1. Introduction

2.

Investor protection

3.2 General compliance concerns

3.3 Systemic risk

3.3.1 Problem

3.3.2 Regulatory strategies

4. Self-regulation

4.1 The self-regulation game

4.1.1 Interests of regulators

4.1.2 Collective interests of the industry

4.1.3 Interests of individual firms: the problem of enforcement

4.2 Limits of self-regulation

5. Government regulation

5.1 Regulatory competition

5.1.1 Regulatory arbitrage

5.1.2 Regulatory competition as state capture

5.1.3 Evaluating regulatory competition

5.2 Regulatory harmonization

5.2.1 Incentives to harmonise

5.2.2 The mechanics of harmonization

5.2.3 Harmonising hedge fund regulation

5.2.4 Evaluating harmonization

6. Conclusion

  Abstract

After the global financial crisis, systemic risk regulation has taken centre stage. Many consider

hedge funds a potential threat to financial stability. Regulating hedge funds, however, is

necessarily a transnational challenge because no national government alone can effectively

control the systemic risks affecting its economy. This article takes the example of hedge funds for

a case study of emerging transnational regulation. After an introduction to hedge funds and the

reasons for regulating them, it considers the possible elements of a transnational regulatory

regime for hedge funds: transnational industry self-regulation, including such induced by the

government, regulatory competition between government regulators, and harmonisation of

government regulation. The main conclusions are: self-regulation cannot substitute fully for

government regulation in controlling systemic risks caused by hedge funds. Equally, regulatory

competition tends to undercut systemic risk regulation. Effective transnational regulation can

only be accomplished through harmonisation of government regulation. Such harmonisation is

likely to arise if regulation is needed to control systemic risk in global financial markets.

1. INTRODUCTION

The financial crisis has been a powerful reminder of how interconnected financial markets have

become. Originating in the US real estate market, the crisis swiftly affected financial institutions

in Europe and elsewhere. A steep recession ensued in much of the industrialised world. In view

of the dire consequences, policymakers and scholars have begun to devote greater attention to

financial crisis prevention. In doing so, they need to acknowledge that causes and effects

transgress the boundaries of nation states. As financial markets are converging, regulatory

governance has to keep pace. The term ‘transnational regulation’ is meant to capture the

response to this challenge. Like its sibling ‘transnational law’, it starts out from cross-border

activities and effects as the object of regulation. Yet it also carries with it the notion that

regulation can come in forms other than the conventional one of legal rules imposed and

enforced by national governments.1 Such other modes of regulation  include non-binding or less

binding rules (‘soft law’) as well as self-imposed or self-enforced rules (‘private ordering’). Even

where regulation ultimately remains the business of government, it must reflect the transnational

scope of the regulated activity. This can lead governments to coordinate their regulatory

strategies, thus adding another layer of policy debate and possibly rules at the international level.

The following analysis embraces this broad concept of transnational regulation for a case study

of the hedge fund industry.2 Hedge funds are among the most important innovations

transforming the financial system during the last decades. Their growth has been staggering. In

1990, assets under management in hedge funds were believed to be little more than 50 billion US

dollars.3 Assets increased to around 400 billion US dollars in 2000, over 1,350 billion US dollars

in 2005 and over 2,100 billion US dollars in 2007. The financial crisis caused a decline to a still

impressive amount of around 1,500 billion US dollars in 2008, with a recovery to 1,700 billion

US dollars in 2009. While this is still a minor fraction of global financial assets, hedge funds are

particularly active players and therefore have a much stronger impact on financial markets than

their mere volume would suggest. At the same time, they have not been blamed as a (.primary)

cause of the recent financial crisis. Of course, hedge funds can still pose a threat to financial

stability under different circumstances. The next crisis will almost certainly differ from the last

one. If one believes that regulation can reduce the risk of future calamity, it should cover all

relevant financial markets and institutions, including hedge funds if necessary.

1. G.-P. Calliess and P. Zumbansen, Rough Consensus and Running Code: A Theory of Transnational Private Law (Oxford, Hart 2010); C. Scott, “‘Transnational Law” as Proto-Concept: Three Conceptions’, 10 German Law Journal (2009) p. 859; C. Tietje and K. Nowrot, ‘Laying Conceptual Ghosts of the Past to Rest: The Rise of Philip C. Jessup's “Transnational Law” in the Regulatory Governance of the International Economic System2 T. Caldwell, ‘The Model for Superior Performance’, in J. Lederman and R.A. Klein, eds.,  Hedge Funds, Investment and Portfolio Strategies for the Institutional Investor (McGraw-Hill, New York 1995) p. 1.3 M.R. King and P. Maier, ‘Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks’, 5 Journal of Financial Stability (2009) p. 283, at p. 285

