Hedge funds and investor protection regulation

A recent Securities and Exchange Commission (SEC) ruling requiring hedge fund advisers to register with the SEC aims to foster conduct and compliance to better protect hedge fund investors. This article focuses on investor protection regulation, considering its goals and likely costs and benefits. After reviewing some alternative regulatory approaches, the author examines the current U.S. regulatory structure for hedge funds, which has, perhaps unwittingly, separated hedge fund investors into two distinct classes -- retail and wholesale -- defined by wealth levels. ; The SEC's recent ruling reflects its concern about the growing "retailization" of hedge funds -- the increasing ability of less qualified (retail) investors to access hedge fund investments -- as general wealth levels rise and as more affordable investments, such as funds of hedge funds (FoFs), proliferate. In addition, institutional investors have increased their investments in hedge funds, exposing even more individual investors, at least indirectly, to a type of risk they may be unfamiliar with. ; The author believes that the costs of increased regulatory protection for hedge fund investors will ultimately prove to outweigh the benefits, and he argues that hedge fund investment strategies be made more, not less, accessible to a broader array of retail investors. In particular, he recommends that the SEC consider authorizing FoFs under a regulatory structure that better enables hedge funds to pursue absolute-return strategies so that retail investors can benefit from them.Hedge funds

The decline of traditional banking: implications for financial stability and regulatory policy

In recent years, the traditional business of banks--making long-term loans and funding them by issuing short--dated deposits-has declined. This development has raised concerns that more banks will fail or be forced to assume greater risk to remain profitable. This article first examines the economic forces responsible for banks' reduced role in financial intermediation. The authors then consider whether banks may be jeopardizing the stability of the financial system by extending riskier loans or engaging in derivatives dealing and other "nontraditional" financial activities that bring higher returns but could carry greater risk. The authors conclude that because most nontraditional activities expose banks to risks and moral hazard problems similar to those associated with banks' traditional activities, the new activities can be regulated as effectively as the old.Banks and banking ; Financial services industry ; Bank supervision

The Decline of Traditional Banking: Implications for Financial Stabilityand Regulatory Policy

This paper outlines the fundamental economic forces that have led to the decline in traditional banking, that is the process of making loans and funding them by issuing short-dated deposits. The declining competitiveness of traditional banking may threaten financial stability by increasing bank failures and by increasing the incentives for banks to take on more risk, either by making more risky loans or by engaging in 'nontraditional' financial activities that promise higher returns but greater risk. This paper argues that most nontraditional activities, such as banks acting as derivatives dealers, expose banks to risks and moral hazard problems that are similar to those associated with banks' traditional activities, and that these activities can be regulated as effectively as can traditional activities. One regulatory approach to maintain financial stability and strengthen the banking system is to adopt a system of structured bank capital requirements with early corrective action by regulators. An important element in this approach is that market- value accounting principles would be applied to banks and there would be increased public disclosure by banks of the risks associated with their trading activities. With this regulatory structure in place, banks could be permitted greater freedom to expand into nontraditional activities.

Derivatives and the Bankruptcy Code: Why the Special Treatment?

The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank\u27s subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the automatic stay and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor\u27s assets. It is commonly believed that the exemption for derivatives contracts helps reduce systemic risk in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring. A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm\u27s going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code\u27s treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code\u27s treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code\u27s exemptions for derivatives contracts

Derivatives and the Bankruptcy Code: Why the Special Treatment?

The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank\u27s subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the automatic stay and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor\u27s assets. It is commonly believed that the exemption for derivatives contracts helps reduce systemic risk in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring. A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm\u27s going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code\u27s treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code\u27s treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code\u27s exemptions for derivatives contracts

New proposals to regulate hedge funds: SEC Rule 203(b)(3)-2

On September 29, 2003, the Securities and Exchange Commission (SEC) issued a report on the “Implications of the Growth of Hedge Funds” (the “Report”). The Report raised several issues related to hedge funds and proposed a number of regulatory initiatives that the SEC might take. Its principal recommendation was that the SEC should require most hedge managers to register as investment advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). On July 14, 2004, after a lengthy period of public comment on the Report, the SEC (“Commission”) adopted (by a split vote) Rule 203(b)(3)-2, which implements this registration recommendation, and set a two-month period for public comment before formally adopting the Rule on December 2, 2004

