Is There Any Regulation Of Hedge Funds?

Summary: The financial crisis of 2008 exposed the lack of regulation of hedge funds and investment banks. Is this right that these financial goliaths should operate outside of the normal rules? This article looks at the situation.

Hedge funds are very difficult to regulate. This is a fact, but it is in large part by design.

Most traditional investment funds (mutual funds and unit trusts for example) have very specific Terms of Reference which is designed to limit the markets and sectors to be invested in and also places limits on how the fund can or cannot borrow money.

These Terms of Reference also have to abide by the local laws. This means that any legal restrictions placed on investment funds must be respected.

For the fleet-footed entrepreneurial types that run hedge funds, these limits are clearly wrong and hold them back from earning all that they can with their capital. Such constraints are simply an obstacle to be overcome!

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While investment managers can argue that the 'market' regulates better than a government can, and they may have a point, the experience of 2007/8/9 suggests quite clearly that many in the investment business do not act with the correct care and attention. They may in fact not be at risk of moral hazard.

As noted on another page about hedge fund due diligence, the international structures used make effective regulation of hedge funds almost impossible. When combined with the complexity of their activities, hedge funds have been effectively operating outside of the financial services regulatory system for many years.

The financial crisis highlighted the problems in such an extreme way that financial regulators have been working hard to fill in the gaps ever since.

This process is made much harder by the need for any regulations to be as close to identical as is possible between the United States and the European Union. Any gaps or small advantages will surely be used by hedge fund managers.

It goes without saying that this has required some very steep learning curves for many politicians that suddenly found themselves on a 'Financial Crisis Committee'.

At the time of writing in mid 2011, legislation is not yet in place. However, the process of drafting and reviewing is well progressed.

It is hoped that the legislation will help to bring more of the activities of a hedge fund onshore so that improved regulation is possible. It is also hoped that borrowing limits (leverage) will be set and that much of this borrowing will be brought onshore where it can be monitored. The intention is to limit access to the market by use of a 'passport', meaning that funds that do not comply will not be able to sell themselves. This might work.

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It is likely that only be denying access to the market of investors will governments be able to have any new influence over the hedge fund community.

It goes without saying that the hedge fund community is not happy with the proposals for greater transparency. They fear that by disclosing their results more openly, they may expose their trading methods to their competitors. This will either provide them with less of an advantage in the markets, or will be used against them by others wishing to start new funds.

While these arguments have some merit, the real and perceived bad behaviour by the industry when combined with the massive salaries and bonuses managers earn, means that there is little hope for them to escape increased regulation.

If you would like to read more about hedge funds, please follow these links:

It is also worth noting that the regulation framework will almost certainly be improved over time, which will make their compliance procedures and reporting schedules even more onerous.

If you would like to read more about hedge funds, please follow these links:

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