Hedge Funds and Regulations

Technically, the term hedge fund does not exist. In fact, the term hedge fund applies to any fund which is sold to accredited private investors and does not have to follow through with the regulation process! Now, investment advisory is a highly regulated industry and there are several laws which have been passed to ensure compliance and minimize foul play.

However, hedge funds are immune to most of these laws. This is probably the reason why investors prefer them. However, of late, experts have been lobbying to bring this trillion dollar hedge fund industry under some sort of regulation.

In this article, we will have a closer look at some of the regulations that are avoided by the hedge funds as well as arguments in favor of and against bringing hedge funds under the purview of the Securities and Exchange Commission (SEC).

The Laws Avoided By Hedge Fund Managers

  • No Prospectus Required: The Securities Act 1933 mandates that any kind of securities being sold must first submit a detailed prospectus of the risks and rewards to the Securities and Exchange Commission (SEC). Only after the Securities and Exchange Commission (SEC) approves the prospectus are the funds allowed to sell to investors. However, since hedge funds are sold only to private accredited investors who do not total more than 99 in number, they do not have to follow this law,

    Also, they are exempted from other compliance procedure like submitting the details of their trade for oversight and approval, maintaining their record keeping in the prescribed manner and most importantly the limits on the amount of money that they can charge as fees.

  • Taxation: Most mutual funds are considered to be American entities if their investors as well as their operations are largely American. This subjects them to tax laws. Hence, the amount of profits that they earn by way of fees is marked down by at least 30% because of stringent tax laws. Hedge funds on the other hand, usually incorporate in a tax haven. Also, they structure their operations in a way that American tax authorities cannot lay hands on them. The small number of investors that make up hedge funds makes it possible to avoid taxes and obtain much better returns.

The Rationale for Regulations

  • Excessive Leverage: Hedge funds are defined by the amount of leverage that they undertake. Some of these funds i.e. arbitrage funds commonly use a 10:1 leverage. This creates problems for the fund itself since the likelihood of going bust increases. However, it also affects other players since hedge funds are counterparties to other regulated players like banks and mutual funds. Therefore, the inability of a hedge fund to meet its own obligations is likely to have a trickledown effect on other players as well.

  • Systemic Risk: Given that hedge funds are huge in size and that if they were to go bankrupt trillions of dollars would be lost causing a crash in the market, it is easy to see why hedge funds pose a systemic risk. It is because of this risk that detractors want hedge funds to be tightly regulated. In fact some of them believe that hedge funds are capable of causing an international systemic crisis which would lead to a collapse of economies and currencies.

    Hedge funds have been blamed for several crises. Some prominent ones are the subprime mortgage crisis and the LTCM crisis. However, proponents of hedge funds believe that the funds have come a long way and given the new and better risk management practices, a catastrophic event triggered by hedge funds seems almost impossible.

The Rationale for No Regulations

  • SEC Does Not Have The Resources: The Securities and Exchange Commission is already understaffed. They do not have the money, people or the time required to police a defiant hedge fund industry. Attempts at regulating the hedge fund industry will impact the regulatory process in other important businesses like mutual funds since resources will be diverted.

  • Investors Are Sophisticated Enough: The biggest argument against regulating hedge funds is that investors usually pool in a minimum of a hundred thousand dollars to invest into this fund. People with that kind of money are called accredited investors. It is assumed that they have the skills required to deal with these sophisticated investments. Hence putting regulations in place is considered unnecessary due to these facts. The governments resources and money are better spent on people who need assistance and not on the super rich who wish to gamble with their money.

  • Hedge Funds Would Move Offshore: Hedge funds have always been the playground of the super rich and they are likely to remain that way. In case the government starts interfering too much and puts regulations in place, the business is likely to move to a different country. This is because both the investors and the management are in favor of no regulations. In fact the only reason why they invest in hedge funds is because of a lack of regulations.

    America is the primary market for hedge funds today. However, these funds are also spreading to other regional financial centers like London, Hong Kong and even Singapore. If the American government insists on regulation, funds may move their business outside the nation and then only the tax authorities will be the real losers.

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