In examining the particular area of hedge funds, this article aims at providing a comprehensive

account of the interests involved and mechanisms at work in transnational regulation. Its main

contribution lies in combining and evaluating the different elements of a transnational regulatory

regime for hedge funds, as well as in analysing their interaction. These elements consist of

industry self-regulation,  including such induced by the government, regulatory competition

between government regulators, and harmonisation of government regulation. Covering the full

spectrum of regulatory arrangements is essential for a research agenda in transnational

regulation. Even though hedge funds are essentially beyond the reach of individual governments,

there is reason to believe that an adequate transnational regulatory response can and will emerge

if it is needed. While transnational regulation differs significantly from the traditional model of

regulation within a single nation state, regulatory outcomes need not be inferior, on the whole, or

biased towards laissez-faire. To reach this conclusion, the study does not take a strong view on

whether and how the hedge fund industry should in fact be regulated. More modestly, it looks at

the incentives and constraints of the relevant players to determine if transnational regulation is

likely to consider available information and reflect the relevant concerns. The aim is to evaluate

the process of transnational regulation, not (or only by inference) the outcome.

The article starts out with an exposition of hedge funds and their role in financial markets

(section 2). It goes on to analyse the need for regulation, which is by no means uncontroversial,

at least as regards direct regulation by the government. Proponents have cited the protection of

hedge fund investors and a concern for compliance with market regulation and other laws as

justification for government oversight. Yet the more important argument, particularly for

transnational regulation and in light of the recent financial crisis, is the potential risks hedge

funds pose to the stability of the global financial system (section 3). Systemic risks are

transnational in that they regularly exceed the scope of any single national jurisdiction. A natural

response would be to entrust regulatory responsibility to non-government actors, which are not

subject to territorial restrictions. As it turns out, however, market players lack adequate

incentives to restrict systemic risk. The industry, collectively, is prepared to establish a self-

regulatory scheme, but only to forestall more intrusive government intervention. Even to the

extent that the industry succeeds in writing its own rules, enforcement remains deficient without

the government taking an active role. In a transnational approach to regulating systemic risk,

self-regulation only complements but cannot substitute government regulation (section 4).

The burden of mitigating systemic risk thus remains with governments. National regulators,

however, face the difficulty that firms in the hedge fund industry can choose the most favourable

regulatory environment (‘regulatory arbitrage’). Jurisdictions find themselves competing for

hedge fund business by offering less costly regulation or no (direct) regulation at all. Such

‘regulatory competition’ can improve the quality of regulation provided by governments along

certain dimensions, but it deprives national regulators of the ability to adequately control

systemic risk (subsection 5.1). To regain power, governments have to coordinate their regulation

- they need to curb regulatory competition by forming a ‘cartel’. Accomplishing such ‘regulatory

harmonisation’ requires the consent of all relevant jurisdictions. To exert pressure on other

states, an emerging cartel can condition access to its investor base and other relevant resources

on participation in the coordination endeavour.  Harmonisation thus builds on elements of both

persuasion and coercion. While the bargaining process is not a democratic one, it is likely to

respond to the concerns that should be relevant for regulation. Accordingly, one can read the

ongoing process of harmonising hedge fund regulation as a reaction to lessons from the financial

crisis (subsection 5.2). Section 6 summarises and concludes.

WHAT ARE HEDGE FUNDS?

If hedge funds are to be regulated, one should know what they are. Like the more familiar mutual

funds, hedge funds are asset pools for investment purposes operated by an asset management

firm - the ‘manager’ for short - and funded by investors with a share in the pooled assets. The

difficult part lies in distinguishing hedge funds from other investment vehicles and mutual funds

in particular.4Legally speaking hedge funds are defined simply as those investment funds  that

are not governed by mutual funds regulation. This definition, however, fails to recognise the

economic characteristics of hedge funds  and hence the potential reasons why they should (or

should not) be subject to specific regulation. While it is sometimes said that hedge funds  are too

diverse to allow for a non-trivial definition,5 they differ in one important aspect from mutual

funds even if only by degree. This common characteristic relates to the source of returns

that hedge funds are supposed to deliver.

There are two basic methods of seeking returns from an investment in asset markets. One option

is to invest indiscriminately in a particular class of assets, such as Asian equity, government

bonds or copper. For many types of assets, a passive investment strategy can be expected to earn

a positive return in the long run because markets are at least somewhat efficient.6 In asset

management lingo, such return  from a passive exposure to market risk are referred to as

‘beta’.7 Even though most mutual fund managers engage in active securities picking, the greater

part of mutual fund returns stems from tracking the market.8 It is for this reason that performance

is typically presented in relation to a market benchmark (for instance, a stock market index). By

contrast, a much more challenging investment strategy consists of betting on mispricings in the

market - exploiting gaps between the current market prices and the underlying value of assets

