Regulating hedge funds

Jon Danielsson and Jp. Zigrand

Financial Stability Review, 2007, issue 10, 29-36

Abstract: Due to the ever-increasing amounts under management and their unregulated and opaque nature, hedge funds have emerged as a key concern for policymakers. While until now, hedge funds have been left essentially unregulated, we are seeing increasing calls for regulation for both microprudential and macroprudential reasons. In our view, most calls for the regulation of hedge funds are based on a misperception of the effectiveness of financial regulations, perhaps coupled with a lack of understanding of the positive contribution of hedge funds to the financial system. There are real concerns about consumer protection following from the expansion of the consumer base. However, it would be misguided to relax accreditation criteria. A more important issue is the investment of regulated institutions, in particular pension funds, in hedge funds. Since such institutions to enjoy direct or indirect government protection, the investment in hedge funds has to be regulated. However, such regulations are best implemented on the demand side by the pension fund regulator, rather than by directly regulating the hedge fund advisors themselves. Hedge funds provide considerable benefits, not only to their investors and advisors, but more importantly to the economy at large by facilitating price discovery, market efficiency, diversifi cation, and by being potentially able to put a floor under a crisis, a function not easily implemented by regulated institutions due to a minimum capital ratios, relative performance evaluation and other considerations. It would however be imprudent to leave hedge fund advisors completely unregulated since the failure of a systematically important hedge fund has the potential to create such uncertainty as to impede trading and in a worst case scenario cause significant damage to the real economy. These issues cannot be addressed by standard regulatory methodology such as disclosure and activity restrictions. Indeed, supervisors would be well advised to leave the hedge fund sector unregulated in their normal day-to-day activities. However, the regulator needs to have the power to resolve the informational uncertainty caused by the failure of a systematically important hedge funds. Prime brokers and other client banks would in such a scenario have a de facto or a de jure obligation to participate in the expedient removal of the uncertainty. To this end targeted consultation and contingency planning is essential.

Date: 2007
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