This Article is a rejoinder to a recent comment by Professor Romano on an earlier paper I coauthored with Christian Kirchner. Professor Romano suggests regulatory arbitrage, rather than the targeted regulation of bank lending to hedge funds under Basel III, as a hedge against systemic failure. I contend that it was not harmonization through Basel H but rather the profitability of certain assets and business strategies that caused banks to hold similar assets and engage in similar strategies. In particular, I find that the increasing role of hedge funds in the credit derivatives market, in combination with the market's recent failure, suggests that an increased emphasis on banks' lending exposure to hedge funds could be justified. Using the methodological approach of New Institutional Economics, I evaluate recent regulatory changes, including the U.S. Dodd-Frank Act, the AIFM Directive, and other pertinent regulation. I provide an impact analysis of regulatory changes, de lege lata and de lege ferenda, with a special emphasis on, and historical analysis of, hedge fund registration rules and asymmetric regulation in Dodd-Frank and the AIFM Directive.
TABLE OF CONTENTS I. INTRODUCTION II. METHODOLOGY III. HEDGE FUND REGULATION IN THE AFTERMATH OF THE FINANCIAL CRISIS 1. The AIFM Directive a) A Controversial Drafting Process b) The Final Version c) Imp act Assessment 2. Dodd-Frank Hedge Fund Rules a) History of Hedge Fund Registration in the United States b) Dodd-Frank Hedge Fund Rules (1) Disclosure Requirements (2) Hedge Fund Registration Exemptions. (3) De Minimis Hedge Fund Investment Exemption (4) Revision of Accredited Investor Standards c) Impact Assessment of Hedge Fund Rules Under Dodd-Frank (1) Increased Disclosure Obligations (2) SEC's Rulemaking Authority (3) Blue Sky Laws (4) Cost of Compliance (5) De Minimis Investment Exemption d) Revision of Accredited Investor Standards 3. Impact Assessment of Asymmetric Regulation in Dodd-Frank and the AIFM Directive IV. BASEL III 1. The Evolution of the Basel Accords 2. The Basel Approach Revised 3. The Core Rules in Basel III V. AN ALTERNATIVE APPROACH TO HEDGE FUND REGULATION 1. Moral Hazard and Its Impact on Indirect Regulation of Hedge Funds via Counterparty Credit Risk Management (CCRM) 2. Systemic Risk and Externalities 3. Market Failure in Financial Instruments 4. Hedge Fund Regulation via Basel III VII. CONCLUSION I. INTRODUCTION
The collapse in the market for exotic financial instruments, the liquidity crisis in major financial institutions, and the government bailouts of 2008-2009 have undermined confidence in the financial markets and illustrated shortcomings in corporate governance and banking regulation.1 Hedge funds have been blamed for their part in the crisis (2) and have become a scapegoat for the problems affecting many aspects of financial markets. (3) Regulators worldwide increasingly scrutinize hedge funds and have introduced, among other measures, registration requirements, limits on leverage, and more disclosure. (4)
Much of the new regulation in the Dodd-Frank Act has been criticized for being reactive and shortsighted. (5) Similar criticisms of the Alternative Investment Fund Managers Directive (AIFM Directive) are likely. Scholars have proposed a wide range of possible solutions to address the concerns in the debate on hedge funds and hedge fund regulation. (6) In response to an earlier paper coauthored with Christian Kirchner, Professor Romano suggests regulatory arbitrage, rather than the targeted regulation of bank lending to hedge funds under Basel III, as a hedge against systemic failure. (7) Others contend that the pre-Dodd-Frank approach of allowing advisers to voluntarily register was more effective, and they propose a trust-based approach that would allow funds that earned general trust from the public to operate on the basis of that trust, without the interference of regulation. (8) The debate over the most appropriate form of hedge fund regulation is far-ranging, and important proposals include changing the criteria for investing in hedge funds, (9) setting up a self-regulatory organization, (l0) subjecting counterparties to greater disclosure, (11) increasing leverage limits (12) and transparency, (13) using the concept of superfunds and collecting taxes from hedge funds, (14) regulating hedge fund creditors, (15) relaxing the regulation of mutual funds to increase competition for hedge funds, (16) introducing proprietary rights for hedge fund trading strategies, (17) and regulating hedge funds through their investors. (18)
Using New Institutional Economics as a methodological approach, the analysis in this Article is based on the assumption that regulation of hedge funds could minimize some of the social externalities that may be generated by the hedge fund industry. Given the global scale of hedge fund activities and the dynamic nature of their trading strategies, however, it is unclear if and to what extent hedge funds generate social externalities. The role of hedge funds in the financial crisis is also unclear. (19) After the collapse of Long-Term Capital Management (LTCM) in 1998, most dealerbanks required full collateralization of hedge fund transactions. (20) Accordingly, hedge funds were less levered than banks. (21) Later, the collapse of large hedge funds, like Amaranth in 2006, (22) and large redemptions by investors during and after the crisis (23) did not cause systemic problems. Moreover, hedge funds have fewer assets and less leverage than banks. This may decrease the likelihood that hedge funds cause the next crisis. Without the threat of systemic risk and without a clear delineation of social externalities caused by hedge funds, the purpose of direct hedge fund regulation is unclear.
