The need for a comparative approach

In the first two chapters of the thesis hedge funds’ potential systemic implications for the financial markets are analyzed. This chapter also provided a theoretical framework for hedge fund regulation. The rest of the thesis adopts a comparative approach and analyzes the post-crisis laws and regulations aimed at addressing the potential systemic implications of hedge funds in the two major jurisdictions within which most hedge funds are established or are operating.

This comparative legal approach to hedge fund regulation can serve several objectives. First, it will be helpful in understanding the legal definition of a hedge fund in different legal systems.

Since different definitions of hedge funds are used in major hedge fund jurisdictions, the term

‘hedge fund’ for the financial entities should be used with caution. For example, the term ‘hedge fund’ can hardly be found in the U.S. codes of laws, instead, the term ‘private fund’ is used which encompasses different funds such as private equity and venture capital funds as well as hedge funds. On the other hand, in the EU, the term ‘alternative investment fund’ (AIF) is used which includes all non-UCITS, a subcategory of which can be the hedge fund industry. In addition, these two regulatory systems differ in many significant ways in how they treat such entities and how they differentiate hedge funds from the rest of the private fund industry or AIFs.

The comparative approach to hedge fund regulation will further help analyzing the divergences and convergences of regulations in the main hedge fund jurisdictions. Providing such an analysis can further help mitigate the potential adverse effects of regulatory arbitrage by hedge funds, a phenomenon that can render regulatory reforms having a stringent view on hedge funds ineffective.

156 The Dodd-Frank Act addresses this problem by introducing a laddered approach in hedge fund regulation. Small hedge funds are not even required to register with the SEC, mid-sized hedge funds are required to register, however, they should disclose limited amount of information and should do so less frequently. In contrast, hedge funds designated as Systemically Important Nonbank Financial Companies (SINBFCs) by the Financial Stability Oversight Council (FSOC) not only should register and disclose information, but also they will be subject to the prudential regulation of the Fed.

The U.S. and the EU are chosen for comparative purposes because of their significance in terms of their size and the number of hedge funds accommodated in these two jurisdictions. As mentioned earlier, the hedge fund industry is geographically concentrated. For example, in 2008, about 75% of all hedge fund assets were managed by U.S. funds, while around 15% of assets were managed by European hedge funds.¹⁵⁷ These data show the significance of the size of the U.S. hedge fund industry. Therefore, almost any regulatory change in the U.S. is expected to have a dramatic impact on the industry. The second largest jurisdiction for hedge funds is the EU which makes it a good candidate for the purposes of comparison. Although the size of the hedge fund industry in the EU is relatively small, it still is one of the popular jurisdictions for hedge funds particularly because of the sources of investments coming from institutional investors from Europe.

The U.S. legal system is the cradle of the hedge fund industry in which hedge funds were born and fledged. It has also the longest history of exposure to the risks posed by the hedge fund industry either to investors or to the financial system at large. Therefore, it is expected that the U.S. regulatory regime is equipped with the most sophisticated regulatory and legal mechanisms for addressing the potential risks of the industry. Indeed, as it will be demonstrated, not only is the U.S. jurisdiction the most popular jurisdiction for hedge funds worldwide, but also it provides a role model for hedge fund regulatory systems all around the globe.

Furthermore, one of the most important reasons that the EU and the U.S. are compared in this dissertation is that these two jurisdictions have taken relatively divergent views towards the regulation of hedge funds. The EU regulation of hedge funds relies mostly on direct regulatory measures. On the contrary, the U.S. hedge fund regulation mainly employs indirect regulatory measures to address the potential risks of the hedge fund industry. Therefore, the hedge fund regulatory system in Europe provides a counterfactual to the hedge fund regulatory system in the U.S. in many aspects.¹⁵⁸

Another reason for choosing two main jurisdictions of the U.S. and the EU for a comparative study of hedge fund regulation is that they represent two main hedge fund regulatory

157 Stowell, An Introduction to Investment Banks, Hedge Funds and Private Equity: The New Paradigm.

158 A detailed analysis of the differences of hedge fund regulation in these two jurisdictions can also be useful for the design of future empirical studies aimed at regulatory impact assessment (RIA).

philosophies, i.e., market-based approach adopted by the U.S. federal regulators and direct government regulation approach adopted by the EU regulatory authorities.¹⁵⁹ Market based approach to hedge fund regulation mainly relies on the market participants such as counterparties to check the risk taking behavior of hedge funds. Needless to say, such an approach corresponds to the indirect regulatory approach to hedge funds.¹⁶⁰

Since the study of the hedge fund regulatory regime is essential for the understanding of hedge funds, an overview of hedge fund regulation before the Dodd-Frank Act will be provided.

However, such an investigation seems to be unnecessary about hedge fund regulation in Europe before the enactment of the Alternative Investment Fund Managers Directive (AIFMD). Prior to the AIFMD in the EU, there was no EU-wide hedge fund regulatory regime and hedge funds were regulated by national regulatory authorities. This brought about a fragmented regulatory regime across Europe. This diversity in regulatory approaches makes the detailed study of hedge fund regulation prior to the AIFMD beyond the scope of this thesis.

