The U.S. (Un)regulation of Hedge Funds

Abstract

Hedge funds can pose and spread systemic risk across the financial markets and, additionally, they can be used by their managers to commit fraud and misappropriation of the assets, that, in turn, can seriously damage their investors.

With regard to systemic risk, it seems that the majority of the commentators now agree on their potential capability to pose and spread this type of risk. Evidences of that can be found in the quasi-failure of Long Term Capital Management (LTCM) as well as in other significant collapses from the recent past. Such issue has been considered very serious even by the U.S. legislature which in 2010, as a legislative response to the global financial crisis of 2007-2008, enacted the so-called Dodd-Frank Act, mainly in order to promote the financial stability of the United States.

On the other hand, the second issue is not always considered as a real priority in light of the argument that only sophisticated, wealthy and institutional investors are allowed to buy interests in hedge funds. These investors are deemed to be able to fend for themselves and therefore they would not need to be protected by the regulation due to their skills and/or economic condition. This argument, however, can be criticized on the basis of the number of scandals that in the recent past have involved hedge funds damaging their investors regardless of their level of sophistication and wealth. Also, due to the so-called “retailization”, now even investors who are neither particularly sophisticated nor very wealthy can directly and indirectly invest in hedge funds. These elements can prove that an investor protection issue exists and as such it should be seriously taken into account by the U.S. legislator. In this regard, even though the Dodd-Frank Act includes among its legislative purposes also the protection of consumers from abusive financial services practices, its new provisions seem un-able to reach this goal.

In a political context in which the new U.S. Administration has clearly declared that it will abolish a number of Dodd-Frank Act’s provisions in order to lower the costs of compliance for financial intermediaries, this article critically argues that the current regulation is inconsistent and inappropriate to prevent and face the two main issues posed by these funds, namely the creation and spread of systemic risk and the com-mission of fraud. It follows that a further decrease of the level of regulation and supervision could proportionally increase the peril that hedge funds seriously impact the markets and hurt their investors.

Keywords: Hedge Funds, SEC, US Regulation, Broker-Dealer