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Hedge funds' days of anarchy are numbered

Discussion paper of International Organisation of Securities Commissions (IOSCO) on valuation norms for hedge fund portfolios marks a long overdue move to bring some order.

The 32nd annual conference of IOSCO, global body of capital market regulators, is being held in India for the first time in April. The meet comes against the backdrop of growing anxiety among regulators the world over about the role of hedge funds.

Technically, India is out of bounds for hedge funds. But it is well known that many of them operate in India through the ubiquitous PN route. What is also well known is that both RBI and Sebi have reservations about PNs, with RBI being the more outspoken of the two. Early last week, RBI governor again expressed his concern over hedge funds.

Consequently, when regulators from more than 100 countries meet in Mumbai early April, hedge funds will be very much on their minds. Remember they now command investor capital to the tune of $1.5 trillion. Also, extensive use of leverage when making investments means hedge funds play an important role in global capital markets, with concomitant challenges and risks.

Chief among these is the difficulty in valuing complex, illiquid financial instruments. This is because of the nature of the investment strategies that many funds pursue and financial instruments that underlie them. In some cases, reliable market information about precise values for certain types of financial instruments is not readily available (eg., distressed securities and over-the-counter structured notes).

Such instruments can be difficult to value for many reasons, including lack of a liquid market, use of valuation models that rely on imperfect data and/or are dependent on the occurrence of a future event (the probability of which may be difficult to estimate).
But in a move that is likely to be the thin edge of the wedge as far as hedge fund regulation is concerned, IOSCO has recently (March 2007) come out with a discussion paper detailing nine principles on valuation of the investment portfolios of hedge funds. These are:

• The governing body of the hedge fund should ensure written policies and procedures are established which seek to ensure integrity in valuation process by covering issues like (a) the competence and independence of personnel responsible for valuing financial instruments, (b) specific investment strategies of the hedge fund and the financial instruments in the investment portfolio (c) and controls over the selection of valuation inputs, sources and methodologies.
• The policies should set out the methods to be used for each financial instrument. They should specify a framework applicable to both current and future instrument types in which the hedge fund anticipates investing.
• Persons who value financial instruments should apply policies and procedures and methods consistently. The policies and procedures and the methodologies should be applied to all financial instruments within a fund that share similar economic charact-eristics and applied across all hedge funds that have the same manager.
• The desirability of consistent application over time of the policies and procedures should be balanced with a periodic review of, and appropriate changes to, the policies and procedures.
• Independence should be embedded into the processes adopted for valuation and within any party appointed to undertake valuation responsibilities. The governing body should ensure that the parties involved in the valuation process have an appropriate level of experience, competence and that an appropriate degree of independence.
• There should be a review process for individual values generated by the policies and procedures to ensure their appropriateness. Some specific cases in which the risk of inappropriate pricing may be greater include cases where prices are only available from a single counterparty or broker source or valuations are influenced by the manager. Since experience and expertise to value complex and illiquid instruments in an appropriate manner may rest with a limited number of individuals, policies and procedures should include sufficient controls to ensure that an appropriate degree of objectivity is brought to bear in considering values that are obtained from external sources, such as counterparties and potential counterparties.
• In certain exceptional circumstances, the value of a financial instrument determined in accordance with the fund’s policies and procedures may not be appropriate. In such cases deviate from that value and use another.
• When a third-party is appointed, due diligence should be conducted to determine that the service provider has and maintains appropriate systems and controls and a sufficient complement of personnel with an appropriate level of knowledge, experience and training commensurate with the hedge fund’s valuation needs.
• Relevant information that should be made available to investors upon request. These principles are innocuous enough. There is bound to be a great deal of discussion (IOSCO has invited comments to its paper by June), especially since hedge funds have so far been a law unto themselves. But whether it will suffice to ensure that the next big financial crisis does not come from hedge funds remains to be seen.
Source : Economic Times

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