After the brief survey of previous regulatory regime for hedge funds in the U.S., the rest of the thesis will embark upon an analytical assessment of the recent regulatory reforms in the U.S. and the EU to analyze the question whether the introduction of these regulations would be effective in addressing potential systemic risk arising from the hedge fund industry. The analysis of the post-crisis U.S. regulatory framework will mainly focus on the Title I, IV, and VI of the Dodd-Frank Act. And the analysis of the EU regulatory framework will be based on the recently enacted AIFMD and its subsequent implementing measures.

159Bianchi and Drew, Hedge Fund Regulation and Systemic Risk, pp. 15-16.

Prior to the global financial crisis, there were, roughly speaking, two predominant approach to hedge fund regulation. The first approach was based on the trust in the market forces to regulate hedge funds (Also known as the Market-making approach).The second approach was mostly based on mistrust on the market forces and mainly relied on the government to take the lead in the hedge fund regulation (market-shaping approach). The former is the Anglo-American approach to hedge fund regulation, and the latter is continental European approach. Although the impact of government distortions in the market economy and its contribution to the financial collapse of the 2008 was not negligible, the free market approach propagating the market discipline receded in the aftermath of global financial crisis. Consequently, regulators on both sides of the Atlantic proceeded to push for more government intervention and more restraints on the hedge fund industry.

160 It should be reminded that, inter alia, the distinction between hedge fund regulation in the EU and the U.S. based on direct and indirect regulation could not be constructed without certain degree of generalization.

Conclusion

In this chapter it is argued that the choice between direct and indirect regulation of hedge funds should be based on the relative effectiveness of the direct and indirect regulation in addressing hedge funds’ contribution to systemic risk at the lowest cost. The proxies for measuring the effectiveness of indirect regulation in mitigating potential systemic risk of hedge funds such as reduced leverage, improved transparency, counterparty risk management, and funding liquidity suggest that indirect regulation could have a significant impact. In fact, the effectiveness of indirect regulation is potentially so high that this regulatory approach could be just sufficient to cope with the systemic risk generated by hedge funds. On the contrary, direct regulation is unlikely to address hedge funds’ contribution to systemic risk without compromising their benefits to financial markets. In addition, the greatest obstacle to the success of direct regulation of hedge funds remains to be the regulatory arbitrage by hedge funds.

There are, however, arguments against the indirect regulation of hedge funds, which are reviewed in this chapter. These arguments suggest that even if the indirect regulation of hedge funds were effective, it would be far from sufficient to cope with systemic risk. Most critiques of the indirect regulation are based on the potential shortcomings of indirect regulation. However, this dissertation argues that the mere presence of problems with indirect regulation does not necessarily imply that direct regulation is the right choice. Indeed, the counterarguments for the effectiveness of hedge fund indirect regulation imply that there is a need for direct regulation of hedge funds’ counterparties (not hedge funds themselves) in order to enhance the market discipline. Needless to say, such direct regulation of counterparties, particularly including prime brokers, is the essence of the model of indirect regulation being advocated by this chapter.

This chapter argues for the indirect regulation of hedge funds. In this model of regulation, in addition to the government regulatory agencies, ‘surrogate regulators’ such as investors, counterparties and creditors, rating agencies, and hedge fund professional associations can play a role and reinforce the market discipline on hedge funds. In this perspective, the chapter argues that there is a need for a comparative study of hedge fund regulation in the U.S. and the EU to which the dichotomy of direct and indirect regulation illustrated in this chapter can best apply.

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Introduction

The recent global financial crisis harbingered substantial changes in the regulatory environment of financial markets and institutions throughout the world. One of the first and foremost sweeping changes was the enactment of the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (hereinafter the Dodd-Frank Act) passed on July 21, 2010. Unless otherwise provided in the Act, it became effective one year after the date of its enactment. The enactment of this Act triggered massive regulatory reforms and resulted in a major overhaul of the regulatory environment of the U.S. financial markets. The reforms introduced by this Act are only comparable, in the extent and depth, to the financial regulatory overhaul after the Great Depression.¹

The main objectives of the Dodd-Frank Act is to promote “the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, [and] to protect consumers from abusive financial services practices.”² In general, with respect to systemic risk, its objective is to limit the risks ex-ante, and minimize damage in case of failure of giant financial institutions by regulating instruments such as derivatives and institutions which are perceived to be Systemically Important Financial Institutions (SIFIs).³

To promote the financial stability and address the systemic risk, the Dodd-Frank Act introduces far reaching provisions focused on the macro-prudential regulation.⁴ For example, it requires

1 The Dodd-Frank Act amounts to 845 pages, 16 titles, 225 new rules involving 11 agencies. See Acharya and Richardson, Implications of the Dodd-Frank Act, p. 2.

It is estimated that the Act will result in approximately 400 rules and 87 studies before its full implementation. See Davis Polk, Dodd-Frank Rulemaking Progress Report: Progress as of June 1, 2011, 2011).

So far, a majority of regulations have been proposed and passed. See Davis Polk Regulatory Tracker, Dodd-Frank Progress Report: October 2013, 2013).

