The Regulation of Hedge Funds

Is more needed, and if so, where?

Originally published in the April 2009 issue

It is universally acknowledged that hedge funds did not play a major role in the emergence of the global banking crisis. Nonetheless the crisis has spawned a number of proposals for greater regulation of hedge funds. The potential systemic impact of hedge funds on financial markets is cited as the justification.

Regulatory issues for hedge funds fall under three broad headings. First; prudential regulation (the extent to which hedge funds pose a systemic risk to the financial markets); second, investor protection (the extent to which hedge fund risks are disclosed to investors and how conflicts of interest between the managers and investors are managed); and lastly, market abuse (the extent to which there is a risk that hedge funds may commit a marketabuse, for example, abusive shortselling practices).

There is at least a logical connection between prudential regulation and a concern about the systemic risks which hedge funds might create. There is a rather more tenuous connection between the banking crisis and the need for regulatory reform to protect the interests of sophisticated hedge fund investors or to reduce the risks of insider dealing or market manipulation by hedge fund managers. This note considers the extent to which proposed regulatory reforms are legitimately linked to systemic risk concerns and whether the prudential regulatory reform proposals are proportionate to the systemic risks identified.

The boom and bust cycle
The only certainty is that the economic cycle of speculative asset appreciation followed by a sharp correction in asset values will recur. During a boom period with easy credit, investment returns or yields on traditional low risk or safe investments may diminish. Investors will seek better returns employing greater credit leverage and investment in riskier assets and financial products (whether or not the investor consciously appreciates the real extent of risk assumption). These circumstances may in turn result in artificial asset price inflation (of one or more of any number of potential asset classes such as technology stocks, real estate or securitised subprime mortgages) until that bubble eventually bursts.

Management of the boom and bust cycle is principally a matter of macro economics, a matter of governmental and central bank monetary and fiscal policy. An increase in the quantity and quality of overall bank and other financial institution capital (including countercyclical capital buffers), may reduce the risk of reckless bank lending and credit extension accentuating a boom but is probably not central to the prevention of a speculative boom in stock markets, real estate and so forth. The risk posed to the general economy by the speculative cycle, is more directly managed by general economic tools than the prudential regulation of financial institutions.

The regulatory reforms proposed are not so much about the prevention of a speculative bubble but are principally concerned with preventing the insolvency of financial institutions when that bubble bursts, if their failure may cause systemic harm to the ongoing operation of the financial markets. If the public believe that the raft of regulatory reforms now proposed have the main objective of preventing development of a speculative bubble or protecting the value of their fund investments in the next speculative bust, then they may be sorely disappointed.

Hedge funds and systemic risk

Systemic risk means a risk to the effective operation of the financial markets to support the general economy. Banks are particularly important because the failure of a bank can cause considerable consequential damage beyond holders of its securities by the creation of a run on other banks, a loss of confidence in the interbank money markets, disruption to the interbank payment system and loss of finance facilities for its business and consumer customers. The failure of a long-only investment fund with limited gearing, on the other hand, will mean losses to its investors but little likelihood of further significant consequential damage. Hedge fund strategies employing credit leverage and derivative investments to generate higher investment returns create counterparty risks for banks and primebrokers that provide finance and trade with hedge funds. To the extent banks and primebrokers do not hold adequate collateral for a hedge fund default and do not have adequate capital to absorb unsecured losses on a hedge fund default, then in those circumstances a systemic risk may arise if the hedge fund default were to be large enough.

The main regulatory reforms proposed

The Larosiere Report (February 2009): [1] The Larosiere Report recommends the imposition in all EU member states and internationally, of registrationand information requirements on hedge fund managers, concerning their strategies, methods and leverage, including their world wide activities; and the introduction of capital requirements on banks owning or operating a hedge fund.

The FSA Turner Report (March 2009):[2] Against a background where UK hedge fund managers are already subject to authorisation requirements the Turner Report recommends that regulators internationally have the power to gather much more extensive information on hedge fund activities and that regulators have the power to apply appropriate prudential regulation (e.g. capital and liquidity rules) to hedge funds or any other category of investment intermediary, (or to otherwise restrict their impact on the regulated community) if at any time they judge that the activities have become bank-like in nature or systemic in importance.