(‘arbitrage’9 ). The returns from such an active approach may be labelled as ‘alpha’.10 The basic

idea of a hedge fund is to seek only (or mainly) ‘alpha’ returns and to do without the ‘beta’ 4 Hedge funds can also be hard to distinguish from private equity funds, see Financial Services Authority (FSA), Private Equity: A Discussion of Risk and Regulatory Engagement (Discussion Paper 06/6, 2006), at para. 3.1-3.144, available at: <http://www.fsa.gov.uk>5 The Regulatory Environment for Hedge Funds : A Survey and Comparison (2006), at pp. 5 and 22, available at: <http://www.iosco.org>.6 K.J.M. Cremers and A. Pettajisto, ‘How Active Is Your Fund Manager? A New Measure That Predicts Performance’, 22Review of Financial Studies (2009) p. 3329.7 M.C. Jensen, ‘The Performance of Mutual Funds in the Period 1945-1964’, 23 Journal of Finance (1968) p. 389.8 K.J.M. Cremers and A. Pettajisto, ‘How Active Is Your Fund Manager? A New Measure That Predicts Performance’, 22Review of Financial Studies (2009) p. 3329.9 R.M. Stulz, ‘Hedge Funds: Past, Present, and Future’, 21 Journal of Economic Perspectives (2007) p. 175, at pp. 180-181.10 T. Caldwell, ‘The Model for Superior Performance’, in J. Lederman and R.A. Klein, eds.,  Hedge Funds, Investment and Portfolio Strategies for the Institutional Investor (McGraw-Hill, New York 1995) p. 1.

component. Eliminating ‘beta’ seems attractive because market returns are inexorably linked to

market volatility. The key promise of hedge funds is independence from the ups and downs of

the market or ‘absolute returns’ instead of a markup relative to market performance. Of course,

‘alpha’ does not come without risk either. Whether ‘absolute returns’ turn out to be positive or

negative depends on the skill of the individual asset manager (and on luck, to be sure).

Hedge funds should thus be defined as investment funds that aim primarily at ‘alpha’ returns

from actively exploiting mispricings. Alfred W. Jones is credited for having invented the hedge

fund in 1949. He pioneered a financial technology to purge ‘beta’ risk from the fund's returns.

While investing in stocks that he considered undervalued, he would ‘hedge’ this position against

market risk by short-selling other securities. This ‘short’ position would rise when the market

went down (and fall when the market went up). Combined with the ‘long’ position in the stocks

that Jones had selected, his fund stood to win if his picks performed better than the market.

Today, only a fraction of the hedge fund universe employs this particular method to focus on

‘alpha’ returns. There is even a large group of hedge funds that intentionally incur market

risk. Yet unlike mutual funds, they do so in an attempt to time the market, that is, to ‘go long’

before an upswing and to ‘go short’ before a   downswing. Over time, such strategies still pursue

‘absolute returns’ independently of market conditions.

Most mutual funds also advertise themselves as being ‘actively managed’. Mutual fund

regulation in the European Union now widely permits the use of derivatives,11 which effectively

allows mutual funds to pursue hedge fund strategies.12 The fact that managers can claim - and

investors concede - such a sizable share of returns strongly indicates that their skill and effort is

the single critical factor in hedge fund performance.

  3. WHY REGULATE HEDGE FUNDS?

Mutual funds are often sold directly to retail investors. Imposing regulation on them seems

uncontroversial.13 By contrast, opinions vary on whether hedge funds and their managers ought

to be regulated and, if so, what issues should be addressed. Advocates of hedge fund oversight

rely on three different lines of argument: the protection of investors in hedge funds (subsection

11T. Garbaravicius and F. Dierick, Hedge Funds and Their Implications for Financial Stability (European Central Bank Occasional Paper Series No. 34, 2005), at pp. 8-10.12 W.K.H. Fung and D.A. Hsieh, ‘Hedge Funds: An Industry in Its Adolescence’, 91 Federal Reserve Bank of Atlanta Economic Review (2006) p. 1, at pp. 7-813 A. Khorana, et al., ‘Explaining the Size of the Mutual Fund Industry around the World’, 78 Journal of Financial Economics (2005) p. 145, at p. 156.

3.1), a general concern that hedge funds might be a fertile ground for illegal trading behaviour

(subsection 3.2), and a potential threat to the stability of the financial system (subsection 3.3). As

systemic stability is at the heart of the current debate, the analysis in later sections will focus on

this issue.

3.1 Investor protection

Investing in mutual funds generates the returns of the particular market segment, compounded by

some deviation due to active securities picking (and, of course, an additional layer of fees and

other costs). Insofar as the respective market is relatively efficient, the error risk in selecting a

mutual fund is limited. It consists primarily of picking the wrong market segment; the quality of

the individual asset manager carries less weight. In this regard, hedge funds differ fundamentally

from mutual funds. Because hedge funds are devoted to exploiting inefficiencies in the market,

their expected returns fully depend on their managers' ability to spot arbitrage opportunities. A

less skilful or unlucky manager will take positions that lose heavily if what he perceived as a

mispricing fails to disappear or actually widens. Hence, in the business of chasing ‘alpha’ returns

the quality of the asset manager is the key ingredient. Investors may not be very adept at

evaluating asset manager quality. To make matters worse, hedge funds  cannot disclose a lot

about their strategies because their ‘alpha’ returns depend on having an informational advantage

over other market players. As a consequence, the information asymmetry should be more

pronounced for hedge funds than for mutual funds , and so should be the need to prevent an

adverse selection of low-quality fund managers.

