By Stephen Brown, Anthony Lynch, and Antti Petajisto
Now that the Dodd-Frank Act has been passed by both houses of Congress, we finally know its broad implications for hedge funds. As expected, it requires all large hedge fund advisers to register with the SEC. Also the new rules on derivatives trading have an additional impact on many hedge funds. However, since the Act leaves many specifics up to the regulators, considerable uncertainty remains about the exact form of the new rules. The main tradeoff is between the government's desire to learn more about hedge funds, both to assess systemic risk and to protect investors, and the compliance costs this imposes on funds and investors. Overall, how economically sensible is hedge fund regulation in the Act, and how well does the Act resolve this tradeoff?
The main economic argument for regulating hedge funds is based on their potential to generate systemic risk. Systemic risk can arise from counterparty exposures when a large fund (or group of similar funds) uses leverage but subsequently runs out of cash and thus cannot meet its obligations, either because of a negative net asset value or temporary lack of liquidity. The classic example is Long-Term Capital Management in 1998, which had almost a trillion dollars in notional exposures but only $4 billion in equity. The secondary argument for regulating hedge funds is based on protecting unsophisticated investors. However, hedge fund investors are already restricted to a small subset of "accredited investors" for this reason, which makes the case for further investor protection much weaker.
How much systemic risk do hedge funds really generate? The recent financial crisis represents an extended period of real-life "stress testing" which was more extreme than in 1998 and certainly should have exposed most fragilities in the system. Yet hedge funds held up relatively well: the average fund did fall 20%, but the equity market fell twice that much, and there were no major hedge fund blow-ups due to the crisis. Prime brokers and other hedge fund counterparties appear to have learned from 1998: leverage was lower throughout and counterparty risk did not seem a significant threat. Hedge funds also appear to have been prepared, as many of them put up gates to suspend withdrawals, which significantly curtailed the threat of runs on illiquid assets. Rather than causing or contributing to the recent crisis, hedge funds helped mitigate the crisis by taking some illiquid assets off the balance sheets of other institutions and by providing liquidity in general (Aragon and Strahan, 2010). Hence, the new hedge fund legislation is not so much about fixing newly discovered flaws as it is about preventing potential problems from arising in the future.
The Dodd-Frank Act requires all hedge fund advisers above $150 million to register with the SEC. They have to maintain extensive records about their investment and business practices, provide this information to the SEC, hire a chief compliance officer to design and monitor a compliance program, and be subject to periodic SEC examinations and inspections. The SEC is also given considerable power to expand its own authority in the future: it has the power to request any additional information it deems necessary, it can define "mid-sized" private funds and require them to register as well, and it can impose separate recordkeeping and reporting requirements on all other hedge funds. However, "family offices" are exempt from registration.
Also the derivatives section of the Dodd-Frank Act affects hedge funds. For example, a hedge fund trading OTC derivatives may be deemed a "major swap participant" and thus be subject to additional regulation described in the derivatives section of the Act. Again, a lot of the important details are left for the regulators to decide later.
Overall, we would like to see a broad but light regulatory approach to hedge funds. It would be reasonable to require all hedge funds to register with the SEC and to file Form ADV to provide useful information to investors. Particularly troubling is the family office exemption which has the potential to turn into a loophole that encompasses a large fraction of the industry. However, compliance costs should be kept low, and the SEC's mandate should be limited to collecting information on the items explicitly mentioned in the Act. In its current form, the Act gives the SEC essentially an open mandate to regulate and to define the scope of its own authority over the industry. Because regulators in general have an incentive to expand their own power and because the SEC in particular has an unimpressive track record of discovering even simple fraud, any additional powers granted to the SEC should be more narrowly targeted toward a specific task.
Protection of hedge fund investors is now something the SEC is also officially authorized to engage in. We hope that any such future rules would focus on disclosure, such as requiring explicit disclosures of all expenses charged to the fund and differential tax treatment of investors. Beyond that, it should be up to the accredited investors themselves to make their own investment decisions. Fiduciaries should bear more responsibility for doing due diligence and pay a high price for neglecting this fundamental duty.
The sensibility and impact of the new hedge fund legislation will almost entirely depend on the specific rules that will be written later by the regulators, so we cannot pass our final judgment yet, especially given the considerable leeway the Act has left for the regulators. It may even take a year or two before we will really see how the hedge fund rules have changed.
In the future, the hedge fund sector will only grow in size and importance, since the Volcker rule of the Dodd-Frank Act requires banks to spin off their proprietary trading desks and their internal asset management divisions into stand-alone hedge funds. As a result, hedge funds will be the only source of sophisticated and relatively unconstrained capital, thus making them perhaps the main liquidity providers across a variety of markets. Efficient allocation of capital is the key function of the financial market, so it is all the more important that the subsequent rules following the Dodd-Frank Act will not stifle hedge funds or reduce the intense competition between them.