Hedge funds and the new regulatory agenda

Abstract

Regulatory interest in ‘hedge funds’ has intensified in the wake of the collapse of the Long-Term Capital Management (LTCM) hedge fund, and the growing retailisation of the sector through vehicles such as ‘fund of funds’ hedge funds. Though recognised by the Financial Services Authority (FSA) as playing an important role in the financial system, the hedge fund sector continues to pose formidable regulatory challenges. In particular, there is a real possibility that hedge funds and ‘prime brokers’ will increase their risk profiles, thus threatening not only their own solvency but, more importantly, the stability of the financial system more generally. Similarly, there exist problems surrounding issues such as asset valuations and side letters which raise heightened fears about conflict of interest abuse and investor protection. While any attempt by the FSA to subject the sector to closer regulatory scrutiny needs to be sufficiently robust to ensure that the above regulatory concerns are adequately addressed, any measures adopted must not be so heavy handed as to drive lucrative hedge fund business further offshore to less heavily regulated centres. In striking the right balance, a further complication is that of ‘moral hazard’– to the extent that the FSA seeks to tighten its grip on the hedge fund sector through more exacting regulation and oversight, there is the worry that such moves will encourage investors and financial market operators to take less care over their investment decisions. Although it is clear that prime brokers and other market counterparties have very real incentives to engage in private supervision of the hedge funds with which they deal, given the presence of significant market failures there is a danger that the private interests of these entities will not always be fully aligned with the public good. I argue that the FSA’s reliance on private interests and incentives to regulate an industry, the collapse of which could have serious public consequences, is an understandable yet ultimately deficient form of regulatory strategy. It is understandable because of the obvious limitations of the FSA’s scope for unilateral action. Yet it is deficient because the FSA must do more to challenge the complacency of the current international regulatory consensus – one that the FSA has helped shape, and one that its recent reform measures are part. This challenge would, at the very least, require minimum standardised disclosure requirements to be imposed on hedge funds, and for the full risks that these funds take to be fairly reflected in the cushion of capital that they are required to maintain, as well as the ‘margin requirements’ and ‘risk management’ systems they are required to adopt. These reforms would, if instituted at the international level, represent an important first step in helping to ‘bring to heel’ an industry which has assumed for far too long that it is a law unto itself.