By Daisy Ku

LONDON (Reuters) - Sovereign wealth funds may have transparency issues, but they stabilise markets and increase liquidity, the Financial Services Authority said in a report on Tuesday.

As the rising class of state-controlled investment groups in the Middle East and Asia bail out financial institutions wounded by the subprime crisis, concerns are growing among western countries that such funds act for political, rather than economic reasons.

Politicians and business leaders in the United States and Europe have proposed legislation to make it harder for sovereign funds, which control $3 trillion (1.5 trillion pounds) in assets, equivalent to 5.7 percent of assets under the management of mature-market institutional investors, to take over flagship firms.

"Processes to vet foreign ownership of strategically important firms ... could be viewed as a protectionist measure. This may prove disruptive to other participants trading in the same markets," the FSA said.

Germany, for example, is redrafting a proposed law to block takeovers by state-owned firms and investment funds.

French President Nicolas Sarkozy vowed to use France's state pension fund to defend French enterprises "in the face of a rise in the power of extremely aggressive sovereign funds".

U.S. President George Bush has also signed an executive order to tighten national security reviews of proposed foreign investments.

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