| Hedge fund regulation: target the investors, not the industry, academics say |
|
|
| 21/11/2004 | |
|
The absence of hedge fund regulation has been beneficial to the financial system as a whole. In a paper recently released, three academics from the London School of Economics argue that hedge fund regulation is likely to wipe out the benefits generated by these strategies. Leave the market unregulated and at best, only regulate less sophisticated investors, they say. "The costs of regulation would overweight the benefits for the system, especially given the feedback effect of the regulation likely to worsen an unravelling crisis", says Jean-Pierre Zigrand, one of the authors of the paper. According to the academics, while harming the development of the industry, the regulation of the sector is likely to impede hedge funds from delivering market benefits such as increased liquidity, which they have done up to now. At the same time, they agree that retail investors could benefit from a regulatory framework, such as those developed in Germany, Ireland, Italy, Luxembourg and Switzerland, where micro-prudential restrictions apply only to investors that might otherwise not get a complete understanding of their investment due to the opaque nature of hedge funds. For sophisticated investors, mostly composed of institutions that are themselves already regulated, they argue that a demand side regulation would be more efficient than any attempt to restrict what hedge funds do and cannot do. "Ultimately, it is the responsibility of the investing institution's regulator, i.e. such investments should be regulated on the demand side for hedge fund investments and not on the supply side", they write. Other unregulated – and generally wealthy – investors should be left to their own means. "Accredited investors willingly place their money with unregistered hedge funds, fully cognizant of the potential for abuse. If there is any desire by those investors for better auditing, the intensely competititive hedge fund industry will likely provide such services, without any regulatory prompting", they write. However, Lorin Gresser, Head of Alternative Investments at Threadneedle, an investment manager, and Mark Brady, partner at Crowell & Moring, a law firm, warn that proper controls should always be in place to ensure that the investors have the capacity to invest in this asset class, such as what is done in UK through due diligence conducted by the asset manager. "Contrast this with the position in the US, where most hedge fund explosions have happened, and where wealth has been equated with sophistication, an assumption which has had disastrous consequences", they say. Danger of regulation Jean-Pierre Zigrand adds that while disclosure rules certainly don't have the same kind of operational consequences as restrictions on activities, regulators have until now restrained from fully opening the hedge fund books, largely for political reasons. According to him, it would put them at risk of having to step too frequently in the management of hedge funds, on fear of being accused of not having done anything should a crisis really happen. On the other hand, resorting to a less intrusive mean such as setting a maximum leverage might be a double-edged weapon. According to the data used by the LSE academics, 84% of hedge funds had leverage level of less than 200% and only 2% used leverage of 500%. "In normal time, a maximum leverage of 4 would be benign since the vast majority of hedge fund managers do not use such a high leverage", says Jean-Pierre Zigrand. But should a crisis break out, the consequences of such a prudential rule could be devastating. "[…] Dangerously high leverage is probably due to a vanishing capital base in a crisis situation, rather than a deliberate strategic decision. In that case regulation is counterproductive, since forcing the hedge fund to lower the leverage ratio would mean that the hedge fund needs to sell risky assets in a fire sale at the worst moment. This might not only use up market liquidity, but is likely to lead to further falls in asset prices, leading to yet more turbulence, which in turn would require hedge funds to sell even more assets and so forth", write the LSE academics. While hedge funds are the only financial institutions exempted from most prudential regulations, the LSE academics They point out that hedge funds deal with other regulated institutions, among which prime brokers that carry out most trading activity on their behalf. "Because the prime brokers are regulated, their hedge fund business indirectly falls under supervisory oversight", they remind. Enough to shatter the myth that hedge funds operate with total disregard for the rules that command the financial markets. Julien Laplante |
|
© Copyright 2008 bfinance. This document is for your personal non-commercial use. Any further copying, reproduction, distribution is strictly prohibited. To obtain permission please contact This e-mail address is being protected from spam bots, you need JavaScript enabled to view it