Before embarking upon the debate about hedge fund regulation, a few words of caution about hedge fund regulation is in order. The traditional response to the problem of externalities is the Pigouvian and lump sum taxes, or compensation (subsidies). This approach in addressing the externalities is focused mostly on the incentives of the externality generator, whereas it mostly overlooks other factors that might contribute to the generation of externalities. Due to potential misallocation of resources involved in these types of interventionist mechanisms, they are not and will not be sufficient in addressing different types of externalities. Therefore, there is an
153 Markus K. Brunnermeier and Stefan Nagel, "Hedge Funds and the Technology Bubble," The Journal of Finance 59, no. 5 (2004), 2013-2040.
154 Boyson, Implicit Incentives and Reputational Herding by Hedge Fund Managers, 283-299.
increasing need for more innovative, market-based, and efficiency enhancing solutions that can in the meanwhile address the problems arising from those externalities.
The economic theory suggests that the mere existence of an externality cannot justify government intervention.155 There are instances that existence of externalities is either tolerated or is left to the private bargaining to be dealt with. Generally speaking, corrective measures should at least take the following caveats into account while addressing the problem of externalities.
First, if there is ex-ante or ex-post compensation such as external benefits which cancels out the external costs or vice versa, there is no need for intervention to correct the externalities, because the externalities have already been internalized.
Secondly, the problem of causation in generating externalities is much subtler and more intricate than traditionally perceived in traditional Pigouvian approach. Traditional approach tends to treat externalities as if they are unilaterally imposed by one party upon the other. Whereas the costs of externalities are as much the result of the actions or presence of the victim of externalities as it is the result of the actions or presence of the party generating externalities. Indeed, the existence of externalities could also be attributed to the producer of an externality as much as its victim.
Accordingly, so far as the social welfare is concerned, causation in generating externalities might be irrelevant, and the efficient outcome might be achieved irrespective of which party pays for the reduction in harm.156 As Coase puts:
“The problem which we face in dealing with actions which have harmful effects is not simply one of restraining those responsible for them. What has to be decided is whether the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produces the harm.”157
Thirdly, the problem of “joint causation of externalities”158 requires more than an outright tax on the producer of externalities. This approach towards addressing externalities may, in some instances, require punishment of the victims suffering from externalities by taxation as well. It
155 For more details, see Ronald H. Coase, "The Problem of Social Cost," Journal of Law and Economics 3 (1960), p. 27.
156 Cento Veljanovski, Economic Principles of Law (Cambridge: Cambridge University Press, 2007), pp. 50-53.
157 Coase, The Problem of Social Cost, p. 27.
158 David D. Friedman, Law’s Order: What Economics has to do with Law and Why it Matters (Princeton, New Jersey: Princeton University Press, 2000a), p. 46.
requires mechanisms for alignment of interests and incentives of the producer and the victim of the externality and/or mechanisms facilitating trade between the two parties. An example of joint causation of externalities and its effect on the policy responses towards this phenomenon in the financial markets is that there are circumstances in which financial institutions, assured of being too-big-to-fail,159 hold highly levered positions with excessive maturity mismatch and overexpose themselves to the risk of being trapped in liquidity spirals.160 It is argued that this happens due to “two risk-spillover externalities”, i.e., fire-sale externalities, and interconnectedness externalities. The fire sale externalities arise due to the fact that each individual financial institution does not take into account the “the price impact its own fire-sales will have on asset prices in a possible future liquidity crunch.”161 In this view, the fire sale by one financial institution has a negative impact on the balance sheet of other financial institutions.
On the other hand, a failing financial institution does not take into account its failure’s negative impact on other financial institutions in distressed periods of financial markets.162
Last but not least, the other important implication of the Coase theorem163 is that the optimal social outcome is for the externality to end up somewhere with the least net damage. This is suggestive of an externality trading system.164 Although the Coase theorem is rich in its insights, its applicability might be limited because of its strong assumptions, such as the absence of transaction costs. Obviously, such assumptions largely restrict the application of the Coase
159 The moral hazard problem stemming from a prospect of possible future bail-outs for big and too-interconnected-to-fail institutions has at least two effects. First, it gives incentives for financial institutions to expose themselves to become too-big-to-fail and after becoming big enough, the associate moral hazard problem will encourage them to overexpose themselves to risks to get the upsides of taking risks, and avoid the downsides of the same activity by being bailed out by taxpayers. See Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, p. 23.