The regulation of hedge funds : financial stability and investor protection

While hedge funds have been around at least since the 1940's, it has only been in the last decade or so that they have attracted the widespread attention of investors, academics and regulators. Investors, mainly wealthy individuals but also increasingly institutional investors, are attracted to hedge funds because they promise high “absolute” returns -- high returns even when returns on mainstream asset classes like stocks and bonds are low or negative. This prospect, not surprisingly, has increased interest in hedge funds in recent years as returns on stocks have plummeted around the world, and as investors have sought alternative investment strategies to insulate them in the future from the kind of bear markets we are now experiencing. Government regulators, too, have become increasingly attentive to hedge funds, especially since the notorious collapse of the hedge fund Long-Term Capital Management (LTCM) in September 1998. Over the course of only a few months during the summer of 1998 LTCM lost billions of dollars because of failed investment strategies that were not well understood even by its own investors, let alone by its bankers and derivatives counterparties. LTCM had built up huge leverage both on and off the balance sheet, so that when its investments soured it was unable to meet the demands of creditors and derivatives counterparties. Had LTCM’s counterparties terminated and liquidated their positions with LTCM, the result could have been a severe liquidity shortage and sharp changes in asset prices, which many feared could have impaired the solvency of other financial institutions and destabilized financial markets generally. The Federal Reserve did not wait to see if this would happen. It intervened to organize an immediate (September 1998) creditor-bailout by LTCM’s largest creditors and derivatives counterparties, preventing the wholesale liquidation of LTCM’s positions. Over the course of the year that followed the bailout, the creditor committee charged with managing LTCM’s positions effected an orderly work-out and liquidation of LTCM’s positions. We will never know what would have happened had the Federal Reserve not intervened. In defending the Federal Reserve’s unusual actions in coming to the assistance of an unregulated financial institutions like a hedge fund, William McDonough, the president of the Federal Reserve Bank of New York, stated that it was the Federal Reserve’s judgement that the “...abrupt and disorderly close-out of LTCM’s positions would pose unacceptable risks to the American economy. ... there was a likelihood that a number of credit and interest rate markets would experience extreme price moves and possibly cease to function for a period of one or more days and maybe longer. This would have caused a vicious cycle: a loss of investor confidence, lending to further liquidations of positions, and so on.” The near-collapse of LTCM galvanized regulators throughout the world to examine the operations of hedge funds to determine if they posed a risk to investors and to financial stability more generally. Studies were undertaken by nearly every major central bank, regulatory agency, and international “regulatory” committee (such as the Basle Committee and IOSCO), and reports were issued, by among others, The President’s Working Group on Financial Markets, the United States General Accounting Office (GAO), the Counterparty Risk Management Policy Group, the Basle Committee on Banking Supervision, and the International Organization of Securities Commissions (IOSCO). Many of these studies concluded that there was a need for greater disclosure by hedge funds in order to increase transparency and enhance market discipline, by creditors, derivatives counterparties and investors. In the Fall of 1999 two bills were introduced before the U.S. Congress directed at increasing hedge fund disclosure (the “Hedge Fund Disclosure Act” [the “Baker Bill”] and the “Markey/Dorgan Bill”). But when the legislative firestorm sparked by the LTCM’s episode finally quieted, there was no new regulation of hedge funds. This paper provides an overview of the regulation of hedge funds and examines the key regulatory issues that now confront regulators throughout the world. In particular, two major issues are examined. First, whether hedge funds pose a systemic threat to the stability of financial markets, and, if so, whether additional government regulation would be useful. And second, whether existing regulation provides sufficient protection for hedge fund investors, and, if not, what additional regulation is needed

Can regulatory reform prevent the impending disaster in financial markets?

Deposit insurance ; Financial institutions