November 14, 2008
Hedge Fund Regulation Revisited
Posted by Michelle Harner

The Chief Executive of the United Kingdom’s Financial Services Authority recently hedged his response to the increasing pressure for more regulation of the hedge fund industry.  He said, “I don't particularly think more regulation is needed, but I do think more effective regulation is needed.”


In the United States, we have been debating the issue of increased hedge fund regulation for at least the past five years.  (For insightful posts by others on The Conglomerate regarding hedge fund regulation, see, e.g., here, here and here.)  Interest in hedge fund regulation surfaced in 2003-2004, following the Enron, WorldCom and other corporate scandals of that time and Eliot Spitzer’s investigation into mutual fund practices.  Interest arose again in 2007 at the start of the current financial crisis.  Although hedge funds caught a brief reprieve during the past several months as the country focused on investment banks, financial institutions and the subprime crisis, the House Committee on Oversight and Government Reform has refocused its attention on the hedge fund industry.


In a hearing yesterday before the Committee, several witnesses testified about the role of hedge funds in the current financial crisis.  The witness list included several academics and senior managers from five of the country’s largest hedge funds—Paulson & Co., Inc.; Soros Fund Management, LLC; Renaissance Technologies, LLC; Harbinger Capital Partners; and Citadel Investment Group, LLC.  According to Rep. Henry A. Waxman’s opening statement, these five funds made, on average, over $1 billion last year.


The statements of Professors David Ruder, Andrew Lo and Joseph Bankman and Houman Shadab (a Senior Research Fellow) certainly are an interesting and worthwhile read.  In particular, Professor Lo provides a succinct explanation of why financial crises “may be an unavoidable aspect of modern capitalism.”  He suggests that any “[n]ew regulations should be adaptive and focused on financial functions rather than institutions, making them more flexible and dynamic.”  From this premise, he urges measures such as standardizing derivative contracts and establishing an organized exchange and clearinghouse for certain of those contracts.  Those latter sentiments were echoed in varying degrees by Professor Ruder and some of the fund managers.


I was not really surprised by any of the academic testimony.  I was, however, slightly surprised by the testimony of the fund managers.  As you might expect, the fund managers emphasized the role of investment banks, ratings agencies and risky credit derivatives in the current financial crisis.  (For another fund manager's similar views on the crisis and an interesting explanation of the leverage carried by many funds, listen to yesterday’s interview of Jim Chanos on CNBC.)  Nonetheless, several of the fund managers indicated support for more transparency, and even some regulation of the hedge fund industry.


For example, James Simons of Renaissance Technologies suggested, “A proposal the Committee may wish to consider is to require hedge funds’ positions to be reported to an appropriate regulator and then to allow the Federal Reserve Bank of New York, or some similar such authority, to have access to aggregate position information and to recommend appropriate action should the situation warrant it.”  Likewise, Philip Falcone of Harbinger Capital Partners said, “I support some additional government regulation requiring more public disclosure and transparency for hedge funds, as well as for public companies.  All investors, whether individuals or sophisticated institutions, have a right to know what assets companies have an interest in—whether on or off their balance sheets—and what those assets are really worth.”


The results of a recent survey of 313 hedge fund senior managers may, in part, explain these comments.  According to the survey, 98% of the respondents “believe that the new administration is likely to increase regulation of the hedge fund industry.”  Moreover, 77% of the respondents “agreed that the overall impact of the new administration on the hedge fund industry will not be positive.”  So, perhaps hedge funds see the writing on the wall and are operating in damage-control mode.  Whatever the explanation, I think the dialogue is positive and, hopefully, will assist Congress in striking the right balance in any regulation of the hedge fund industry.

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