Definitional problems, legal interpretation and regulatory arbitrage

Therefore, from such a regulatory bifurcation come the two separate playing fields which are subject to separate rules of the game.²⁰⁷ The dual governance, though beneficial, is not without costs. The main problem is that such a system of regulation stimulates strategic responses by the firms to the regulatory fragmentation of the industry. Profit maximizing firms in such a segmented regulatory system will seek to shift their business or structure their business in order to fall under the least costly regulatory regime.

By creating opportunities for regulatory arbitrage, regulatory bifurcation and regulatory competition can inhibit the cooperation among regulators to effectively address the externalities in financial markets.²⁰⁸ Indeed, it is argued that absent more coordination between regulators, such regulatory arbitrage may undercut the attempts to limit excessive risk taking in financial markets.²⁰⁹

statutory definitions and subsequent interpretations. Regardless of how precise and determinate a rule is, the limits of human foresight implies that even the least vague terms may become vague upon their application to a particular situation which was not predictable at the time of rulemaking.²¹⁶ Therefore, it is argued that “a rule ... is only as good as its interpretation.”²¹⁷ In this sense, the choice of a particular method of interpretation in financial regulation, enforcement, and adjudication can significantly affect the problems arising from boundaries set out by statutory definitions in financial markets.

This limited linguistic ability coupled with problems of interpretation breed opportunities in which the technical compliance with rules and regulations can be achieved while undermining the underlying justifications on which the entire regulatory system or a specific law is predicated.

Compliance of this sort, dubbed ‘creative compliance’, which essentially involves “using the law to escape legal control without actually violating legal rules”,²¹⁸ is well-documented in the regulation literature.²¹⁹

Aside from the intrinsic limited ability of legal systems to capture the substance and the economics of transactions, another source of regulatory arbitrage is associated with ‘legal formalism’. Legal formalism, not recognizing the “necessity of choice in penumbral areas of rules”,²²⁰ follows the letter of a rule, even if this fails to serve its purpose.²²¹ The emphasis on literal interpretation and legal formalism highlights the role of definitions in legislation, rule-making and adjudication. Needless to say, contrary to the principles-based regulation the focus of which is on ‘goals’ rather than ‘means’ of achieving the goals, rules-based regulation creates vast opportunities for regulatory arbitrage.²²² Likewise, rules-based direct regulation of hedge funds along with the appeal to the literal meaning of words in adjudication and legal

215 Joseph Raz, The Authority of Law: Essays on Law and Morality (New York: Oxford University Press, 1979), pp.

214-218.

216 Julia Black, Rules and Regulators (Oxford: Clarendon Press, 1997).

217 Ibid.

218 D. McBarnet and C. Whelan, "The Elusive Spirit of the Law: Formalism and the Struggle for Legal Control,"

Modern Law Review 54, no. 6 (1991), p. 848.

219 See Karen Yeung, Securing Compliance: A Principled Approach (Oxford: Hart Publishing, 2004).

220 Hart, The Concept of Law, pp. 124-130.

221McBarnet and Whelan define formalism as “a narrow approach to legal control – the use of clearly defined, highly administrable rules, an emphasis on uniformity, consistency and predictability, on the legal form of transactions and relationships and on literal interpretation.” See McBarnet and Whelan, The Elusive Spirit of the Law: Formalism and the Struggle for Legal Control, pp. 848-849.

222 McBarnet, Financial Engineering Or Legal Engineering? Legal Work, Legal Integrity and the Banking Crisis, p.

72.

interpretation can be used to undermine the very purpose of regulation designed to address hedge funds’ externalities.

Accordingly, the necessity for interpretation implies that regulators’ reliance on definitions is not necessarily helpful. On the contrary, it can be counterproductive. In the words of Judge Randolph, in Goldstein v. SEC, “[t]he lack of statutory definition of a word does not necessarily render the meaning of a word ambiguous, just as the presence of a definition does not necessarily make the meaning clear. A definition only pushes the problem back to the meaning of the defining terms.”²²³ Therefore, the direct regulation of hedge funds which cannot avoid using definitions is unlikely to cope with regulatory arbitrage by hedge fund.

