Hedge funds are relying too heavily on their open-plan office arrangements to overhear and prevent illegal trading activities, Britain's financial watchdog has warned.

Following its latest programme of visits to assess UK-based hedge funds' controls for monitoring staff trading activity and preventing market abuse, the Financial Services Authority said there is "scope for improvement".

In its Market Watch newsletter for October, the regulator said: "Of particular concern was an over reliance on an open-plan office setting for overhearing suspicious activity and a reliance on counterparties or other staff to detect irregular trading behaviour."

"There was little monitoring of potential manipulation around valuation dates, and insufficient review of 'day trades' around announcements, with management concentrating on monitoring end of day positions," it added.

Hedge funds are regarded with suspicion in some quarters due to the opacity of their trading strategies. Some have blamed the industry for exacerbating the market volatility during the credit crisis as hedge funds sought to make a profit while stocks fell.

SHORTING BAN

In March this year they were accused of spreading rumours about HBOS in order to profit from short-selling shares in the mortgage lender. As similar rumours surfaced again last month, the FSA led a global move to ban short-selling on financial companies.

In its newsletter, published late Thursday, the regulator also raised concern that the use of long-term remuneration structures has led to an "overly sanguine" attitude towards market abuse risk among hedge funds.

Firms believe that by rewarding managers for long-term performance they remove the incentive to engage in market abuse in order to pursue short-term gains.

However, the regulator said that although this can mitigate the risk, managers concerned about losing their job due to underperformance would still have an incentive to focus on short-term returns.

The regulator said the use of "reason for trading" records was a good initiative especially as the size of many hedge funds argues against sophisticated detection systems and places greater reliance on management information and compliance overview.

The FSA said its observations will inform future risk assessments as it continues to monitor the issue.