Protecting hedge funds from fraud

Hedge funds have distinct product and market characteristics that make them vulnerable to money laundering, fraud and even terrorist financing.

They are manager skill-based, which means there is a certain level of proprietary knowledge involved in the asset selection and trading strategy of the fund.

Dion  Bodden

Dion Bodden

In addition, most funds are based in offshore tax jurisdictions and are not regulated, which means they are not obliged to disclose their holdings.

Meanwhile, the recent trend of retail hedge funds makes these products more accessible with lower minimum investments than what has historically been the case.

Because of these risks, hedge funds are increasingly attracting regulator attention, and may be subject to more rigorous regulation in the near future.

Hedge funds may be the most susceptible to money laundering of all unregistered investment companies (such as venture capital or private equity) because of the relative liquidity of their interests and their structures. Hedge funds allow investment and valuation on a monthly, quarterly or annual basis.

It is typical for money launderers to seek investment vehicles that are less likely to detect or report their activity. The secrecy and weak regulation that characterises this market segment, along with the rapid proliferation of funds, have combined to create a host of circumstances that make hedge funds susceptible to perpetrators of fraud and money laundering.

It is common for each investor to meet minimum income and net-worth standards, with funds open only to qualified purchasers’ or ‘accredited investors.

Even though fund managers or administrators often know their customers through pre-existing relationships, it is important for them to gather Know Your Customer information on potential investors to determine whether the investors meet minimum requirements.

Nevertheless, investors often use intermediaries that do not divulge the identity of the end-investor to the fund managers. Investor intermediaries and nominees may introduce their investor clients to a hedge fund, or may invest in hedge funds on their clients’ behalf. Similarly, a fund of funds may make investments in a hedge fund on behalf of its investors. KYC plays an important role in reducing the risk of money laundering and terrorist financing.

Based on the above, fund administrators can play a significant role in helping to mitigate the previously mentioned risks. In many cases it is up the fund administrator to manage the risk for the processing of subscription documents, and to ensure compliance with anti-money laundering laws and regulations applicable in the fund’s jurisdiction.

By implementing policies and procedures for AML and monitoring client relationships, administrators are able to concentrate on the relevant legal and regulatory requirements (where applicable). It is also the responsibility of administrators to maintain appropriate client records and to identify and report any suspicious transactions or activities. Due to the nature of the business, administrators often have direct contact in maintaining the primary relationship with the investor, they are often best suited to perform the procedures for KYC.

As a result, a hedge fund may, directly or indirectly, rely upon the investor identification and verification procedures performed by such third parties.

Strong AML and KYC controls are just a couple of the key risk management areas for administrators to focus on. However, it is also important that the administrator have a robust overall control environment. One effective tool for identifying and mitigating the operating risks and ensuring there is an effective control environment is the Statement of Accounting Standard No 70 (SAS 70).

This audit reports on the processing of transactions by service organisations, and provides guidance to companies that outsource accounting tasks to service organisations. The new standard is intended for all entities that use a service company for conducting transactions and maintaining related accountability and/or for recording transactions and information processing.

These entities would therefore include electronic data processing service centres, bank trust departments and mortgage banks. SAS 70 also provides guidelines to auditors engaged by service organisations to report on the internal control policies and procedures that have been adopted.

Guidance is likewise given for testing the effectiveness of the internal control structure. The issuance of SAS 70 internal control reports has become an industry practice for custodians, investment advisors, and transfer agents.

Lastly, an SAS 70 can benefit clients by lending credibility to a service provides/organisations control procedures, and by providing a marketing leverage against competitors.

Dion Bodden is a Senior Consultant in the Enterprise Risk Services group of Deloitte in the Cayman Islands. He has a Bachelor of Arts Degree in Business Administration with a major in Finance and minor in International Business. As a senior consultant with Enterprise Risk Services, Dion specialises in risk management for the off-shore financial industry. Since joining Deloitte, Dion has assisted in the evaluation of system and business controls, and has worked with financial auditors to provide risk assessments over financially significant operational controls and procedures. He can be contacted at [email protected] or via + 1 (345) 814-2294.