The Direct Regulation of Potential Systemic Risk of Hedge Funds in the U.S. before and after the Dodd-Frank Act

Abstract

This article compares the direct regulation of hedge funds in the U.S. prior to the Dodd-Frank Act with the direct regulatory measures to address potential systemic risks of hedge funds ensued in its aftermaths. The direct regulation involves regulatory measures focusing immediately on the regulation of the target industry. In contrast, the imperatives or commands of indirect regulation is mediated by or transmitted through an intermediary to the (primarily intended) regulated entity or activity, which is ultimately the target. To address the potential contribution of hedge funds to financial instability, the Dodd-Frank Act uses a mix of direct and indirect regulatory measures. This article focuses solely on the direct regulatory measures.The first part of the article briefly sketches the regulatory environment of hedge funds in the U.S. prior to the enactment of the Dodd-Frank Act. The second part analyzes 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 the registration and disclosure requirments on hedge funds and collection of systemic risk data. On the other hand, as an additional direct regulatory measure, the Dodd-Frank Act requires the Federal Reserve (Fed) to impose prudential regulation for hedge funds contingent upon their designation as Systemically Important Non-bank Financial Companies (SINBFCs) by the Financial Stability Oversight Council (FSOC). This article concludes that in the absence of the indirect regulatory measures focusing on the banking entities placing restrictions on their relationships with private funds (embodied in the Volcker Rule), the direct regulation of hedge funds is unlikely to mitigate the potential systemic risk of hedge funds.