Guide to Hedge Funds: What they are, what they do, their risks, their advantages, Second Edition

Chapter 4

Hedge fund regulation

Hedge funds were created to exploit a gap in the regulatory structure. Conventional fund managers were unable to go short, and thus limit market risk; they also found it more difficult to invest in illiquid instruments, or charge performance fees. This left a potential area for profit unexploited. Regulators allowed hedge fund managers to exploit these gaps on the grounds that they were small (in systemic terms) and catered only for the wealthy or institutions, and because they felt that if hedge funds were restricted in one country, they would only spring up somewhere else.

But all that is changing. The credit crunch brought hedge funds into the spotlight. Those who had never liked the industry, particularly in continental Europe, saw their opportunity to act. In a clear reference to hedge funds, a statement by the G20 group of leading nations in November 2008 said:

All firms whose failure could pose a risk to financial stability must be subject to consistent, consolidated supervision and regulation with high standards.

Politicians seem to be concerned about four things:

• Hedge funds might pose a systemic threat because of their links to the banks and to market prices. The use of leverage by hedge funds means that a sharp fall in asset prices might make a hedge fund unable to pay its debts, creating risk for the lenders. The need to sell assets to repay debts means hedge funds can exacerbate market falls.
• The secretive nature of hedge funds makes ...