The problem is attenuated by the fact that hedge fund managers tend not to market their services

to retail investors.14 In part this is due to regulatory constraints,15  but it arguably also reflects the

information asymmetry, which makes hedge funds less suitable for retail

investors.16 Traditionally, hedge funds served mainly wealthy individuals.17 With the tremendous

growth of the industry, investor composition shifted towards institutional investors, which are

now reported to own 74 percent of hedge fund assets. Both affluent individuals and institutions - 14 H.B. Shadab, ‘Fending for Themselves: Creating a US Hedge fund Market for Retail Investors’, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-29.15 S.M. Davidoff, ‘Black Market Capital’, 2008 Columbia Business Law Review (2008) p. 172.16 T.A. Paredes, ‘On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission’, University of Illinois Law Review (2006) p. 975, at pp. 990-998, particularly at pp. 992-9917 J. Danielson, et al., ‘Highwaymen or Heroes: Should Hedge Funds Be Regulated?’, 1 Journal of Financial Stability (2006) p. 522, at pp. 527-528. But see, e.g., R. Sklar, ‘Hedges or Thickets: Protecting Investors from Hedge Fund Managers' Conflicts of Interest’, 77 Fordham Law Review (2009) p. 3251 (arguing for investor protection specifically against conflicts of interest).

funds of hedge funds, pension funds, insurers, banks and endowments - invest significantly

larger amounts of money than retail investors and can afford an extensive screening and selection

process to cope with the information asymmetry. Because hedge fund investors can be expected

to be sophisticated, there appears to be no point in imposing mandatory safeguards. It seems

questionable that a regulator should be better able to determine the amount and type of

information necessary to evaluate the integrity and skill of a given hedge fund manager. With

respect to secrecy, hedge fund managers can feel somewhat more comfortable disclosing

information to a limited audience of individual clients and market intermediaries than making the

information available to the general public. Also, professional investors should know for

themselves whether a particular fee scheme sets the right incentives or whether additional

monitoring and constraints are needed. To many, investor protection in hedge funds is therefore

no cause for concern, let alone a justification for regulation.

  3.2 General compliance concerns

Hedge fund managers have potent incentives to deliver large returns in order to attract investors

and earn performance fees. Given that ‘alpha’ returns derive from predicting market prices of

financial assets, hedge fund managers may be more tempted than others to engage in illegal

investment strategies. Examples of violations or questionable practices include insider

trading,18 market manipulation.19 and participating in (alleged) fiduciary breaches by other asset

managers.20 or investment banks. So-called activist hedge funds have also been criticised for the

aggressive tactics they use to influence the corporate governance of publicly traded

corporations. Of course, any general laws and regulations, such as those against fraud, insider

trading or market manipulation, apply equally to hedge funds and their managers. In this sense,

there is no need for regulation directed specifically at hedge funds. At the same time, however,

regulatory oversight of market participants can help to ensure compliance with applicable legal

18 R.A. Booth, ‘Who Should Recover What for Late Trading and Market Timing?’, 1  Journal of Business and Technology Law(2006) p. 101; P.G. Mahoney, ‘Manager-Investor Conflicts in Mutual Funds’, 18 Journal of Economic Perspectives (2004) p. 161, at pp. 173-176; E. Zitzewitz, ‘Who Cares about Shareholders? Arbitrage-Proofing Mutual Funds’, 19 The Journal of Law, Economics and Organization (2003) p. 245.19 R. Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Fourth Estate, London 2001); F.R. Edwards, ‘Hedge Funds and the Collapse of Long-Term Capital Management’, 13  Journal of Economic Perspectives (1999) p. 189, at pp. 197-207.20 A.W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008 (2008), available at: <http://ssrn.com/abstract=1301217> (‘central bankers … know it when they see it’); S.L. Schwarcz, ‘Systemic Risk’, 97 Georgetown Law Journal (2008) p. 193, at pp. 196-204 (citing various attempts at defining systemic risk);

rules. It does so through record and filing requirements, organisational mandates such as an

independent compliance function and inspections by the supervisor. Facilitating enforcement

only for professional market participants - but not for private investors - is a consistent  policy

choice in that professionals typically handle larger amounts and are more sophisticated, which

makes them a greater risk for market integrity. Nonetheless, compliance alone is hardly a

compelling argument for transnational attempts at regulating hedge funds. The international

debate is instead concerned primarily with controlling potential threats to overall financial

stability.

