Accusing some funds of insider dealing and market manipulation, the chief City regulator outlined the many regulatory risks posed by the new breed of investor.

It also turned the spotlight on the lucrative relationships between hedge funds and investment banks, suggesting that these were leading to market abuse in some cases.

The report comes days after it emerged that Goldman Sachs had sacked a London-based managing director for tipping off Britain’s biggest pure hedge fund group, GLG Partners, about a price-sensitive transaction two years ago.

The FSA stopped well short of threatening a serious clampdown, arguing that, overall, hedge funds were beneficial to the financial system, providing liquidity and choice to investors. However, FSA officials will be more pro-active in investigating trading areas where hedge fund managers or investment bankers may have been tempted to stray.

One of these areas is convertible bond issues. Hedge funds are routinely made “insiders” in such deals, being told of the issue in advance on the understanding that they do not trade. However, the FSA suspects that some fund managers may have been tempted to deal in related classes of security or derivative.

A second area of concern is credit portfolio trading. The FSA fears that some hedge funds may be trading on the basis of non-public information, for example ahead of downgrades by debt rating agencies.

The FSA applauded the Takeover Panel’s plan to force hedge funds and other investors to disclose large holdings of contracts for difference or other derivatives that gave them effective control over the underlying shares in bid situations.

The authority said that the same rule changes in situations not involving a bid — which some blue chip company chairman are clamouring for — would require legislation. However, it is understood that the authority has lobbied the Department of Trade and Industry and the Treasury to introduce such legislation.

Addressing the danger of insider dealing, the report, compiled under the auspices of the former UBS banker Hector Sants, now the FSA’s wholesale markets chief, noted that there had been suspicious share price movements ahead of block trades and large bought deals.

It also raised concerns that “larger hedge fund managers might be tempted to use their size, or start market rumours, to deliberately move the market. . .”. It pointed to weaknesses in training on market abuse at hedge funds and the failure to tape phone calls, a routine precaution in more conventional City houses.

Another risk, it said, was the difficulty in accurately valuing complex and illiquid positions. But it said the risk of a major systemic jolt had been significantly reduced since the Long Term Capital Management collapse in 1998.

In a separate discussion paper, the FSA appeared neutral on whether to relax rules to make it easier for small investors to buy into hedge funds.

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