160Ibid.The legal theory of finance may provide a different explanation for this phenomenon. Since the financial regulation applies flexibly in the apex of the financial system, the financial institutions have greater incentives to get closer to the apex of the financial system by becoming TBTF.
161 Markus K. Brunnermeier, "Financial Crises: Mechanisms, Prevention and Management," in Macroeconomic Stability and Financial Regulation: Key Issues for the G20, eds. Mathias Dewatripont, Xavier Freixas and Richard
Portes (London: Centre for Economic Policy Research (CEPR), 2009b),
http://www.ssc.wisc.edu/~mchinn/dewatripont_G20_ebook.pdf., p. 95
162 Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, p. 23. This interconnectedness is much intense and severe in OTC markets.
163 Coase theorem posits that regardless of the initial allocation of property rights, and in the absence of transaction costs in trading externalities, bargaining will result in efficient allocation of externalities. This theorem suggests that the mere existence of the externalities does not necessarily result in an inefficient outcome.
164 For a trade to be meaningful, property rights should be defined. Government intervention in the form of an intervention which enhances market mechanisms, as the case of lighthouses in the 17th century England suggests, can also enhance social welfare while providing the public goods. See Zerbe and McCurdy, The Failure of Market Failure, pp. 566-567.
theorem.165 The entire debate about the externalities will resurface while trying to craft regulatory responses to the problem of externalities hedge funds pose to the financial system.
Conclusion
This chapter discussed one of the most controversial issues in the regulation of hedge funds which is their potential contribution to systemic risk and financial instability. In this chapter the aim was to identify the relevance of hedge funds to systemic risk and assess whether they can potentially contribute to financial instability. The theoretical models and empirical findings were molded in the conceptual framework of this chapter to underlie and reinforce the arguments made for or against hedge fund regulation.
To study hedge funds’ relevance to the systemic risk and financial instability, the following steps were taken. First, the notion of SIFI was studied to determine whether a hedge fund as an individual entity can become a SIFI. In other words, this chapter assessed whether hedge funds are or can potentially become TBTF, or whether the potential for hedge funds’ unlimited leverage could make them TBTF. Therefore, two main considerations in studying individual hedge funds as being systemically important are their size and their level of leverage.
The third important consideration is interconnectedness of hedge funds with LCFIs. This chapter studied the possibility for the hedge fund industry to become too-interconnected-to-fail (TITF).
This investigation was mainly focused on the role of counterparty risk as a venue for creating systemic risk. In this regard, the relationship between hedge funds and prime broker-dealers was illustrated and particular risks were identified. With respect to the interconnectedness of the hedge fund industry with LCFIs, three main relationships of hedge funds with LCFIs offering
165 Two main limitations for the externality as a justification for regulation should also be taken into account in addressing problems stemming from externalities. First, pecuniary externalities need not be regulated. As mentioned earlier, since pecuniary externalities does not generate a shift in the utility function or production possibilities frontier of a third party and hence does not result in misallocation of resources and inefficiency, there is no need for regulation, compensation or any other corrective measures. They are simply considered as the result of the “natural play of market forces”. See Ogus, Regulation: Legal Form and Economic Theory, p. 37.
Second, transaction costs in addressing externalities should be taken into account. In other words, if the administrative costs of correcting (trivial) externalities exceed the costs of externalities, it might be optimal to tolerate externalities. See Ibid.
prime brokerage services were highlighted. The LCFIs can be hedge funds’ prime brokers, their trading counterparties, and the owners or manager of hedge funds.
The data on the direct exposure of the banking industry to hedge funds, however, suggest that the exposure of hedge funds to the finance sector was low before the global financial crisis. This exposure remained modest compared to the exposure of banking sector to the listed financial intermediaries after the financial crisis. However, even with low levels of exposure, legitimate concerns remain. For example, although it is expected that the hedge fund investors shoulder the losses in hedge funds, sometimes due to reputational risks and perverse incentives, prime brokers tend to bail out the sponsored hedge fund with their own government subsidized funds. This chapter concludes that despite the limited direct exposure of the hedge fund industry to LCFIs, these exposures can give rise to cross-subsidization of hedge funds by depository institutions (banks). Since such cross-subsidizations can potentially put the taxpayers’ money at risk, they warrant government scrutiny.
