why are hedge funds important to financial market and important clients of investment banks?

Answer 1

At the outset, please note that the jury's still out on whether hedge funds are important to financial markets. The latter can function without the former but vice-versa is not possible. Different people/markets perceive hedge funds in different ways. To some, they are very dynamic, aggressive and innovative while some others perceive them to be risk to the financial system (for eg Mohammed Mathir of Malaysia). Regulators in US and UK have identified the following risks vis-a-vis Hedge funds:

Regulatory Concerns – US, UK & IOSCO

A. Concerns in the US
In the Study, SEC has outlined the following regulatory concerns:
1. Lack of Regulatory Oversight
• Inability to detect fraud and other misconduct at an early stage
• Lack of meaningful information about Hedge Fund and their advisors
2. Valuation concerns of Hedge Fund Portfolio Securities
3. Increasing Retailization of Hedge Funds
4. Disclosure issues
5. Conflict of Interests vis-à-vis different clients and also Prime Brokers
6. Concerns about General Solicitation

B. Concerns in the UK
Financial Services Authority, UK has identified the following concerns vis-à-vis regulation of hedge fund:

1. Serious market disruption and erosion of confidence in case of failure of large-sized Hedge Funds
2. Market abuse / insider trading and manipulation
3. Control and Operational issues
4. Preferential treatment of certain investors
5. Retailisation
6. Mis-valuation of complex illiquid instruments/fraud

IOSCO - International Organisation for Securities Commissions concerns

IOSCO has recently published a paper titled "Principles for the Valuation of Hedge Fund Portfolios". This paper outlines high level principles that should be utilized by hedge funds to control the valuation process when valuing financial instruments within their investment portfolios. It seeks to tackle challenges arise when valuing illiquid or complex financial instruments and because of the central role that the hedge fund manager may have in contributing to valuations.

As far as Hedge Funds and Investment Banks are concerned, one of the current emerging avenues for earning incomes apart from traditional advisory and investment banking is prime brokering. A Prime Broker is a one stop shop for hedge funds providing a host of services which a hedge fund can pick and choose from such as:

•Custodian services
•Capital Introduction i.e seeding
•Securities lending
•Office Space Leasing and Servicing
•Financing and Valuation
•Risk Management Advisory Services
•Operational support
•Research and Consulting Services

Investment Banks also tend to sell hedge funds structured i.e financially engineered products which are customized to their specific needs. Hence the importance I-Banks attach to hedge funds.