3.3 Systemic risk

Problem

Even before the financial crisis of 2008, hedge funds had been viewed as a threat to financial

stability, with the collapse of Long-Term Capital Management (LTCM) in 1998 providing the

quintessential example. What imperils financial stability is referred to as ‘systemic risk’. There is

no widely accepted definition of the term. The basic idea is that of a chain reaction of failure or

large losses in financial institutions or financial markets, with the effect that the supply of capital

to the economy is significantly impaired. From a policy perspective, a central feature of systemic

risk is that single individuals or firms cannot protect themselves at reasonable cost as long as

they participate, directly or indirectly, in financial markets. For example, even the most

conservative bank can be bankrupted when depositors lose confidence in the banking system at

large or when a great number of debtors collapse all at once. This is not to say that systemic risk

is unrelated to individual risk taking. On the contrary, the level of systemic risk follows from

individual choices regarding financial risk. Yet the prudence applied by a single individual, firm

or institution has little influence on the aggregate amount of systemic risk in the economy.

Keeping systemic risk low is therefore a public good.21

The failure of a single market participant alone, however large it may be, is not an instance of

systemic risk because it does not affect the working of the financial markets generally. Individual

failure causes harm only to creditors, shareholders and other parties dealing directly with the

person or entity. The corresponding risk can be  managed using the standard legal toolbox,

including contractual protections and legal rules from corporation law, securities law and

bankruptcy law, among others. These safeguards rest on each actor's incentive to limit his own

21 L.B. Chincarini, ‘The Amaranth Debacle: A Failure of Risk Measures or a Failure of Risk Management’, 10 Journal of Alternative Investments (2007) p. 91.

risk exposure. Only insofar as the damage extends beyond the immediate counterparties do

market participants lose their ability, and hence their incentive, to monitor and control risk; only

this type of risk qualifies as ‘systemic’ and as a true externality. Accordingly, if a hedge fund's

immediate investors or creditors suffer because the fund's investments turn sour, this does not

raise a systemic risk issue. A prominent example is the collapse of Amaranth Advisors, which in

2006 lost over four billion US dollars tallying the largest hedge fund loss on record. Investors

had to bite the bullet as the fund was orderly liquidated.22

In theory, a hedge fund may trigger a systemic event if, by bankrupting one of its counterparties,

it sets off a chain reaction of additional failures by financial institutions. Hedge funds rely on one

or more investment banks as ‘prime brokers’ for a broad range of services, including brokerage,

clearing and settlement. More importantly, prime brokers also extend credit to hedge funds

through securities lending, derivative contracts and other transactions.23 While they use the fund's

assets as collateral and tend not to lend on an unsecured basis,24 prime brokers bear a residual

credit risk if asset prices fall too quickly to be liquidated in order to cover the fund's liabilities.

To further reduce credit risk, prime brokers require an additional ‘margin’.25 These precautions

may be the result of bad experience and pressure from bank regulators.42 But as matters stand,

the risk of prime broker failure hinges on the value and liquidity of the collateral. In this regard,

hedge fund exposure raises essentially the same issues as the assets held for the bank's own

account.

Therefore, a systemic event will likely not be the result of a hedge fund default leading to the

collapse of a prime broker. Rather, hedge funds cause systemic risk through their impact on

market prices. The aim of hedge funds is to make a profit   from exploiting mispricings.

Irrespective of whether a manager's estimate of fundamental asset value is correct, there is a

significant risk that hedge funds suffer losses because fundamentals or the markets turn against

them.26 Losses may be realised if the position is liquidated, or they may appear only on paper as

22 M.K. Brunnermeier and L.H. Pedersen, ‘Market Liquidity and Funding Liquidity’, 22 Review of Financial Studies (2009) p. 220123 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220.24 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220.25 M.K. Brunnermeier and L.H. Pedersen, ‘Market Liquidity and Funding Liquidity’, 22 Review of Financial Studies (2009) p. 2201.26 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220.

assets are ‘marked to market’. In either event, the fund's financiers will start worrying. Hedge

fund investors are very sensitive to poor performance and react at short horizons by withdrawing

money. Managers impose redemption and notice periods to control outflows but investors accept

restrictions only to a limited degree. Even when investors cannot withdraw immediately,

managers have to prepare for redemptions that will inevitably follow the losses. Large losses

therefore often entail a forced liquidation of positions. But there is an even stiffer financing

constraint: hedge funds can ‘leverage’ their positions not just by putting their investors' capital to

work but also by borrowing from their prime brokers. As noted above, prime brokers require

hedge funds to post collateral in the full amount of the credit exposure plus an additional safety

margin. When the market value of the security falls below the required amount, the prime broker

will demand additional collateral. If the hedge fund does not meet the ‘margin call’, the bank can

(and will) sell assets to cover its credit exposure. To avoid losing control of its assets, hedge fund

managers will be anxious to maintain an equity cushion and liquidity in excess of current margin

requirements, which forces them to liquidate positions well ahead of potential margin calls.

