSA rules as private cus-tomers) can invest in hedge funds but only where an authorised intermediary has taken steps to ensure the particular investment is suitable for that investor. Retail investors are excluded from participating in many hedge funds, due to the high minimum investment typically required. FSA noted that, should a retail investor invest in a hedge fund, there would be few protections available to them. They would only have recourse if a regulated intermediary had advised them to make the investment. Unregulated collective investment schemes are outside the scope of the FSA regulation.

Hedge funds invariably fail to meet the listing criteria under the UK Listing Rules but a few fund of funds products investing in hedge  funds were listed and marketed as ISAs in early 2001. The FSA's response was to publish an alert, warning investors of the risks of investing in these products. Unsurprisingly, few, if any similar products have since been made available.

In the consultation, FSA raises concerns harboured about the activi-ties of funds themselves, including concerns about the potential sys-temic risk posed by high-leveraged funds and short selling (one of the primary reasons for hedge funds being ineligible for a London listing).

The consultation seeks views on whether there is a case for relaxing rules on the promotion of hedge funds, allowing them to be made more widely available to retail investors.

Furthermore, FSA does not envisage any change in the rules limiting hedge fund investment only to intermediate customers and market counterparties. The Association believes that the ability of retail investors, who would normally be classified as private customers, to opt-up to intermediate customer status, is adequate. However, FSA acknowledges that this option will only be pursued by the sophisticated retail investors and any regulated intermediary is unlikely to find this opt-up attractive, as it imposes a burden on them to ensure that the opt-up has been properly made. This involves the intermediary in assessing the experience and under-standing of the investor before making the opt-up.

The solution FSA appears to be aiming at is that certain types of hedge fund could come within the scope of authorised funds or within the scope of the Listing Rules.

Regulated funds are subject to various obligations and restrictions designed to provide protections for retail investors, including restrictions on the available investment (generally they can only invest in shares or money market instruments), and diversification requirements, which include limits on exposure to any particular investment and limits on borrowing. The wide variety of hedge fund types is such that FSA does not envisage hedge funds will become a new class of regulated funds. Currently, only moderately geared futures and options funds are capable of authorisation. There will undoubtedly be some tension between FSA's objective of achieving consumer protection through a low risk product and achieving higher returns. The alternative of allowing hedge funds to list with suitable risk warnings is also put forward. The consultation paper indicates that the level of risk they are prepared to allow retail investors on the short side would be limited to 20% or less.

The paper also considers fixing a high minimum, although FSA expresses concerns as to whether it could be maintained post issue.

In November, 2002, Howard Davis, FSA chairman, told the Treasury Select Committee that FSA was proposing new rules for split capital investment trusts calling for greater clarity of policies, gearing and providing appropriate risk warnings. Consequently, it is likely that FSA will proceed cautiously in relation to changes in the regulation of hedge funds. It is unlikely that we are going to see the results of the consultation any time soon or any significant changes to the regulation of hedge funds in the near future.