Fears of hedge-fund meltdown prompt FSA to launch probe

John Tiner, the chief executive of the Financial Services Authority, has launched a wide-ranging investigation into the workings of hedge funds in London which is expected to lead to a massive shake-up in the way they are regulated.

The probe was prompted by concerns that certain of the "cutting-edge" trading practices in the £500bn industry, much of which is based in London, could lead to market abuse and financial instability. There are also fears that a massive financial scandal could be brewing after what was described by an industry insider as "a few near misses".

Regulators from the FSA have been visiting scores of hedge funds in recent weeks, often sitting in with traders and checking dealing data. They have also been taking written submissions from leading hedge fund managers and talking to traders who deal with them at the large investment banks.

It is hoped that a report on the hedge fund industry, which will recommend new reporting and regulatory procedures, will be on Mr Tiner's desk by the end of next month. He is expected to send it out to the City for consultation before any new systems are put in place.

The FSA is concerned that hedge funds are having a disproportionate influence on the markets, increasing volatility and adding to trading risks.

It has also been concerned that it is not up to speed with some of the highly sophisticated trading strategies that have been developed in this fast-moving sector.

Hedge funds are different to traditional "long only" fund managers because of their use of derivatives to "short sell" - selling shares without owning them - and the use of borrowings to increase the amount of money they put in the market far beyond the value of the fund.

Alan Greenspan, the chairman of the US Federal Reserve Board, warned last week that a disaster might be brewing in the hedge fund sector because of the level of borrowings. In the US, unlike in the UK, the industry is not directly regulated.

In London, the sector has been riddled with rumours and accusations after many top funds delivered less than stellar performances.

Jonathan Bailey, the founder of the Bailey Coates hedge fund, accused rivals and investment banks last week of causing his company difficulties though aggressive trading strategies. "There has been speculative short selling against our positions - that is a fact," he said.

A few weeks ago, the market was gripped with rumour - which proved to be untrue - of an FSA investigation into the relationship between Goldman Sachs and Marshall Wace, a £7bn hedge fund.

Marshall Wace is one of the stars of the London market, famed for its Trade Optimised Portfolio System (TOPS), which relies on electronic inputs from investment banks vying for a rumoured £130m of commission handed out by Marshall Wace.

An internal Goldman Sachs probe found there had been no improper conduct.