It is apt here to provide a synopsis of the arguments, key themes, and ideas that unites the thesis.
This will help connect the dots and concepts introduced in each chapter and will provide the big picture of the overall thesis. The following roadmap also explains the key concepts, and the basic theories of the thesis.
The first chapter discusses the justifiability of the arguments for and against hedge fund regulation. It deals with the question whether hedge funds should be regulated at all or should go
44 Roger Ferguson and David Laster, "Hedge Funds and Systemic Risk," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), p. 46.
45 David Stowell, An Introduction to Investment Banks, Hedge Funds and Private Equity: The New Paradigm (Burlington, MA: Elsevier, 2010), p. 204.
46 Indeed, hedge funds are essentially considered as an Anglo-American phenomenon. It is estimated that the U.S.
and the UK host almost 90 percent of hedge fund managers. See Andreas Engert, "Transnational Hedge Fund Regulation," European Business Organization Law Review 11, no. 03 (2010), pp. 364-365.
free of regulation. The chapter starts with a standard law and economics approach, which posits that the government intervention is only justified if there is a market failure. Therefore, the basic assumption is that the resource allocation by market mechanisms, under certain assumptions, is optimal (the first fundamental theorem of welfare economics). Accordingly, to develop an argument for possible market failures, the concept of market failure is briefly studied. It is shown that market failure has three distinct sources; incomplete information, imperfect competition, and externalities, including systemic externalities. In line with the above-mentioned theorem, namely the first fundamental theorem of welfare economics, the possibility of market failures in the hedge fund industry and its overall activities within and across markets will be discussed.
The second chapter addresses one of the most controversial issues in the regulation of hedge funds, namely their potential contribution to financial instability. In this chapter, the aim is to study the relevance of hedge funds to systemic risk and ascertain if they can potentially contribute to financial instability. The theoretical models and the empirical findings will be molded in the conceptual framework of this chapter to underlie and reinforce the arguments to be made for or against hedge fund regulation.
The second chapter also takes the following steps to study relevance of hedge funds to the systemic risk and financial instability. In the first step, the study of the notion of SIFI deserves special attention. The aim is to assess whether a hedge fund as an individual entity can become a SIFI. This topic will also include hedge funds falling under the rubric of the too-big-to-fail (TBTF). The question is whether hedge funds are or can potentially become TBTF, or their potential for taking unlimited leverage can 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 the interconnectedness of hedge funds with LCFIs. Studying the interconnectedness requires special attention to be paid to the role of financial instruments and strategies and their potential for connecting the financial institutions to each other. However, this study will be limited to the role of counterparty risk as a venue for creating systemic risk. In this regard, the relationship between hedge funds and prime broker-dealers deserves special attention. Therefore, the third consideration would be whether hedge funds can potentially become too-interconnected-to-fail (TITF).
The fourth element in studying hedge funds and their importance for financial stability involves hedge funds’ potential herding behavior. This part of the chapter two will survey the existing theoretical and empirical studies on hedge funds’ herding to establish whether hedge funds are prone to herding. In addition, special attention will be paid to contagion channels while studying the TITF, and herd behavior in the hedge fund industry.
The third chapter studies regulatory strategies and instruments for addressing the potential systemic risk of hedge funds. Due to the implications of the choice of regulatory strategies and instruments in terms of mitigating systemic risk, it focuses on one critical aspect of hedge fund regulation, i.e., direct regulation vs. indirect regulation. Having defined the dichotomy of direct and indirect regulation and mapped its relationship with regulatory techniques and instruments, the arguments for and against direct and indirect regulation of hedge funds are analyzed. It is argued that the indirect regulation of hedge funds through their counterparties and creditors, while being less costly, can specifically better address hedge funds’ regulatory arbitrage and potential systemic risk. This policy recommendation is further supported by the economic and organizational structure of hedge funds and differences in the number and composition of their counterparties and creditors.
The first three chapters of the book discuss the potential market failures, systemic risk, and also the regulatory strategies to address those problems. The fourth, fifth, and sixth chapters include a comparative study of hedge fund regulation in the U.S. and the EU. The fourth chapter studies the U.S. direct regulatory measures to address potential contribution of hedge funds to financial instability. The fifth chapter discusses indirect measures to deal with potential systemic risk of hedge funds in the U.S. The sixth chapter investigates the regulation of potential contribution of the hedge fund industry to systemic risk in the EU.
The first part of the fourth chapter will briefly sketch the regulatory environment for hedge funds in the U.S. prior to the enactment of the Dodd-Frank Act.47 Then, the second part will analyze
47 The U.S. “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the Dodd-Frank Act) was signed into law on July 21, 2010. This Act triggered massive regulatory reforms and resulted in a major overhaul of the regulatory environment of the U.S. financial markets. 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.” To promote the financial stability and address the systemic risk, the Dodd-Frank Act introduces far-reaching provisions focused on the macro-prudential regulation of financial institutions. This
the relevant provisions of the Dodd-Frank Act intended to address the potential contribution of hedge funds to financial instability with direct regulatory measures. On the one hand, these measures mainly address the information problems in the hedge fund industry through the imposition of registration and disclosure requirments on hedge funds and collection of systemic risk data. On the other hand, as another direct regulatory measure, the Dodd-Frank Act requires the Federal Reserve (Fed) to impose prudential regulation for hedge funds contingent upon their designation as SINBFCs by the Financial Stability Oversight Council (FSOC).
