Hedge funds, risks and regulation - a study of the regulatory engagement in the United States, the United Kingdom and Sweden

Abstract

The rapid growth in hedge funds has triggered an international debate on the risks involved with their operations and potential negative effects on the financial system. The rise and fall of Long Term Capital Management - which prompted the US Federal Reserve to engineer a bail-out - still haunts the sector 10 years on. Simultaneously we have to admit that markets and investors benefit from a wide diversity of players and hedge funds as a group, add to the depth, liquidity, and vibrancy of global financial markets. The aim of this thesis is to discuss the case for further regulation of hedge funds based on the concerns for financial stability and consumer protection. Much of the debate about hedge funds raises the view that the risk is due to a lack of regulatory oversight. A chapter outlining the legal environment for hedge funds is therefore essential for the understanding of the regulatory debate and the response to the key risks. FSA's approach is fundamentally different using their outspoken principle-based regulation and their Alternative Investment team that carries out risk-based supervision of hedge fund managers. The US has distinguished itself by having a complex rules-based system governing financial institutions, where hedge funds rely on and exploit the loopholes. The Swedish Finansinspektionen (FI) has taken a risk-based approach and provides hedge funds with a ''quality label'' in the way investors appreciate the FI authorization as an effective substitute for their own due diligence - a viable approach in Sweden with 50 hedge funds and less liquidity. The retail investors' access to the hedge fund industry is perhaps what is the most significant within the Swedish approach. As retail investors (as opposed to high net worth individuals) have - directly or indirectly - got increasingly exposed to hedge fund type investment, the ''retailisation'' of the industry has become a much-debated topic with regards to consumer protection. However, the main challenge in designing a regulatory structure for hedge funds is to mitigate the risks of a systemic event attributed to hedge funds without restraining the benefits they provide to the financial system. To this dilemma, we can apply three different regulatory methodologies: direct regulation of the funds (or the fund managers), indirect regulation through the regulated counterparties with which they deal, and market discipline - regulation by the market through due diligence including greater transparency and disclosure to counterparties and investors. Market discipline also includes reliance on self-regulation imposed by the industry. Central to this thesis is the contradiction between the perceived lack of regulatory oversight internationally and different approaches that can be applied to manage the specific risks that arise. This thesis argues that since direct regulation means struggling with regulatory arbitrage, moral hazard and difficulties to reach cost effective supervision we need to recognize the limitations of regulation and supervision. We cannot cover all risks, unless we are prepared to regulate away the whole function of hedge funds and finance in general. The purpose of regulation should only be to limit the costs (risks) if we at the same time want to preserve the potential benefits. One could argue that the complexity of today's markets has been dispersed beyond the regulated sector meaning it is the strong market participants that have the resources to anticipate and fend off the risks, not the regulator. Having to choose among the three regulatory methodologies outlined in this paper, the emphasis from the international regulators should continuously be on indirect regulation by setting expectations regarding risk management practices by banks and financial institutions dealing with hedge funds. It is the banks that have the competence to deepen their understanding of their own sensitivity to market shocks by strengthening their stress-testing and scenario-analysis capabilities, particularly with respect to scenarios that involve erosion of market liquidity and that could generate domino effects. The major challenge facing the financial industry is risk management, especially in relation to the valuation of increasingly correlated assets, complex derivatives and the management of collateral as a means of mitigating counterparty risk. These areas represent the key regulatory challenges arising in respect of hedge funds and those who manage and provide services to them. The preferred role of the regulator should be to co-operate with the market participants and enforce continuous improvements in risk management systems through deliberate regulation of all market participants with a more principle-based approach. The regulator should support market discipline with its enforcement powers, tackle perceived breaches of industry guidelines and come down heavily on weak risk management within large impact players (including some hedge funds) in the market. The objective should not be to regulate the ongoing activities of the hedge funds, but rather to address the failures. The key is risk management within all financial firms. This way we would stay vigilant in protecting against any potential systemic problems while at the same time allow the benefits of hedge funds to unfold. In a cost-benefit analysis I argue that hedge funds rather have the capability of managing risk than increasing it. To strangle their freedom and their possibility to provide solutions to a potential crisis would be a serious mistake.

• author: Vaissi, Alexandra
• supervisor: Lars Gorton
• organization: Department of Law
• year: 2007
• type: H3 - Professional qualifications (4 Years - )
• subject: Law and Political Science
• keywords: Förmögenhetsrätt, Bankrätt, Komparativ rätt
• language: English
• id: 1562755
• date added to LUP: 2010-03-08 15:55:30
• date last changed: 2010-03-08 15:55:30