Nonetheless, regardless of the subjects of rules and regulations, any kind of regulation necessarily involves definitions and, to a certain degree, is subject to regulatory arbitrage. In other words, direct regulation relying on precise rules and definitions spurs regulatory arbitrage by hedge funds as much as it encourages regulatory arbitrage by hedge funds’ counterparties and creditors. However, as it will be argued in the next two sections, the costs of regulatory arbitrage for hedge funds are substantially lower compared to the costs of regulatory arbitrage for banks and mutual funds. Therefore, regulating hedge funds through, for instance, the banks they deal with is less likely to encourage regulatory arbitrage.

Taking all the above-mentioned problems with definitions into account, it is not surprising to observe a consistent tendency of regulators to avoid engaging in definitional issues in hedge fund regulation, especially the issues concerning the hedge fund as an entity.²²⁴ The hassles in defining dynamic and heterogeneous entities such as hedge funds give rise to problems that make direct regulation difficult, if not impossible, to implement. Indeed, regulatory arbitrage is the

223 See Goldstein, 451 F.3d, 879.

224 Since the problem of definition is ubiquitous in regulation of economic activities and is not limited to the institution-based financial regulation, entity-based approach to regulation or institutional regulation has its own proponents. In other words, definitional problems also pose almost the same challenges to the ‘product-based approach’ to regulation. Gibson shows how regulation of swap agreements could escape regulation because there is uncertainty and complexities in defining financial products such as securities and futures. She concludes that concerning swap markets, the regulatory problems such as definitional and jurisdictional problems can best be addressed by focusing on the ‘market participant-based regulation’ rather than the classification of swap agreements as futures or securities. See Gibson, Are Swap Agreements Securities Or Futures?: The Inadequacies of Applying the Traditional Regulatory Approach to OTC Derivatives Transactions, p. 416.

With respect to hedge fund regulation, most regulations opted for an institutional one-size-fits-all regulation for

‘alternative investment funds’ or ‘private funds’.

main obstacle for a rules-based direct regulation of hedge funds. Such problems can better be addressed by using principles-based regulation or even indirect regulation which focuses on financial entities other than hedge funds themselves.

Conclusion

This chapter briefly discussed the concept of market failure and identified its three major sources; namely, externalities including systemic externalities, incomplete information, and imperfect competition. In terms of the market failures associated with information problems, the lack of transparency in the hedge fund industry was highlighted. As a general attribute of financial markets, the socially optimal level of information is not provided in the absence of mandatory disclosure. Multiple factors contribute to such socially suboptimal provision of information in financial markets in general and in the hedge fund industry in particular, such as the problem of externalities. In addition, it was argued that there is a need for the provision of higher levels of information to maintain trust in the financial system because of credence goods nature of financial services and the intertemporal nature of financial transactions. Therefore, similarly to the financial markets at large, in the hedge fund industry minimum disclosure requirements are needed for the well functioning of the markets. The disclosure of aggregate information is also essential for the assessment of the potential systemic impact of the hedge fund industry.

The imperfect competition is often a result of economies of scale and network effects, or some type of government licensing requirements which create monopolies. The primary concern with the economies of scale and network effects as related to hedge fund regulation does not concern hedge funds themselves, but it is mainly related to the prime finance industry. There is a considerable evidence of economies of scale in the banking industry. Moreover, the prime finance industry is very likely to project the features of platforms in which the relationship between hedge funds and their prime brokers creates a two-sided market. This two-sided market reinforces the effects of network economies in the prime finance industry and makes this market prone to monopolies.