In sum, there is a considerable risk that hedge funds lose their financing when they need it most

to avoid transforming paper losses into real losses.27 What turns this into a systemic risk is the

effect that forced liquidations have on market prices. Hedge funds are ‘smart money’ that pushes

market prices towards fundamental value. Their role in policing mispricings includes providing

liquidity for other market participants:28 orders from investors can move prices even if

fundamental asset values remain the same. ‘Providing liquidity’ means preventing such an

unjustified price change by taking the opposite side of the transaction. Hedge funds are credited

with supplying liquidity for a broad variety of financial assets, sometimes to the point that certain

markets would not exist without hedge funds. Given that the business model of hedge funds

consists of correcting prices and providing liquidity, they often end up as the marginal buyer or

seller determining the price of the asset. This is especially likely in asset markets that depend on

hedge funds for liquidity. If hedge funds, as marginal buyers or sellers, determine the market

valuation of certain assets, prices change when they are forced to sell or buy in order to raise

cash or close their positions. As long as hedge funds hold only small positions, other traders may

27 L.H. Pedersen, ‘When Everyone Runs for the Exit’, 5 International Journal of Central Banking (2009) p. 177; A.E. Khandani and A.W. Lo, What Happened to the Quants in August 2007? Evidence from Factors and Transactions Data (2008), available at: <http://ssrn.com/abstract=1288988>.28 H.B. Shadab, ‘The Challenge of Hedge Fund Regulation’, 30 Regulation (2007) p. 36, at p. 40; see also generally on hedge fund leverage, Garbaravicius and Dierick, supra n. 17, at pp. 28-32.

be ready to step in. However, when the market expects a large and extended dissolution of hedge

fund holdings, the only rational strategy for other players may be to wait on the sidelines until

hedge funds have unloaded their positions. As a consequence, market liquidity ‘dries up’ and

hedge funds' trades move markets more against their positions, causing more losses and hence

more forced liquidations.In this way, the vulnerability of individual hedge funds becomes

‘contagious’. Price changes translate into book losses which trigger more forced buying or

selling, which in turn brings more traders into trouble and prevents them from stemming the tide.

The disease is also likely to spread to other markets. In their frantic attempts to raise cash and

avoid realising losses,  and hedge funds other traders will start selling other assets, thus dragging

other markets into the spiral. Recent empirical research points to a common risk factor that

shows up in hedge funds returns only in times of crisis, which strongly indicates hedge funds

contagion.While the LTCM breakdown   in 1998 is the most famous example, the so-called

‘quant meltdown’ of August 2007 is arguably more illustrative of how hedge funds might

contribute to a systemic crisis. In this episode, the emerging subprime mortgage crisis caused a

number of hedge funds to unravel in spite of their sophisticated strategies having little if any

connection with the troubled mortgage securities. The fire sales led to sudden price swings in

various markets.29 Ironically, the threat to systemic stability results precisely from the benefit that

hedge funds create for financial markets. Other players get into trouble because they rely on the

liquidity and price efficiency provided by hedge funds. The damage consists of a benefit being

withdrawn unexpectedly.

 Regulatory strategies

In their very role as arbitrageurs and liquidity providers, hedge funds can cause or amplify

potentially devastating disruptions of markets and financial institutions. Because individual

hedge fund managers cannot control the amount of systemic risk in the economy, they do not

consider the implications of the amount of risk they incur to achieve performance. Of course, no

manager positively wants his hedge fund to go bankrupt. Hedge fund managers therefore have

incentives to control risk by limiting leverage and hedging their bets. At the same time, however,

some probability of failure is inevitable, and higher risks lead to larger returns. As long as

financial stability does not enter their calculus, managers will incur risk beyond the social

29 S. Malliaris and H. Yan, Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices  (2009), available at: <http://ssrn.com/abstract=1291872>.

optimum. Internalising the systemic risk externality is a worthy errand for regulation. How it can

be accomplished is a more difficult question. A comprehensive discussion is beyond the scope of

this article, but it will be helpful to give a basic sense of the regulatory options. Systemic risk is a

familiar theme from bank regulation. Prudential oversight of banks, at its core, consists of capital

adequacy rules: the rules limit the financial risk which a bank can incur as a function of its

capital endowment. Differently put, for a given amount of risk, banks are required to maintain a

certain amount of equity to reduce the likelihood of default. The leverage restriction relates to

a   measure of risk that is both highly sophisticated and complex. It might seem straightforward

to adopt this same model for hedge funds, that is, to treat and regulate them as banks. Such a far-

reaching proposal, however, is conspicuously absent from the debate, and for good

reason.30 Hedge funds differ fundamentally from banks. The key distinctive feature is the

composition and nature of hedge funds' financiers. Banks have a large number of weak creditors

in the sense that they neither demand security nor monitor the bank's credit standing. This blind

trust relies to some degree on prudential oversight, which may well reflect an efficient

centralisation of monitoring. It could be valuable economically if the solvency of certain

financial institutions is beyond doubt, the paradigmatic example being the use of bank

deposits.31 Be this as it may, hedge funds face entirely different financing conditions. They

borrow from one or very few sophisticated prime brokers. These strong creditors insist on being

more than fully secured, thus requiring a minimum amount of equity. As a consequence, hedge

funds are effectively prevented from betting their creditors' money.32 Losses fall on the fund's