Nevertheless, recent regulatory initiatives in Europe and the United States attempt to address many perceived shortcomings of the current regulations and harmonize international banking regulation more effectively than before the crisis. (24) Regulatory initiatives such as registration requirements, (25) a passport regime, (26) limitations on leverage, (27) and general disclosure requirements (28) limit hedge funds' ability to provide above average returns to their investors. The Dodd-Frank Act restricts a banking entity from having an ownership interest in or being a sponsor of a private equity or hedge fund if such investments amount to more than 3 percent of the bank's Tier 1 capital or the bank's interest is more than 3 percent of the total ownership of the fund. (29) Moreover, private equity and hedge funds with assets under management of $150 million or more will have to register with the SEC, although venture capital funds will be exempt from full registration. (30) In the European Union, the EU Commission introduced the AIFM Directive. (31) The AIFM Directive provides the possibility of harmonized requirements for entities engaged in the management and administration of alternative investment funds, i.e., European-wide regulation of hedge funds. (32) The AIFM Directive seeks to regulate more than just the hedge fund and private equity industries; it is an attempt to gain regulatory oversight over a large share of the "shadow banking system" that is presently unsupervised. (33)
At the same time, measures that are primarily intended to ensure the well-functioning of financial markets impact hedge funds as primary market participants. For instance, proposed EU legislation allows EU member state authorities, subject to coordination by the European Securities and Markets Authority (ESMA), to restrict or ban credit default swaps. (34) Similarly, the U.S. Dodd-Frank Act grants federal agencies broad regulatory authority over the trading of derivative securities and other financial instruments that were blamed for the financial crisis. (35) As discussed below, the hedge fund industry is a major user of credit default swaps, and rules curtailing derivatives could disproportionally affect hedge funds. Because of hedge funds' role in the credit derivatives market, in combination with the market's recent failure, this Article suggests that an increased emphasis on hedge fund lending exposure could be justified.
The interdependence of corporate governance deficits, financial regulation, and hedge fund regulation has so far not been studied systematically. The Dodd-Frank Act and AIFM Directive appear to be mostly patchworks of politically motivated rules without an attempt to address the combined effects of deficits in different fields of regulation. Dodd-Frank and the AIFM Directive approach the regulation of banks and hedge funds separately, resulting in asymmetric regulation of financial institutions (hedge fund regulation versus bank regulation). (36)
This Article shows that financial market regulation in the European Union and the United States is suboptimal, and the asymmetric hedge fund regulation in Dodd-Frank and the AIFM Directive is counterproductive. The AIFM Directive could create incentives for regulatory arbitrage and potentially cause retaliatory action by non-EU countries. The Article explains how the Directive could undermine the competitiveness of the European Union's alternative investment community and the financial markets in Europe. The approach suggested here would minimize asymmetric hedge fund regulation by introducing hedge fund regulation via Basel III. Many of the regulatory complications in the AIFM Directive and Dodd-Frank Act could be avoided if the Basel Committee were to introduce a charge for banks' lending exposure to hedge funds. Building on the suggested increase in capital requirements for counterparty risk in Basel III, (37) Basel III could also include a charge for banks' assets based on their lending exposure to hedge funds. To minimize systemic risk in the lending practice of banks to hedge funds, the New Basel III Accord could add a provision establishing capital...