The fifth chapter of the thesis will discuss the indirect regulatory measures crafted to address the potential systemic risk of hedge funds. The main focus of this chapter will be on the Volcker Rule which is a part of the post-financial crisis regulatory reforms aimed at addressing problems associated with the interconnectedness of hedge and private equity funds with LCFIs through prohibiting proprietary trading and banking entities’ investment in and sponsorship of hedge and private equity funds. The remaining of the fifth chapter will discuss miscellaneous indirect regulatory measures in the Dodd-Frank Act whose objective is to mitigate the potential systemic risk associated with hedge fund operations. In this part, the focus will be on the provisions of the Dodd-Frank Act that address the concerns arising from the interconnectedness and herding behavior of hedge funds. In this regard, the leverage and portfolio liquidity requirements will be surveyed. Then, the margins for trades in derivatives and collateral requirements aimed at preventing hedge fund herding will briefly be discussed. Finally, the potential self-regulatory measures for addressing hedge funds liquidity and leverage requirements will be examined.
The sixth chapter discusses the regulatory approach to hedge funds in the EU. In the aftermath of the financial crisis, hedge fund regulation was put at the top of European regulators’ agenda for the alleged contribution of hedge funds to financial instability. This chapter studies the recently enacted Alternative Investment Fund Managers Directive (AIFMD) in the EU and its attempt to cope with contribution of hedge funds to financial instability in the EU.
The legislative process of the AIFMD suggests that hedge fund regulation in the EU was a politically motivated overreaction to their perceived contribution to financial instability. The
dissertation will focus on the hedge fund-related provisions of the Dodd-Frank Act, particularly its Title IV, Private Fund Investment Advisers Registration Act, the Volcker Rule embedded in the Title VI, as well as the provisions of the Title I regarding the “Enhanced Supervision and Prudential Standards for Nonbank Financial Companies”.
main objective of the Directive seems to be the creation of a single market for Alternative Investment Funds (AIFs) rather than addressing systemic risk. The EU regulators’ emphasis on the investor protection can also be understood in light of creating a single European market for financial services. Despite the fact that the impetus for the enactment of the AIFMD was mostly the concerns about hedge funds’ systemic aspects and their contribution to the financial instability, hedge fund regulation in the EU only marginally addresses systemic risk concerns and more in general, the risks that hedge funds can potentially pose to financial stability.
The sixth chapter also sheds light on the potential future regulations supplementing the AIFMD and the possible future amendments thereto. This chapter argues that the EU’s regulatory policy towards hedge funds, particularly in areas involving the direct regulation of hedge funds because of investor protection concerns, should be revised. Instead, the regulatory focus should be shifted towards indirect regulation of hedge funds targeting their interconnectedness with LCFIs and their potential herd behavior. Otherwise, it is suggested that with the high level of protection offered to the investors in the AIFs, the Directive and its implementing measures, or the competent authorities of the Member States can lightly relax the statutory requirements for the investment by retail investors in hedge funds.
Notwithstanding the extraordinary high rate of obsolescence of legal studies of the financial markets due to the introduction of new rules and regulations at a fast pace, the theoretical foundations and the framework of analysis are expected to be the lasting feature of this dissertation. In other words, this thesis is essentially an analysis of a snapshot of an ongoing stream of regulations and could only be useful for a certain period of time. However, the framework and the law and economics insights used to study these specific laws and regulations will not hopefully be lost to the winds of time.
CHAPTER 1:HEDGE FUNDS AND MARKET FAILURE:ANEED FOR REGULATION?
Introduction
In the aftermath of the financial crisis, the quest for bringing the hedge fund industry under official oversight, scrutiny, and regulation gained momentum. In addition, a chain of hedge fund related events reinforced the argument for government regulatory intervention. Yet, the theoretical underpinnings of interventionist approach contain several fundamental and open-ended questions.
In this chapter, after providing a definition of hedge funds and analyzing their role in financial markets, the plausibility of the arguments for and against hedge fund regulation will be discussed. In so doing, the first fundamental theorem of welfare economics, which posits that the resource allocation by market mechanisms, under certain assumptions, is optimal, is the starting point of the analysis. Accordingly, to develop an argument for possible market failures, the concept of market failure is briefly studied. It is shown that market failure has three distinct sources; incomplete information, imperfect competition, and externalities including systemic externalities. In line with this approach, the possibility of market failures in the hedge fund industry and their overall activities within and across markets will be discussed.