(equity) investors, which are rather sophisticated and can hardly develop a false sense of

security. The capital structure of hedge funds thus ensures much stronger incentives for private

monitoring than are present for banks. Given how difficult it is to measure risk and to determine

adequate limits, it is unlikely that bank style prudential oversight can make any improvement on

the private constraints already in place in the hedge fund industry.33

30 Professor Stout develops a similar argument for procedural duties under the business judgment rule, see L.A. Stout, ‘In Praise of Procedure: An Economic and Behavioral Defense of Smith v. Van Gorkom and the Business Judgment Rule’, 96 Northwestern University Law Review (2002) p. 675, at pp. 688-691;

31 S.J. Choi and J.E. Fisch, ‘How to Fix Wall Street: A Financing Proposal for Securities Intermediaries’, 113  Yale Law Journal (2003) p. 269, at pp. 304-306 (analysing the similar problem of financing securities market information intermediaries).32 H.B. Shadab, ‘The Challenge of Hedge Fund Regulation’, 30 Regulation (2007) p. 36, at p. 40;33 S. Malliaris and H. Yan, Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices (2009), available at: <http://ssrn.com/abstract=1291872>.

A more promising path for hedge fund regulation is to support and enhance private risk

monitoring. While private monitoring, presumably, is superior to imposing direct leverage

restrictions, the incentives to control risk are too weak insofar as the main players - hedge fund

managers, prime brokers and investors - ignore the systemic risk externality. In addition, many

actors make decisions on behalf of others. Agency problems can exacerbate risk-taking because

agents tend to exercise less care and may create the appearance of higher returns by incurring

larger risks.34 Short of directly regulating the level of permissible risk, a general approach   to

instil greater caution consists of eliciting more information than the relevant players would either

provide or demand on their own. The underlying assumption is that information will be used to

reduce risk once it is available. An example of this regulatory approach is imposing a duty on

managers to disclose more risk-related information or, conversely, requiring prime brokers or

investors to ask for more information before financing the fund's investments. It seems plausible

that counterparties will consider specific risks when they rise to their attention. Likewise,

regulation can compel managers to devote more time and resources to assessing the fund's risk

exposure. Once a risk management function is set up and starts evaluating risk, there is a good

chance that decision-makers are going to heed its warnings.

Regulation can enhance the information environment for private risk-taking in yet another

important respect. In a systemic market event, forced liquidations become contagious because

other traders hold similar positions. To assess the risk of a market collapse it is therefore not

enough to know one's own position and that of one's immediate counterparties. What really

matters is the aggregate exposure of all market participants who might be forced into liquidating

their holdings, as well as the probability of such an event (indicated, e.g., by the amount of

leverage). With regard to such aggregate information, the under incentive to control risk is

further aggravated by a collective action problem: market participants are reluctant to disclose

their holdings for fear that others could trade against their positions.35 A private data collector

34 L.A. Stout, ‘In Praise of Procedure: An Economic and Behavioral Defense of Smith v. Van Gorkom and the Business Judgment Rule’, 96 Northwestern University Law Review (2002) p. 675, at pp. 688-691;

35 S.J. Choi and J.E. Fisch, ‘How to Fix Wall Street: A Financing Proposal for Securities Intermediaries’, 113 Yale Law Journal (2003) p. 269, at pp. 304-306

would also find it difficult to finance its operation.36 Regulation might help to overcome these

impediments.37

4. SELF-REGULATION

Systemic risk transcends national borders. As financial institutions rely on financial markets all

over the world, those markets become increasingly connected. Systemic risk externalities extend

beyond and into the territory of even the largest jurisdictions. It follows that no national

(government) regulator, standing alone, has the ability to protect its financial markets and

institutions against systemic risk. The task is inevitably a transnational one in the sense that it

exceeds the capabilities of any single nation state. Faced with a problem of a transnational

nature, regulators must look beyond adopting and enforcing binding rules under national law.

‘Transnational regulation’ denotes a regulatory challenge as well as a broader array of regulatory

means.