This chapter also studied the interplay and dynamics of financial regulation and hedge funds’

strategic responses to such regulation which can lead to regulatory arbitrage in the global financial markets and its fragmented regulatory regime. It is argued that the differential regulation of homogenous financial activities giving rise to regulatory fragmentation is the main source of regulatory arbitrage. However, the differential regulatory treatment is not a necessary evil; instead, it yields more efficient outcomes than its alternative (i.e., consolidated regulatory regime) in certain market settings. There are at least three main reasons for differential regulatory treatment of homogenous activities: financial market compartmentalization, regulatory competition, and the possibility of harvesting the benefits of partial industry regulation. These factors, though beneficial, have their own problems. By creating a fragmented regulatory scheme and a dual system of governance, coupled with the definitional and interpretational problems, these factors induce regulatory arbitrage.

In the current financial regulatory patchwork, heavily regulated financial institutions should compete with lightly regulated ones. In the absence of the mechanisms to offset the regulatory costs of heavily regulated firms, it is highly likely that regulatory arbitrage will follow by heavily regulated firms. The problem with the regulatory arbitrage is that it can substantially reduce the effectiveness of the regulations aimed at addressing risks of systemic importance.

In conclusion, it seems that there is a market failure because of the imperfect competition, particularly in the relationships between hedge funds and their prime brokers.²²⁵ In addition, competition between hedge funds and other financial market participants in the broader financial markets will give rise to positional externalities and incentivize regulatory arbitrage and greater risk-taking.

The next chapter will show how these market failures along with some specific features and risks involved in the hedge fund industry can contribute to systemic risk and potentially result in financial instability.

225 The existence of economies of scale and scope and the potential for prime brokerage platforms to become two-sided markets would give rise to imperfect competition in the prime finance industry which will be elaborated in the second chapter where the thesis discusses the interconnectedness of hedge funds with LCFIs.

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Introduction

One of the most important issues in the regulation of hedge funds is their potential contribution to financial instability. In this chapter the aim is to study the relevance of the hedge fund industry for systemic risk and understand if they can potentially contribute to financial instability. The existing theoretical models and empirical findings will be covered to underlie and reinforce the argument to be made for or against hedge fund regulation.

The systemic importance of hedge funds will be studied under four main headings. First, the notion of Systemically Important Financial Institutions (SIFIs) will be studied, and it will be determined whether hedge funds can fall under the category of SIFIs. To determine which institution or institutions can be designated as SIFIs, four main criteria will be discussed: size, leverage, interconnectedness, and herding behavior. Hedge funds can become too-big-to-fail (TBTF) merely because of their size or their leverage; but they can also become systemically important because they are too-interconnected-to-fail (TITF) and/or they are systemically important as a herd.

In addition to the size, the second assessment will involve the amount of hedge fund leverage. It will be determined whether hedge funds’ potential unlimited leverage and risk taking behavior can make them become SIFIs. The question revolves around the assessment whether hedge funds are or can be TBTF, or potential unlimited leverage can make them become TBTF.

The third important assessment to be made is about the interconnectedness of hedge funds with Large Complex Financial Institutions (LCFIs). Financial instruments can connect the financial institutions to each other and may make them TITF. Therefore, to make such an assessment, the financial instruments and their potential role in connecting financial institutions to each other will be discussed. However, studying financial instruments and all the financial strategies at hedge funds’ disposal might derail the focus of this study. Thus, to avoid being strayed in the maze of complex and overwhelmingly complicated financial instruments and strategies, this study will be limited to the role of counterparty risk, functioning as a venue for channeling risks.

In this respect, the relationship between hedge funds and their prime broker-dealers will be of special interest.

The fourth assessment to be made involves hedge funds’ potential for herding behavior. It will be determined whether hedge funds are theoretically prone to herding, and if so whether the data on herding behavior of hedge funds support the theory. The concept of contagion and contagion channels will also be covered while studying the TITF and herding behavior in the hedge fund industry.