Britain’s financial markets watchdog has proposed a crackdown on hedge funds and other investors that secretly build stakes in listed companies using derivatives to cover their tracks.

The Financial Services Authority (FSA) said that it wanted to secure greater disclosure of holdings in derivatives known as contracts for difference (CFD) because the existing regime risks “creating market failures”.

The proposals — which include giving companies the ability to “flush out” investors who hold large stakes through CFDs — are aimed at weakening investors’ ability to creep up on listed companies by announcing, without prior warning, that they own a significant stake. Such stake-building “by stealth”, as the FSA calls it, is useful for certain kinds of activist investors, but it is seen generally as detrimental to the market because it allows investors to gain influence over a company without actually buying its shares.

Under stock exchange rules, an investor can buy up to 3 per cent of a UK-listed company before it has to declare its holding. However, the investor can effectively boost its holding by buying CFDs in the same company.

CFDs, which according to FSA estimates drive 30 per cent of standard share trading, are a form of derivative that gives the buyer an economic interest in the underlying share without actually owning it.

This carries two main benefits: exposure to the company’s share price and, in many circumstances, the ability to exert influence over the company because, although they do not own the shares, the CFD holder can still gain access to the voting rights. Since this can all be done in secret, it means that an investor with a relatively small, or non-existent, stake in a company’s shares can acquire significant influence.

Commenting on today’s proposals, Sally Dewar, the director of markets at the FSA, insisted that it was not “a clampdown on CFDs” but rather a means of “addressing concerns about their use on an undisclosed basis”.

Michael Hatchard, a corporate partner at Skadden, Arps, Slate, Meagher & Flom, the legal firm, welcomed the proposals, saying that they would improve market transparency: “They will not only level the playing field but allow us to see the players without substantially increasing the burden on CFD holders.”

The FSA outlined two proposals on how to tighten up on CFD ownership.

The first would require disclosure of all CFD positions giving the investor more than 3 per cent of the total voting rights of a company, unless it was clear that the holder could not exercise the equivalent votes and there were no arrangements in place for the CFD holder to take ownership of the underlying shares after the CFD deal terminated. Since many CFD deals contain these two conditions, the holders would be exempt from disclosing their stakes and the move would not burden the market with extra costs.

The second approach is to introduce a more general disclosure regime requiring CFD holders to disclose all economic interests above 5 per cent. Although simpler, this method would be costlier to the CFD holder and to the wider equity market.

Jonathan Herbst, a former FSA lawyer who is now a partner at Norton Rose, said: “It is difficult to resist the policy objectives behind this, although some may not agree that this degree of extra regulation is needed.”

James Palmer, a partner at Herbert Smith, the law firm, said: “Although some investors, particularly hedge funds, may not like these proposals because of the extra costs involved in complying with them, they are seen as a means of providing real transparency in an increasingly complicated market and so the FSA is very likely to introduce them in some form.”

Making a difference

— Leading players in two of this year’s biggest deals have used contracts for difference (CFDs) to build stakes in their respective targets without alerting the wider market. Robert Tchenguiz, the property investor, above, built a stake of about 10 per cent in J Sainsbury through CFDs

— Hugh Osmond, chief executive of Pearl Assurance, also used CFDs to build a stake in the insurer Resolution that was larger than it seemed

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