Our objective was to study the need for regulating hedge funds, using existing regulatory approaches and our own models as a frame of reference. Our questions include: Should hedge funds remain unregulated? Should potential regulation of hedge funds fall within the present regulatory structure, or do we need new approaches to effectively regulate hedge funds, and if so what would those approaches be? Existing studies have highlighted the broad benefits that hedge funds can provide to the financial system in terms of diversification, competition and price discovery. Our models emphasise the extremely valuable role that hedge funds, as unregulated institutions, can play in alleviating liquidity problems. Suppose all financial institutions were regulated, and the economy suffers a significant shock leading to a liquidity crisis. In this case the regulated institutions may be prevented from engaging in essential trading activity for regulatory reasons, perversely exasperating the crisis. Unregulated financial institutions, such as hedge funds, are not so restricted and will see a benefit in trading, thus helping to contain the crisis. Despite these potential benefits of hedge fund activities, there are compelling reasons why some form of regulation of hedge funds is necessary. In particular, we would highlight that there is a real potential that the collapse of a large hedge fund may trigger a systemic crisis episode, carrying with it significant economic costs. Furthermore, whilst such a collapse may break the current impasse in the regulatory debate it is likely to lead to a knee-jerk reaction by the public and politicians, forcing the implementation of inefficient and overbearing regulations. By contrast we find arguments for regulating hedge funds directly for reasons of consumer protection unconvincing. Unfortunately, most discussion on the regulation of hedge funds proposes to fit hedge funds within the existing regulatory structure (disclosure and activity restrictions), and fails to address the unique nature of hedge funds. We argue that such regulations are inappropriate, and would either be ineffective or cause an irrevocable harm to the hedge fund industry, impeding their ability to deliver wider market benefits. The systemic risk from hedge funds stems from the aftermath of a large funds collapse, not the ongoing regular trading activities of solvent funds. Therefore regulations should aim at containing the fallout from any such default so as to minimise market disruption. At the same time, regulations should not hinder the benefits associated with funds regular operations. We suggest that this can most effectively be implemented by instituting a formal resolution process whereby the regulator, prime brokers, and client banks all have the legal obligation to ensure that the fund be unwound as quickly as possible. Clearly, such an organized resolution process must not be confused with a bailout, and no public funds must be used.
Also included in: IAM Series No 004.
