Updated January 2004

Hedge funds and derivatives are alternative types of investment that have rapidly become popular since the early 1990s. Hedge funds use a wide variety of trading strategies with the aim of making absolute returns irrespective of which way markets are moving. Derivatives are one of the strategies that hedge funds and other investment funds use to manage risk. They can either reduce or increase risk in order to maximise profit or minimise loss.

Until recently investment in hedge funds and derivatives has involved mainly rich individuals and private endowment funds who are considered to be able to cope with the potential complexity and the specific risks attached. However, there has been increasing interest in the retail sector to invest in hedge funds, or funds of hedge funds, which has led to debate about whether and how they should be regulated. The increased use of derivatives in investment products available to the public has raised questions about whether derivatives are coherently regulated in the various pieces of EU financial services legislation in which they are cited.

There have also been concerns about the impact of hedge funds and derivatives on market stability. The $3.6 billion rescue of Long-Term Capital Management, which came to the verge of receivership, was due to concerns about potential market disruption. Derivatives (or more properly their misuse) were blamed for the Barings downfall.

I was made draftsman of an own-initiative report, which the European Parliament passed on Thursday 15 January. In it I argued in favour of allowing access to funds of hedge funds and eventually direct to hedge funds for the retail investor. The EU should develop a light-handed regime for such alternative investment funds, which might also include funds investing in areas such as property, currencies or commodities. This would allow fund managers to benefit from a single European market and offer the investing public greater choice, whilst reassuring them that the funds were being responsibly managed. The regime would have to be sufficiently light-handed to allow the fund managers freedom in their investment strategies and to attract them to locate in the EU.

Investors must be provided with clear information about the risks inherent in investing in hedge funds, other alternative investment vehicles and in derivative products. A concerted education effort for investors, regulator staff and financial advisers is necessary. There must be stringent qualification requirements and regulatory control of those who sell and distribute these products and more needs to be done to ensure that there are adequate internal risk controls, particularly in corporates that are less-used to dealing with these types of innovative products. Banks and regulators will have to co-ordinate more in order to better assess accumulation of risk in financial markets so as to avoid damage to the international financial system.

The Commission, responding to my resolution, said they are awaiting a report from experts in April 2004 and will take this and the Parliament's position into account in deciding how to proceed.

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