market folly

Just yesterday, we had an intriguing guest post regarding the future of hedge funds. Today, we follow it up with another excellent guest post examining the future regulation of the hedge fund industry. The following is a guest post from Hedge Fund Blog Man, who covers articles of note regarding the hedge fund industry.

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The Future of Hedge Fund Regulation in the United States

Summary
Over the last couple of years there has been a lot of political discourse about the need for greater regulation of the financial industry, including hedge funds. Much of the information (and rumors) about possible hedge fund regulation is somewhat contradictory. We will wade through the debate and provide a summary of current proposals for hedge fund regulation in the US and discuss hedge fund regulation in the EU and other countries.

Though it was highly regulated financial institutions that are widely believed to be the cause of the recent financial crisis and subsequent economic malaise, there is talk of regulating hedge funds and private equity firms as well. There have been a huge number of proposals for regulating hedge funds ranging from registration requirements for just the largest to funds, to almost authoritarian regulation for all private money managers. However, the current proposals with the most support appear to be hedge fund registration requirements, without significant additional oversight.

Current Hedge Fund Regulations
Under the existing system hedge funds and private equity firms are far less regulated than mutual funds and other investment vehicles open to the public. Though some hedge funds are registered with the SEC, a couple clauses in the Investment Company Act of 1940 allow must hedge funds to operate without registering with the SEC or any other government agency. Probably fewer than half of all hedge funds are currently registered as investment advisors with the SEC. For funds that are registered, the SEC requires certain filings, but does not provide operational oversight.

The Need for Hedge Fund Regulation
Hedge funds were clearly not the major players in the current financial crisis. However, the $50 billion fraud perpetrated by Bernard Madoff sparked plenty of public outrage and there have been a couple of multi billion dollar hedge fund failures since 2007. Additionally, many politicians still fear another hedge fund collapse ala Long Term Capital Management, the giant hedge fund that collapsed in 1998 and necessitated a Federal Reserve orchestrated bailout.

Treasury Secretary Timothy Geithner voiced his concern in April, "Today, the consequences of (hedge funds') failure is greater. They need to be subject to a higher set of standards.”

Proposals for Regulating Hedge Funds and Recent Developments (2009)
In January 2009, Senators Charles Grassley (R-Iowa) and Carl Levin (D-Mich.) introduced the Hedge Fund Transparency Act of 2009. The Act would affect funds with more than $50 million in assets (“large firms”). All funds in excess of $50 million would be required to register with the SEC and maintain books and records according to SEC requirements. It would also require disclosure of including information regarding the identity (including addresses) of the fund’s “beneficial owners,” the amount of the fund’s assets, the fund’s equity structure, affiliations the fund may have with other financial institutions, the minimum investment commitment required of investors, and the total number of investors. The bill did not get to a vote.

In March of 2009, Larry Summers , Director of the National Economic Council for Barack Obama, said the U.S. wants large hedge funds and private-equity firms to be subjected to "rigorous public scrutiny," compared with the minimal oversight they now face. Before joining the Obama Administration, Summers was a Managing Director with one of the worlds largest hedge funds, D.E. Shaw Group.

Then in late April, President Obama lashed out at hedge funds refusing to accept a government offer for Chrysler debt. "A group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout," Obama said, "They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don't stand with them."

In July, the Obama Administration, released TG-214, a fact sheet with the Administration’s proposals for regulating hedge funds. Funds with more than $30 million would be required to register with the SEC. Once registered funds would be subject to:
• Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
• Disclosure requirements to investors, creditors, and counterparties of their advised private funds
• Strong conflict-of-interest and anti-fraud prohibitions
• Robust SEC examination and enforcement authority and recordkeeping requirements
• Requirements to establish a comprehensive compliance program
The main rationale for the above requirements is to “protect the financial system from systemic risk”

The most recent House of Representatives proposal for hedge fund regulation, from Aug 6, 2009, seems to have lost some of the initial enthusiasm and would regulate hedge funds under less-stringent conditions than banks and lenders. According to House Financial Services Chairman, Barney Frank, “How can you regulate a hedge fund like a mortgage? It doesn’t make any sense. It will be a form appropriate to them.” In apparent moment of bipartisanship, both Democrats and Republicans seem to be in agreement that hedge fund and private equity firms should be more lightly regulated than other traditional financial firms. It should also be noted that hedge fund industry groups spent almost $4 million in lobbying in the first half of 2009.

Hedge Fund Regulation in Europe
Europe has been quicker to attempt hedge fund regulation and proposals there have generally been more severe than in the US. Likewise, hedge funds and private equity firms in the EU have been more vocal in their opposition to regulation than their US counterparts. The most contentious issue in EU hedge fund regulation appears to be an attempt to limit or place caps on the amount of leverage funds can employ. Because of the possibility of regulatory arbitrage, look for the EU and US to finalize regulations that are relatively consistent.

When Will We Get New Hedge Fund Regulations?
Though there are ongoing talks, there is currently no bill for hedge fund regulation in Congress that is likely to pass. It is unlikely any new regulation will be finalized until 2010. Because compliance with new rules could be costly and time consuming, it is conceivable that new hedge fund regulations might not be enforceable until 2011.

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Thanks to HFBM for the excellent write-up as we will definitely be watching the developments on this front going forward. Regulation and transparency have been big talking points given the crisis, forced liquidations, frauds like Madoff, and numerous other crazy events that have happened recently. The above was a guest post from Hedge Fund Blog Man, who covers articles of note regarding the hedge fund industry.