The IOSCO Report (March 2009):[3] The IOSCO Report recommends (i) the registration/authorisation of hedge fund managers internationally for the purposes of monitoring systemic risks; and (ii) the imposition of independent risk management function requirements on managers with respect to their unregulated hedge funds. The Report stops short of a recommendation that regulatory registration/authorisation requirements be imposed at the level of the (underlying) hedge funds as well as on-going prudential supervision of the fund manager (but which some members of the IOSCO task force favoured). The IOSCO Report also makes recommendations relating, not to prudential regulatory issues, but to the issue of investor protection. Information is identified that regulators should have the power to obtain, to monitor manager remuneration structures and manage conflict of interest issues between investors and fund managers.

US Treasury Announcement (26 March 2009): Tim Geithner, the US Treasury Secretary, has announced a proposed regulatory framework to put to Congress advocating SEC registration of large hedge funds which may pose a systemic risk and the imposition of new SEC disclosure and monitoring requirements. A new US systemic risk regulator is proposed with the power to restrict large SEC-registered hedge funds’ reliance on short-term financing and leverage.

Analysis of the reform proposals
In the past the FSA has taken the policy position that counterparty prudential risk that may arise through hedge fund leveraged and derivative trading was best addressed by gathering sufficient information to understand the nature of these hedge fund counterparty exposures of banks and primebrokers to ensure such banks and primebrokers properly managed this exposure and held adequate capital in this regard. One might suggest in the same way that the regulators monitor a bank’s exposure to major (unregulated) corporate borrowers.

It is unclear whether or not the regulatory reform proposals represent, as far as the UK is concerned, a significant policy change. Authorisation of hedge fund managers established in the UK has been required since 1986 and proposals for greater regulatory powers to gather information may just reinforce the current FSA fund manager and prime broker information surveys. An area of considerable uncertainty is the circumstances where hedge funds may be subject to capital and liquidity rules because they have become “bank-like in nature or systemic in importance”. By “bank-like” one might infer a fund that extends credit to businesses and consumers and/or participates in the interbank money markets, although both prospects would seem remote: a narrow edifice on which to mount a proposal for a major regulatory reform. The expression “systemic in importance” simply begs the question – what is systemic? Unfortunately the discussion of the issue in the Turner Report is brief and provides little basis for any reliable conclusion as to what may have been intended. No attempt is made to consider or explain why prior FSA policy with respect to hedge funds was unsatisfactory in circumstances where there is no evidence of a failure of that policy despite the worst global banking crisis in more than 75 years.
The Turner Report also does not address the legal jurisdictional issue with respect to the exercise of regulatory prudential powers over hedge funds which arises because hedge funds, as opposed to hedge fund managers, are usually established in off-shore tax havens. The pragmatic regulatory response to this characteristic of hedge funds is to focus on hedge fund managers rather than the underlying fund, as was the FSA policy prior to the Turner Report.

In fact the subsequent IOSCO Report (prepared by the IOSCO Technical Committee and jointly chaired by the FSA) at Annex 5 reiterates prior FSA policy – “As our approach to regulation focuses on those entities within our jurisdiction, we do not currently focus on the individual positions or exposures of the funds as these are generally located offshore and therefore outside of our regulatory remit. The FSA considers that the potential for hedge funds to generate systemic risk would emerge through distress at the regulated counterparties to hedge funds rather than at the hedge funds themselves. We address this risk through our supervision of the counterparties by ensuring that we understand their exposure to, and management of, risks posed by dealing with hedge funds. This involves close monitoring of counterparty and liquidity risk management systems.”

Each of the other reports take differing positions on the question of imposing prudential requirements on hedge funds. The Larosiere Report recommends the imposition of prudential requirements only in the case of hedge funds owned by banks. The IOSCO Report notes a divergence between its members but recommends certain measures to control the management of risk by hedge fund managers. The US Treasury Secretary proposes prudential rules to restrict a large hedge fund’s reliance on short – term financing and limit the amount they can borrow to maximize trading profits. It was stated that whether a hedge fund will be deemed to pose a systemic risk would be based on characteristics that include its size, its interdependence with the financial system, its leverage and how much it relies on short term funding. Other criteria include whether the firm is a critical source of credit for households, business and governments or whether it provides a source of liquidity for the financial system.