In addition, the interconnectedness of hedge funds with prime brokers can amplify the risk of hedge fund herding behavior in case a large prime broker is in distress. The failure of a prime broker can have severe consequences for hedge funds, particularly those hedge funds having substantial (rehypothecated) collateral in the failing prime broker. Such a collapse can force hedge funds to liquidate their positions. If substantial hedge funds’ positions experience forced liquidations, it might result in market price dislocation. To better address this risk which might have systemic implications, it is suggested that regulators should focus on the counterparty risk management practices of the financial institutions offering prime brokerage services to hedge funds, with a particular focus on the adequacy of collateral and suitability of margin requirements.
The fourth element in studying hedge funds and their importance for financial stability involves hedge funds potential herding behavior. This section investigated the existing theoretical and empirical studies on hedge funds’ herding to assess whether hedge funds are prone to herding.
To recapitulate, it is argued that although the role of hedge funds in financial instability is highly contested, theoretically speaking, hedge funds’ size and leverage, their interconnectedness with LCFIs and the likelihood of hedge funds’ herding are among the features that can undermine
financial stability. However, the data on hedge funds’ sizeand leverage shows that these features are far from being systemically important. Nevertheless, empirical evidence on hedge fund interconnectedness and herdingis mixed and it remains a major concern for regulators.
C HAPTER 3: T HE H EDGE F UND R EGULATION D ILEMMA : D IRECT VS . I NDIRECT R EGULATION*
Introduction
The first two chapters of the thesis provided a rather extensive overview of the potential benefits and risks of the hedge fund industry to financial markets. Given the benefits and potential risks that hedge funds pose to the financial system, this chapter aims to determine which regulatory strategies can best address these risks with the least impairment to the benefits of hedge funds to financial markets. Direct and indirect regulatory strategies are proposed as two main regulatory schemes to address such a problem and balance hedge funds’ benefits and risks.1
These two strategies were highlighted in the difference of opinion about hedge fund regulation after the recent global financial crisis. On the one hand, the U.S. and UK regulators, along with the hedge fund industry itself, supported the indirect regulation of hedge funds through regulated banks. On the other hand, regulators in continental Europe supported a more direct regulatory framework for hedge funds.2 In the end, the outcome of the clash of these two opposing views was a compromise. One of the catalysts for such a compromise was the increasingly stringent attitude in the U.S. towards hedge fund regulation after the change of administration, i.e. the replacement of Republicans by Democrats in 2008.3 The change of regulatory policy in the U.S.
paved the way for at least a partial realization of the European views on hedge fund regulation.
* This chapter is largely based on: Nabilou, Hossein and Alessio M. Pacces. "The Hedge Fund Regulation Dilemma:
Direct vs. Indirect Regulation." William & Mary Business Law Review 6, no. I (Forthcoming 2015).
1 Direct regulation involves regulatory measures focusing on the regulation of industry itself as a discrete activity, targeting hedge funds’ structure, strategies, and operations. It often employs registration, disclosure, capital requirements, position limits as regulatory instruments. In contrast, indirect regulation involves “market discipline-inspired regulatory measures targeting the creditors and counterparties of hedge funds.” SeePhoebus Athanassiou, Hedge Fund Regulation in the European Union: Current Trends and Future Prospects (Alphen aan den Rijn (The Netherlands): Kluwer Law International, 2009), p. 227.
2 On the one hand, accusations of abusive short selling by hedge funds during the global financial crisis deepened this divergence of opinion. On the other hand, the national elections in France and Germany giving rise to the coalition of these two countries for regulating hedge fund overall led to the expansion of regulatory turf of the EU institutions.
3 See Ferran, After the Crisis: The Regulation of Hedge Funds and Private Equity in the EU, pp. 390-393.
In the end, the efforts to rein in hedge funds culminated in the G20 London Summit in April 2009 in which all parties agreed that hedge funds and their advisers should be subject to mandatory registration and disclosure requirements.4
The remainder of this section is structured as follows. First, the distinction between the direct and indirect regulation is introduced. Secondly, the arguments for and against the direct and indirect regulation of hedge funds are analyzed. Thirdly, the advantages of the indirect regulation in addressing and mitigating the potential contribution of hedge funds to systemic risk are highlighted. Finally, the need for conducting a comparative analysis of the regulatory regimes in the U.S. and the EU is discussed.