Regulatory issues for hedge funds fall under three broad headings. First; prudential regulation (the extent to which hedge funds pose a systemic risk to the financial markets); second, investor protection (the extent to which hedge fund risks are disclosed to investors and how conflicts of interest between the managers and investors are managed); and lastly, market abuse (the extent to which there is a risk that hedge funds may commit a market abuse, for example, abusive shortselling practices).
There is at least a logical connection between prudential regulation and a concern about the systemic risks which hedge funds might create. There is a rather more tenuous connection between the banking crisis and the need for regulatory reform to protect the interests of sophisticated hedge fund investors or to reduce the risks of insider dealing or market manipulation by hedge fund managers. This note considers the extent to which proposed regulatory reforms are legitimately linked to systemic risk concerns and whether the prudential regulatory reform proposals are proportionate to the systemic risks identified.
The boom and bust cycle
The only certainty is that the economic cycle of speculative asset appreciation followed by a sharp correction in asset values will recur. During a boom period with easy credit, investment returns or yields on traditional low risk or safe investments may diminish. Investors will seek better returns employing greater credit leverage and investment in riskier assets and financial products (whether or not the investor consciously appreciates the real extent of risk assumption). These circumstances may in turn result in artificial asset price inflation (of one or more of any number of potential asset classes such as technology stocks, real estate or securitised subprime mortgages) until that bubble eventually bursts.
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