Law and Economics of Hedge Funds
Introduction
The EU since its birth, having a European global market as a desired goal, made many efforts to construct foundations to lubricate and facilitate international market transactions (i.e. institutions, Contract and Competition law, Tax benefits, etc.).
A key element to reach this normative goal is to establish an efficient financial market to allow the flow of capital and liquidity be directed to the various entrepreneurial economic and legal entities that will utilize it for their benefit while in market perspective increase social wealth. The interdependencies between local markets, capital providers and other intermediaries stem from this policy carry with it a big responsibility, the notion of market stability and the risk of a total system failure. It is somewhat surprising that the Regulators and monetary agencies started to analyse and respond to this risk as post crises action after the near collapse of Long Term capital Management, the fall of Bear Stearns and the Current financial crises.
This paper will explore the roll of the innovative unregulated investment vehicle so called “Hedge Funds” (HF) in the last financial crises, the effect it has on the Systemic risk and offer a conceptual framework as to assess what risk are “systemic” (to the market), the sources of those risks and by what means, if any, those risk should be regulated.
The analysis will show that the phenomena of systemic risk related to HF activities in the international market can be seen as some kind of tragedy of the commons, where the legal form, the industry’s adopted practices in respect of risk sharing and incentives structure which stems from the contractual relationship between this highly sophisticated market participants leads to a market phenomena??. Alan Grinspan tries to define this very complex issue, “It is generally agreed that systemic risk represents a propensity for some sort of financial system disruption, one observer might use the term “market failure” to describe what another would deemed to have been a market outcome that was natural and healthy, even if harsh”
Than it should the roll of the legislator to intervene and apply a focused regulation to reduce the impact of HF on systemic risk.
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Therefore, you have to describe your research question(s) at the beginning. It is useful to explain why these questions are important for the development of the legal or economic science and why the study was undertaken. You should state the aims of the paper and give sufficient background information to allow the reader to understand the context and the significance of the question(s) you are trying to address. Moreover, you have to explain the scope of your work, i.e. what will and will not be included.
The emergence of Hedge funds
HF were formed to operate in between the margins of Security regulation and they are considered to be a very vibrant part of the financial markets during the last decade. While utilizing high skilled personal motivated by profit sharing incentive structure and operating “below the radar” of regulation, HF adopted “broad array of risks that would have otherwise been borne by less willing market participants”. The highly versatile investment strategies under low constraints are what make it hard to distinguish HF from other funds as there are some characteristics that we can find in some HF and not find at all in others.
I will begin with exploring the history of HF since its known origin in 1949 and form an acceptable definition for HF as to better understand the risks associated with its operation and in particular systemic risk.
History of Hedge Funds
“HF represents a third stage in the development of investment intermediaries after commercial banks and mutual funds”
In 1966 Fortune magazine published an article about Dr. Alfred Winslow Jones and his first managed investment partnership, a hedge fund, which he established in 1949. His idea was to “to evade SEC regulation and achieve full portfolio versatility and flexibility”. Dr. Jones exercise investment strategies such as long and short positions in equities, in order to increase the value of his portfolio in any market condition while being highly leverage and by utilizing his management expertise.
Since then HF industry developed and became far more complex and diversified, we can identify a real growth of this industry only in the last 15 year as the global industry grew from $50 billion to $1 trillion in 2006 (representing a 4% and 10% of the amount invested in mutual funds, respectively).
Hedge Funds Mangers (“HFM”) took this path even further and by constant innovation and the creation of complex financial instruments succeeded to attract many institutional investors such as pension funds endowments and foundations.
Chart x: HF Assets growth Table x: The ten largest HF managers,(As % of global debt and equity outstanding) Year end 2005
Source: Rose-Smith (I.) (2006): “The hedge fund 100”, Institutional Investor’s Alph, June. See Ferguson, 2007.Alpha, June.
(USD billions) (Assets in USD Billions)
Sources: Hedge Fund Research, World Federation of Exchanges (FIBV), Bank for International Settlements (BIS) and Swiss Re Economic, Research & Consulting. See Ferguson 2007.
When analysing the performance of HF in the last 20 years, Shadab (2009) identifies 3 critical events, where specific systemic risk or global market factors caused losses in a worldwide perspective and thus putting the HF industry to the test as to protecting their investors against market instability. The first one was the Russian debt crises on August 17, 1998, where one of the largest US. HF, Long-Term Capital Management (LTCM) lost 90 percent of its capital and was eventually private rescued at a cost of $3.6 billion. During that crisis the hedge fund industry presented a loss of 7.75 percent in value compared to a loss of 14.46 percent for the S&P 500.
The second event which allowed HF to present outperformance in market downturns over the general market was during the crash of the technology bubble in 2000-2002. While often HF present lower returns on an absolute level, they preserve asset under management value when other indexes are negative. (see Chart below).
Chart xx: Hedge fund mean annual returns compared to U.S. Equity Market returns from 1997 to 2007
Source: EconStats, Shadab (2009).
The third landmark for the industry was and still is the current financial crises which began in 2007. I will explore in details the roll of hedge fund and their performance during the last 2 years in Part E of this section.
