Financial regulators ready themselves to get to grips with the hedge funds

Notorious for their secrecy, hedge funds are - rightly - worried that the Financial Services Authority is coming after them. Hector Sants, the FSA's managing director, said last month: "Some hedge funds are testing the boundaries of acceptable practice concerning insider trading and market manipulation." He added: "It may not be simply a question of considering whether hedge fund managers act inappropriately but also whether their models (including the high commissions they generate and their trading methodology) may create incentives for others to commit market abuse."

Harsh words from the City's top watchdog, which has so far tolerated the activities of the unregulated, rapidly growing hedge fund industry.

Over the summer, the FSA has sought the industry's and other interested parties' views on whether new rules are needed, with the consultation period ending today. The regulator will consider the responses and publish its findings early next year. Risks identified by the FSA include "serious market disruption and erosion of confidence" as a result of the failure of a large hedge fund or a group of funds; as well as liquidity disruption as hedge funds make increasingly illiquid investments in particular markets and products while offering their investors the ability to withdraw their money more quickly.

The watchdog is creating a specialist unit that will supervise hedge fund managers more closely, and is looking for industry initiatives to improve hedge fund disclosure.

The Alternative Investment Management Association asserted yesterday that the risks posed by hedge funds were no higher than in traditional asset management, and warned over-regulation could drive the industry away from Britain. "No evidence has been offered to suggest that hedge fund managers are likely to cause any more disruption to the market than other players," the industry body said.

Catering for rich individuals, hedge funds pool investors' money and invest it in stocks, bonds or derivatives, but unlike traditional fund managers, they are subject to few regulatory controls. Many hedge funds pursue high-risk investment practices to maximise returns.

Hedge funds have mushroomed in recent years to about 8,000 worldwide, which manage a total of about $1 trillion (£560bn). That means that large numbers of funds may be exposed to the same positions and could be caught out simultaneously if events do not turn out as expected, with possible large knock-on effects for financial markets. Hedge funds have also attracted notoriety for the role they have played in corporate takeovers, notably the failed bid from Deutsche Börse for the London Stock Exchange.

Guy de Blonay, a hedge fund manager at New Star Asset Management, said yesterday: "There is an image problem [for the hedge fund industry] due to the fact that there is a lack of regulation. As soon as this improves, we will get a much cleaner picture."

The London-based GLG is under investigation by the FSA and French and Spanish market regulators, which are examining whether the firm traded on non-public information on upcoming convertible bond issues. Regulators are believed to be focusing on GLG's $1.85bn convertible-bond arbitrage fund which is run by Philippe Jabre.

The investigation into GLG centres on trades in convertible bonds (debt that converts into shares at a later date) issued by Japan's Sumitomo Mitsui Financial Group, the French media giant Vivendi Universal and the telecoms company Alcatel. The inquiries concern trading activity during the "pre-marketing" of offerings when security firms sound out investors about their interest in a bond or stock sale. It is a standard practice among banks but those contacted are barred from using the information for trading purposes.

GLG was set up in 1995 by Noam Gottesmann, Pierre Lagrange and Jonathan Green, who has since left, within Lehman Brothers. When they bought the fund from the bank in 2000, Lehman retained a 20 per cent stake. Like many hedge fund managers, the trio hailed from Goldman Sachs where they managed money for wealthy individuals. Talks about selling the fund back to Lehman broke down this year. Managing about $11.5bn, the partners have amassed huge fortunes, for their clients and for themselves, at their Mayfair offices.

M. Jabre, 45, is regarded as GLG's star trader and won an award for convertible arbritrage in 2003. He joined the firm in 1997 to take it into convertible bonds, then one of the fastest-growing areas of fixed income. He reportedly lives in one of the most exclusive areas in the Boltons, Chelsea, and, being a keen skier, owns a second home in Courchevel. He is a governor of London's Centre for Lebanese Studies and along with his wife, a supporter of the Royal Opera House.

An industry insider said: "GLG are thought to be quite aggressive. They will certainly test the rules to the limit." But with pre-marketing for offerings regarded as a bit of a grey area, many in the industry do not expect M. Jabre or GLG to be found guilty of market abuse.

On the other side of the Atlantic, the US Securities and Exchange Commission is concerned about rising levels of fraud within the hedge fund industry. Lehman recently filed a lawsuit against Wood River Capital Management, a hedge fund which allegedly lured the bank into a fraudulent stock-transfer scheme last month, costing a reported $8.6m.

The SEC said in a paper last year: "The growth in hedge funds has been accompanied by a substantial and troubling growth in the number of our hedge fund fraud enforcement cases."

In the past five years, the Commission has brought 51 cases of fraud against fund managers to the tune of more than $1.1bn. A spokesman for the SEC said hedge funds were structured in such a way that they fall below the thresholds that would trigger regulatory provision. But a new rule will come into effect in February that will require advisers to hedge funds to register with the SEC.

Meanwhile, Neil Wilson, at Hedge Fund Intelligence magazine, said scandals involving hedge funds had been largely restricted to the smaller players - "the cowboy fringe of the industry" in the US. He said the larger players had not been involved, referring to nearly 200 American funds that manage at least $1bn each and account for almost three-quarters of the global hedge fund industry.

Hedge funds certainly have to work hard to shed their negative image, as Man Group, the world's largest listed hedge-fund manager, acknowledged recently. Its chairman, Harvey McGrath, said the industry was "characterised wrongly by greed, ego, risk and opacity" and stressed the need to "educate commentators".

That will not be enough since hedge funds have finally caught the eye of regulators.