London’s powerful hedge fund community is failing to stamp out incidences of market abuse such as insider trading, according to the City’s top market watchdog.

The Financial Services Authority, led by the former investment banker Hector Sants, gave warning yesterday that it was planning a series of systematic checks on hedge fund managers and their anti-abuse measures.

It said it had been “disappointed” by the results of a number of informal visits it had carried out over recent months. “Some hedge fund managers had a high level of awareness and appropriate controls in place, while others were less aware, had fewer controls and demonstrated a complacent attitude to the risks,” the FSA said.

It told its membership in a regular newsletter, published yesterday, that it was laying out a “template” for how best to prevent market abuse. The FSA said it “expected things to improve”, stating that senior management needed to claim responsibility for policing against market abuse.

The authority also suggested that recording telephone conversations - a practice endemic at brokerage houses - had merits, as did naming a single staff member to deal with potentially sensitive information. The FSA’s formal visits should begin in the first quarter of next year.

Jonathan Herbst, a former FSA lawyer now at Norton Rose, said: “This is the FSA’s way of reminding hedge funds that clamping down on market abuse remains at the top of its priority list. It is saying: ‘Just because we haven’t brought that many cases so far, don’t get complacent because we are monitoring this extremely closely’”.

The FSA’s shot across the bows of the London industry, second only to New York in terms of assets under management, came as the European Commission called for some member states to crack down more on insider dealing.

David Wright, the Commission’s head of financial services policy, said yesterday: “We certainly think we would like to see more convergence - not harmonisation - of sanctioning regimes. To some extent in some jurisdictions they are not tough enough.”

In the UK, the FSA has not brought a criminal case against insider dealing since it took control of the issue in 2001. Yet according to a study into insider dealing published by the FSA in March, almost a quarter of formal takeover statements to the stock market in 2005 were preceded by questionable share price movements.

The Securities and Exchange Commission, the FSA’s American counterpart, boasts dozens of successful prosecutions each year. Mr Wright did not single out any regulators.

The FSA’s broadside comes less than a month after 14 of the biggest London managers, including Man Group and Marshall Wace, threw their weight behind a voluntary code of conduct. The principles, governing disclosure and transparency, were drawn up by the Hedge Fund Working Group under Sir Andrew Large, the former deputy Bank of England governor.

An FSA spokeswoman denied that the regulator was targeting the hedge fund industry, pointing out that the visits to hedge fund managers had taken place within the context of its general concerns about market abuse among financial services firms. She also said the regulator was not trying to undermine the voluntary code.

However, she said the regulator was engaged in a “pull your socks up” exercise and that shortfalls in areas such as compliance, system controls, training and dealing with inside information among hedge funds were widespread.

“In everyone we visited, there was an area where there was room for improvement,” she said. The FSA declined to go into detail about the number of funds it had visited. It said it had aimed for a representative section, covering firms employing anywhere between eight and 100 staff.

London’s hedge fund industry has exploded since the turn of the century. According EuroHedge, which compiles data on hedge funds, total assets managed by European hedge funds were $540 billion as at the end of June. London accounts for 77 per cent of the European total, Eurohedge said, with London-based hedge funds managing combined assets of $415 billion.

When EuroHedge conducted its first survey of the European hedge fund industry in 2000, there were just over 300 European hedge funds managing total assets of around $100 billion. Now there are comfortably more than 1,500.

However, the prevalence of hedge funds has led to worries that they are able to trade on insider knowledge of price sensitive events such as corporate takeovers.

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