Trying to define a Hedge Fund
As previously mentioned there is a problem in accurately define HF in light of their freedom to operate, but a general definition as a “lightly regulated investment vehicles that try to maximize risk adjusted returns for investors” captures the main elements of this type of fund. Another appropriate description which focus on the HF activity was given by Verret (2007) “They may seek to capitalize on statistically significant divergences between two stock or commodities prices that differ from expected past correlation, using complicated models. They may trade commodities or currency swaps based on macroeconomic data, or trade on expected results of a merger or acquisition between two companies......., High leverage, management expertise, performance fees, and absolute return strategies are the hallmark of the industry”. Moreover their success is often attributable to the “proprietary trading strategies that offer arbitrage opportunities unknown to the market at large”. It is interesting to see that despite HF represent just above 1% of the total global debt and equity outstanding, their high volume frequent activity account for more than 30% of US equity trading volume.
“Hedge funds typically engage one or more broker-dealers to provide a variety of services, including trade clearance and settlement, financing and custody services.”
Legal structure, governance and place of residence
SOURCE 81:
1.1. Hedge Fund Regulation
In the US, hedge funds are formed as limited partnerships whereby the investors are considered limited partners and the hedge fund managers are general partners. The limited partners are wealthy individuals and institutional investors. Compensation for hedge fund managers comprises a 1-2% fixed management fee based on hedge fund asset size and a 15-20% carried interest performance fee based on the profits. Incentive fees align interests of hedge fund managers as general partners and the investors as limited liability partners who only retain their limited liability by not taking part in any aspect of the management of the fund. Hedge funds are not allowed to advertise in the US. There is no restriction on the minimum size to operate as a hedge fund, and no restrictions on the location of key service providers.
Hedge funds in the US can avoid the public disclosure requirements of the US Securities Act of 1933 by claiming the status of a private placement.4 Hedge funds are also exempt from the US Investment Company Act of 1940 (which regulates mutual funds) by having no more than 499 investors5 with more than $5 million in assets, and by not making public offerings. Prior to February 2006, hedge funds in the US were also exempt from any registration requirement. Brown et al. (2006) analyze the impact of this registration requirement and find favorable quality signals are possible with registration. Verret (2007) gives specific commentary on the hedge fund regulatory and presents a model of self-regulation as a major theme of the policy recommendation.
In other countries around the world, unlike the US, there are minimum capital requirements for hedge fund managers to operate a hedge fund, as well as different avenues for marketing (not merely private placements), and restrictions on the location of key service providers typically to be within the same jurisdiction. These regulations are summarized in Table 1 for 24 different countries (see also PWC, 2006, for an extended discussion for most of these countries6). The focus is on the regulations in place in the period 2003 to 2005, which are stable for the regulations and countries enumerated in Table 1.
A typical hedge fund does not have any employees but instead delegates different functions to service providers of the hedge fund . Outsourcing a hedge fund’s functions minimizes risks of collusion among hedge fund participants to perpetuate fraud, and also mitigates liability in the event the hedge fund participants are accused of improperly performing their management duties. A hedge fund’s board of directors or trustee has a fiduciary duty to the investors to ensure that all parties involved in the fund can properly carry out their designated tasks. At issue in this paper is whether the form of regulatory oversight in the countries enumerated in Table 1 provides an additional level of governance and an additional check that fraud is not perpetuated. If regulatory oversight facilitates additional value-added governance then I would expect hedge funds in those jurisdictions to have higher alphas, Sharpe ratios and average returns. In the alternative, one may infer that restrictions on minimum capital requirements for managers, restrictions on the location of key service providers, and limitations on the main market channels for hedge fund distribution constrain the fund to an inefficient scale, give rise to inefficient choice of human resources associated with hedge fund management, create barriers to entry and limit investor participation most suited to the particular hedge fund’s strategy.7 In that case, one would expect worse hedge fund performance and less efficient hedge fund structures (that do not as efficiently align interests of investors and managers) in terms of higher management fees and lower performance fees.
These competing predictions are the focus of the empirical analyses in the remainder of this paper.
1.2. Hedge Fund Location
Hedge fund location depends on economic conditions and proximity to the fund’s investors, taxation and regulatory burdens. The country of domicile of the fund managers may influence fund location particularly in reference to countries with restrictions on the location of key service providers.
As well, fund managers that expect better performance may locate in jurisdictions with fewer regulatory burdens and lower taxes. For instance, offshore locations such as the Bahamas, Bermuda, and the Cayman Islands have few regulatory burdens and minimal tax for funds and their investors. The absence of regulatory oversight in such countries would render it difficult for fund managers without a track record to raise capital from institutional investors, while more established fund managers with a track record are less likely to experience such problems in fundraising.
Counterparty credit risk management (CCRM)
Hedge funds Benefits to the financial market
Source 50 page 47
The roll of hedge funds in the financial crises of 2007-2008.
