The Future of Hedge Fund Regulation: A Comparative Approach (United States, United Kingdom, France, Germany, Italy)

Abstract

Hedge funds are important actors in the global economy that managed 1.7 trillion dollars in 2009, a 13% increase compared to 2008 and down from 2.1 trillion in 2007. It is estimated that 9,400 hedge funds are operating worldwide, a reduction of more than 1,000 funds from the 2007 peak, due to the financial crisis during which three quarters of hedge funds suffered an average 15.7% loss.

Although the industry has faced some difficulties over the past two years, hedge funds play an important role in the global financial system. They assure efficiency in capital markets, they are a significant source of liquidity, and they absorb financial risks. The benefits these investment vehicles bring to the markets are essentially made possible by flexible and light regulatory regimes. Unlike registered investment companies, they escape most of the disclosure, reporting and leverage requirements.

Hedge funds didn’t cause the current crisis, yet there seems to be a consensus among regulators around the world for more regulation. One may wonder why that is and whether regulators are not confusing targets. The rationale behind this desire to take action is twofold. The first concern is systemic risk, which we define here as the risk of chain reactions of failures. The current crisis has shown, if it still needed to be shown, that markets are deeply interconnected and rely on one another. The size and complexity of hedge funds may make some of them systemically significant and likely to provoke chain reactions that could lead to a generalized collapse of financial markets.

In light of the failures of Long Term Capital Management in 1998 and Amaranth Advisors in 2006, the question of whether hedge funds pose a systemic risk needs to be asked and the potential remedies need to be evaluated. Carrying out such assessments can be challenging for regulators if they do not have the tools to evaluate risks. Some entities may escape their oversight, which has become a justification for more regulation. The second concern that according to regulators justifies hedge regulation is the need to achieve greater transparency and cure informational asymmetries in order to guarantee an appropriate level of investor protection.

This paper examines in its first part the relevance of these two arguments. It provides an comparative overview of legal regimes applicable to hedge funds in five jurisdictions. It focuses primarily on the United States and explores four European Union member states’ hedge fund regulations. The United Kingdom, France, Germany and Italy have been chosen, for these countries are representative of the variety of legal frameworks that coexist within the European Union. It concludes that although systemic risk may be a legitimate concern, the investor protection argument is questionable.

Part II explores what the future of hedge fund regulation could look like based on the different proposals that have been sketched out in the past few months2. The European Union3 (“EU”) has introduced the controversial Directive on Alternative Investment Fund Managers (“AIFM”) in April 2009 and the U.S. House of Representatives has enacted the Private Fund Investment Advisers Registration Act of 20094 (“PFIARA”). These recent proposals introducing more regulation are presented and discussed in Part II in which a lack of global coordination in attempts to reform hedge funds is also identified.

Part III develops the idea that hedge funds do not need more but better regulation. The paper proposes a framework to assess whether more regulation is the answer and makes several suggestions as to what elements legislators should take into account in the costs/benefits analysis that should precede any attempt to introduce regulation.

Finally, I develop the idea that national particularisms must be transcended in order to establish an effective legal framework on a global scale. I suggest the creation of a global database for regulators’ use. The database would bring together financial information concerning all systemically-sensitive financial entities, including hedge funds. This system would favor an ex-ante monitoring, which would help reduce the likelihood of a systemic crisis.

* This paper was written in conjunction with the International Finance Seminar at Harvard Law School under the supervision of Professor Hal Scott. It was published in France in The Journal of Regulation n°3 - September 2010, Special Issue : Finance. An updated version will also appear in Volume 10, Issue 3 of the Richmond Journal of Global Law and Business, in the United States.

Keywords: Hedge funds, regulation, systemic risk, database of financial information, reporting, disclosure, SRO, AIFM Directive, Dodd Frank Act, Investment Advisers Act, SEC, European Union, fund managers, harmonization, global financial crisis