2 Negative reactions to the Dodd-Frank Act abound. Indeed, because it may boost their business, the Dodd-Frank Act is called “the Accountants’ and Lawyers’ Welfare Act of 2010.” See Michael Hirsh, "Bonfire of the Loopholes,"

Newsweek, May 20, 2010.

3 David Skeel, "Making Sense of the New Financial Deal," Liberty University Law Review 5 (2011), p. 186.

4 Micro-prudential regulation is about the study of the exposure of an individual financial institution to exogenous risks and it does not take into account the systemic importance of individual financial institutions. In other words,

regulators to measure and provide tools for measuring systemic risk, designate firms or sectors as systemically important, and subject them to enhanced prudential regulation.⁵ The most important of these changes involve identifying and regulating systemic risk by assigning the responsibility of designating the firms as Systemically Important Nonbank Financial Companies (SINBFCs) to the Financial Stability Oversight Council (FSOC), establishing the Office of Financial Research (OFR) within the Department of the Treasury for measuring and providing tools for the measurement of systemic risk aiming at putting an end to the too-big-to-fail problem, and expanding the authority of the Federal Reserve (Fed) over systemic institutions. The Dodd-Frank Act further authorizes prompt corrective action through the Orderly Liquidation Authority (OLA) which should be modeled and run by the Federal Deposit Insurance Corporation (FDIC).⁶ Moreover, the Act restricts the discretionary regulatory intervention through limiting the emergency federal assistance, introduces the Volcker Rule, regulates derivatives markets, and establishes the Consumer Financial Protection Bureau (CFPB). The Dodd-Frank Act also regulates mortgage lending practices, hedge funds (by requiring registration and disclosure), rating agencies, securitization, and risk taking by money market funds.⁷

Nonetheless, the scope of this chapter will be limited to the analysis of the provisions of the Dodd-Frank Act addressing potential ‘systemic’ risk of hedge funds and investigating whether the Act adequately addresses this concern. Therefore, issues such as investor protection and hedge fund compliance with new regulations addressing those concerns will not be covered. In addition to the provisions directly involving hedge funds, many of the above-mentioned provisions indirectly affect them. However, this chapter only discusses the direct regulation of hedge funds. The indirect regulation of hedge funds including the Volcker Rule will be examined in the fifth chapter.

micro-prudential regulation is about the stability of each individual institution and its objective is to force the individual financial institutions behave prudently. See Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, pp. 7-8.

Macro-prudential regulation, however, is concerned with the safeguarding the stability of the financial system as a whole. It requires a system-wide analysis and involves identifying the principal risk factors in a macro level financial system. Micro-prudential risks can be very different from macro-prudential concerns and when one is falling, the other might be rising. See Dijkman, A Framework for Assessing Systemic Risk.

See also Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, p. 10.

5 Acharya and Richardson, Implications of the Dodd-Frank Act, p. 21.

6 Ibid.

7 Ibid.

The first part of this chapter will discuss the hedge fund regulatory regime prior to the enactment of the Dodd-Frank Act in the U.S. Such a brief overview serves two main objectives. First, the alleged contribution of hedge funds to financial instability has been materialized in the regulatory framework prior to the enactment of the Dodd-Frank Act. These allegations have subsequently been used as justification for the need to change regulatory framework of the hedge fund industry. Indeed, without an understanding of that regulatory framework within which those alleged risks existed, the new regulatory framework and specific regulatory measures devised to address the potential risks of hedge funds to the financial system can hardly be understood.⁸ Second, such a brief retrospect to the previous regulatory framework will also be useful in understanding the potential loopholes of the financial regulatory framework prior to the Dodd-Frank Act. The knowledge of those loopholes could vastly be employed in addressing the problems stemming from the similar future loopholes in the Dodd-Frank Act itself. Furthermore, due consideration of the potential future effects of regulation can only be taken into account in comparison to the previous regulatory framework of hedge funds. Indeed, in the absence of such an introduction, the study of many aspects of newly introduced regulations would be out of the context. Thus, cognizance of the legal environment within which hedge funds were defined and operated will be helpful in understanding the potential impact of the recently introduced regulations. Therefore, before taking further steps in studying hedge funds and their regulation with an eye to addressing systemic risk, the hedge fund industry’s legal environment prior to the introduction of recent regulatory frameworks in the U.S. will briefly be discussed which will further be helpful in better understanding of what needed to be changed and what needed not.

8 One of the purposes of studying hedge fund regulation before the enactment of the Dodd-Frank is to provide a cognizance of the amorphous nature of hedge funds and come to a more precise definition. Since the U.S. is the cradle of the hedge fund industry, understanding hedge funds cannot be comprehensive without spotting hedge funds in the hodgepodge of the financial regulation in its regulatory framework. Indeed, the assessment of the contribution of hedge funds to systemic risk cannot be conducted unless hedge funds are objectively defined within a specific financial regulatory system. Therefore, the illustration of regulatory definition of hedge funds can contribute to understanding of the question why there was a need for amendment and change of the regulations already in place and why regulations were inadequately addressing potential systemic risk of hedge funds.