SOURCE 46 PAGE 8(SUPRA NOTE 5):
The increased risk-sharing capacity and liquidity provided by hedge funds over the last decade has contributed significantly to the growth and prosperity that the global economy has enjoyed. For example, hedge funds have raised tens of billions of dollars over the past three years for infrastructure investments, i.e., highways, bridges, power plants, and waste treatment and water purification facilities in India, Africa, and the Middle East. In their quest for greater profitability, hedge funds now provide liquidity in every major market, taking on the role of banks in fixed-income and money markets, and marketmakers and broker/dealers in equities and derivatives markets.
Systemic risk, market efficiency and regulation
The Hedge funds and systemic risk
CCRM
SOURCE :
85!!!!! “The traditional bulwark against financial market disruptions with potential systemic consequences has been the set of counterparty credit risk management (CCRM) practices by the core of regulated institutions. The characteristics of hedge funds make CCRM more difficult as they exacerbate market failures linked to agency problems, externalities, and moral hazard. While various market failures may make CCRM imperfect, it remains the best line of defense against systemic risk.”
60!!
The challenge of Hedge funds of regulation
SOURCE 81!!!
“Hedge fund registration in the US commenced only in 2006 (Brav et al., 2006; Partnoy and Thomas, 2007). In other countries around the world, hedge funds face stricter regulations such as minimum capital requirements, marketing restrictions, and restrictions on retail investor participation, among other things. The growth of hedge funds worldwide has led regulators to reevaluate the suitability and effectiveness of their regulatory oversight (see, e.g., PWC, 2006). How has hedge fund regulation impacted hedge fund structure and performance?”
impacted hedge fund structure and performance?
CCRM/MARKET DECPILINE
SOURCE : 85!!!!! 60!!
Source 68 Government Intervention vs. Market Discipline - Vpage 9
The
Hedge funds and systemic risk
Source 44- page 57
Source 45 page12 D
Source 86!!!
Source 31 page 47!! And page 5 (yellow)”the paradigm...”
Source
SOURCE 60:
III. WHY REGULATE HEDGE FUNDS?
There are a number of groups in the market who may be harmed by the activities of hedge funds, and to whose benefit regulation may be directed:
- Entity Regulation Intended to Protect Area of Regulation
- Protection of Investor Investor Protection
- Protection of Public and Markets Generally Systemic Risk
- Protection of Companies Invested in by Hedge Funds Corporate Governance
These regulatory areas are mostly distinct, and regulation that is designed to affect one area may have unintended and unwanted effects on other areas of regulation.
Then you’re explanatory, analytical, and argumentative parts should follow. Explain the methods you use for your analysis. Describe the results and actual statements of observations, including statistics, tables and graphs. Then discuss the question you described at the beginning.
At the end of your thesis you have to figure out your conclusion. This conclusion should be as concise as possible and it should also refer to the questions at the beginning of your work. You have to make clear what is the strongest and most important statement that you can make from your observations.
Conclusion
Bibliography
“Dr. Jones and the raiders of lost capital, hedge fund regulation, part II, Jay Verret, May 2007.
Written Testimony of Andrew W. Lo Hedge Funds, “Systemic Risk, and the Financial Crisis of 2007–2008”, Prepared for the U.S. House of Representatives Committee on Oversight and Government Reform, November 13, 2008 Hearing on Hedge Funds (http://oversight.house.gov/documents/200811131019).
Carol J. Loomis, “the Jones nobody keeps up with”, Fortune, April 1966, at 237.
George G. Kaufman, “Bank Failures, Systemic Risk, and Bank Regulation”, 16 CATO J. 17, 21 n.5 (1996) (quoting Alan Greenspan, Remarks at a Conference on Risk Measurement and Systemic Risk, Board of Governors of the Federal Reserve System (Nov. 16, 1995)), available at http://www.cato.org/pubs/journal/cj16n-2.html. pubs/journal/cj16n-2.html.
Houman B. Shadab, “The Law and Economics of Hedge Funds: Financial innovation and Investor Protection”, Berkeley Business law Journal, Forthcoming (fall 2009).
Staff report to the United States Securities and Exchange Commission, “Implications of the Growth of Hedge funds”, 2003. (56)
Pinto, Evsey Gurvich, and Sergei Ulatov, Lessons from the Russian Crisis of 1998 and Recovery, 2004. (http://www1.worldbank.org/economicpolicy/documents/mv/pgchapter10.pdf), last visited at 14.7.09.
GAO, “Long term capital management – regulators need to focus greater attention on systemic risk”, report to the congressional requestors, 1999, available at: http://www.gao.gov/archive/2000/gg00003.pdf.
Troy A. Paredes, On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission (Washington Univ., St. Louis, School of L., Working Paper No. 060302, Mar. 24, 2006), at 8.
McCarthy, C., “Hedge fund: what should be the regulatory response?”, speech, European Money & Finance Forum 7, 2006.
Casper G. De Vries and Philip A. Stork, “Hedge Funds and Financial Stability”, Study made for the European Parliamant Committee on economic and monetary affairs, 2007.
Roger Ferguson and David Laster, “Hedge funds and systemic risk”, Banque de France, financial stability review, No.10, 2007.
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