The IOSCO Report also proposes reform regarding investor protection matters (management of conflicts of interest and investor disclosures). IOSCO suggests that the view that sophisticated investors can look after themselves may be questionable given the asymmetry of information and power between investor and hedge fund. It is then contended that given hedge fund investors may not be able to protect their own interests, the lack of conflict of interest and transparency regulation may lead to less substantive due diligence and investor protection and this in turn could lead to significant potential for ill-informed decisions to the detriment of market confidence and stability. This line of reasoning falls short of any solid justification for linking the case for investor protection regulatory change to the need to control systemic risk in the aftermath of the global banking crisis.

Rules that require adequate risk disclosure may enable investors to have a better appreciation of the risks of credit leverage and derivative investments but the case for regulation of this nature for sophisticated hedge fund investors is weak. The imposition on fund managers of a remuneration code and other requirements to deal with conflicts of interest may discourage excessive risk taking for the short term profit of managers, but again the sophisticated nature of hedge fund investors militates against the case for this type of regulation. For the purposes of ensuring transparency of potential systemic risks reinforced powers for regulators to gather information on hedge fund open positions should be sufficient.


The prudential regulatory response ought to focus on protecting the financial system when a speculative crash occurs: the restraint of speculative booms is predominantly a matter of macro economic policy not prudential regulation. Further, the regulatory focus should be upon those financial institutions the failure of which will not only cause loss to their shareholders and employees but also serious consequential damage to the wholesale interbank markets, and bank lending to businesses and consumers. These institutions are principally banks. It is possible that the failure of large hedge funds will have systemic implications because of substantial counterparty debt and trading positions with banks and prime brokers. However, no proper attempt has been made to justify why the past FSA regulatory approach, with fund manager authorisation and information gathering, but without prudential obligations on hedge funds, is inadequate. Indeed such a reform in prudential regulation even if limited to “large” hedge funds is predicated on a failure of prudential regulation of banks with respect to counterparty exposures. Nor does the Turner Report make any attempt to deal with the legal jurisdictional issues associated with the fact that hedge funds are generally established in offshore tax havens beyond the direct jurisdiction of the FSA.

Hedge funds are widely recognised as the providers of liquidity, price efficiency and risk distribution in financial markets and the provision of investment diversification opportunities for investors. The FSA expressly acknowledges that “it is essential that firms do take risks, for without risks there will be no innovation or competition which are the basis for economic prosperity”. Imposition of capital requirements or investment constraints on large hedge funds may reduce market liquidity, reduce investor diversification options and increase investors’ costs. Regulation to impose capital requirements and restrict risk taking by hedge funds ought to be justified on thorough examination and discussion of the prudential risk when weighed against the loss of countervailing market benefits.

Registration or authorisation of all hedge fund managers internationally (already the law in the UK) and the reinforcement of information gathering powers for private disclosure to regulators looks sensible. However, the merits of proposals for more intrusive capital and investor protection regulation of hedge fund managers and hedge funds are less obvious. The regulators have not, in any event, adequately addressed the justification for these measures. It may also be a case of “be careful what you wish for”.

Are regulators really equipped or resourced to monitor the true risk exposure of numerous hedge funds trading in complex derivative products if capital, liquidity, financing and leverage requirements are to be imposed?

1. Report of the High-Level Group on Financial Supervision in the EU Chaired by Jacques de Larosiere, Brussels, 25 February 2009.
2. The Turner Review. A regulatory response to the global banking crisis. FSA March 2009.
3. Hedge Funds Oversight Consultation Report. Technical Committee of the International Organisation of Securities Commission March 2009.

Robert Falkner is a partner in the London office of international law firm Morgan Lewis. He joined the London office of Morgan Lewis as a partner in October 2004. Prior to that he was general counsel for, and a director of, Cantor Fitzgerald International (broker-dealer) and eSpeed International (electronic markets) and their European and Asian affiliates for nine years. During this time, he was also a member of the London Stock Exchange Domestic and International Rules Committee (1998 – 2001).