Abstract
This paper presents the direct vs. indirect debate of hedge fund regulation and attempts to find which approach is better able to mitigate systemic risk that the industry poses to the economy. The waves of regulatory reforms and enhanced concern regarding investors protection have recently brought the attention of the regulators to hedge fund regulation issue. But, many academics fear that direct intervention may limit industry growth and benefit. Addressing these concerns, this paper observes the systemic importance of hedge fund industry based on four criteria’s [size, leverage, interconnectedness to large complex financial institutions (LCFIs) and herding] and concludes that although this industry is still small in terms of size and leverage, their interconnectivity with LCFIs and potential herding make them systemically significant. Hence, regulation of hedge fund is necessary to restrict the transmission of systemic events. Analysing direct and indirect approaches, this paper suggests that the counterparties are best positioned to implement this regulatory change.
Highlights
Over the past decade hedge funds popularity has increased impressively and attracted a number of investors due to the unparalleled returns they yield
The objective of this paper is to find whether regulation of hedge fund would mitigate the systemic threat that they pose to the economy and which form of regulation serves best in this regard; imposing restrictions directly on the funds or regulating their creditors or counterparties
In order to assess the extent to which hedge funds are systemically important and able to magnify the financial instability, four criteria’s, i.e., size, leverage, interconnectivity and herding behavior have been taken as the key determinant of SIFI and are studied to judge their relevance
Summary
Over the past decade hedge funds popularity has increased impressively and attracted a number of investors due to the unparalleled returns they yield. The concern that the size and leverage level of hedge funds might make them systemically important and generate chain reactions leading to a possible collapse of the financial system. Throughout the regulation process, it is important to maintain a balance between leaving hedge funds unhampered in one hand to keep the unique and innovative strategies they apply, and imposing regulation at the same time so that the protection of investors, as well as, economy is ensured against systemic risks. The objective of this paper is to find whether regulation of hedge fund would mitigate the systemic threat that they pose to the economy and which form of regulation serves best in this regard; imposing restrictions directly on the funds (direct approach) or regulating their creditors or counterparties (indirect approach).
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