One way of getting beyond the limitations of national regulators is to pass responsibility to other

actors not constrained by jurisdictional boundaries. The market itself cannot overcome the

systemic risk externality, but it may sustain institutions to control it. In the following, such

market-based institutions will be referred to as ‘self-regulation’. The term is frequently used in

the narrower sense of legally binding rules promulgated by market organisations,64 such as the

‘self-regulatory organisations’ under US securities law.38 Of course, self-regulation may be a lot

more effective if it can muster the enforcement powers and mandatory scope of ‘hard law’. As it

will turn out, this is the critical shortcoming of a self-regulatory approach to hedge funds. Yet, as

the regulatory task is a transnational one, the analysis should extend to regulatory strategies that

do not rely (or do not rely exclusively) on the binding force of national ‘hard law’. For present

purposes, therefore, ‘self-regulation’ should include the mechanisms of private ordering and

notably market discipline as an enforcer of ‘soft law’ rules.39

The self-regulation game

36 H.B. Shadab, ‘Fending for Themselves: Creating a US  Hedge Fund Market for Retail Investors’, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-290.37 H.B. Shadab, ‘Fending for Themselves: Creating a US Hedge fund Market for Retail Investors’, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-290.

38 S.M. Davidoff, ‘Black Market Capital’, 2008 Columbia Business Law Review (2008) p. 172.39 T.A. Paredes, ‘On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission’, University of Illinois Law Review (2006) p. 975, at pp. 990-998

Self-regulation implies that those same market participants who cause the market failure should

also be in charge of preventing it. A natural question to ask is why the players in the game of

regulation should even consider such an unlikely arrangement.

 Interests of regulators

Regulators may have an interest in encouraging self-regulation instead of applying only their

own devices. If self-regulation is effective in addressing the transnational nature of the

externality, responsible regulators will happily embrace it for this  reason alone. But self-

regulation has appeal even beyond the promise of greater reach. Historically, private regulation

of financial markets predated government oversight. Even after governments decided that more

centralised regulation was needed, they often left considerable regulatory responsibility to

private or hybrid organisations. There is widespread consensus that self-regulation deserves a

significant role.40 In fact, self-regulation commands a unique advantage over government-

imposed regulation even in a purely national setting: it can apply the industry's own expertise to

accomplish regulatory goals at the lowest possible cost. 41Albeit by no means a new technique,

self-regulation fits nicely with the ‘responsive regulation’ and ‘new governance’ movements,

which perceive regulation as an ongoing and dynamic relationship between the government and

private actors.42 ‘New governance’ emphasises the benefits of letting private actors participate in

the regulation of their activities. Giving industry associations and individual firms a role in the

process can lead to a cooperative relationship with the government. For instance, a firm's internal

governance structure may ensure that public policy objectives are met. In exchange, the regulator

refrains from imposing detailed (and less efficient) ‘command and control’ rules. The key

advantage of this kind of ‘relational contracting’43 is that the regulator can use non-verifiable

information - such as its own evaluation of measures adopted by the industry - which is not

40 J. Danielson, et al., ‘Highwaymen or Heroes: Should Hedge Funds Be Regulated?’, 1 Journal of Financial Stability (2006) p. 522, at pp. 527-52841 R. Sklar, ‘Hedges or Thickets: Protecting Investors from Hedge Fund Managers' Conflicts of Interest’, 77 Fordham Law Review (2009) p. 3251 (arguing for investor protection specifically against conflicts of interest).R.A. Booth, ‘Who Should Recover What for Late Trading and Market Timing?’, 1 Journal of Business and Technology Law(2006) p. 101; P.G. Mahoney, ‘Manager-Investor Conflicts in Mutual Funds’, 18 Journal of Economic Perspectives (2004) p. 161, at pp. 173-176; E. Zitzewitz, ‘Who Cares about Shareholders? Arbitrage-Proofing Mutual Funds’, 19 The Journal of Law, Economics and Organization (2003) p. 245.42 H.T.C. Hu and B. Black, ‘The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership’, 79 Southern California Law Review (2006) p. 811.43 R. Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Fourth Estate, London 2001); F.R. Edwards, ‘Hedge Funds and the Collapse of Long-Term Capital Management’, 13  Journal of Economic Perspectives (1999) p. 189, at pp. 197-207.

available if all that matters is formal compliance with a set of predefined rules.  As  the

cooperative relationship builds on mutual trust, it can also foster a sense of responsibility for the

goals of regulation on the part of the industry and of individual firms.

In the hedge fund domain, delegating regulation to private actors seems especially attractive.

Information on how hedge funds operate is hard to come by because of the exceptional pace of

innovation in strategies and practices and because hedge fund managers are extremely secretive

to protect their proprietary knowledge. If one adds to this the transnational dimension,

encouraging self-regulation is an all the more desirable option for regulators - provided that it

effectively addresses the systemic risk externality.

Collective interests of the industry

Hedge fund managers, investors and prime brokers should themselves take a genuine interest in

controlling systemic risk. Hedge funds are the likely first victims of a systemic event caused by

other hedge funds. All stakeholders in a hedge fund suffer considerably from a breakdown:

investors lose their capital, managers and prime brokers forego future fee revenue. While these

players lack incentives to consider systemic risk in their individual risk choices, it is clearly in

their collective interest to reduce the expected losses from systemic events. If collective action

were without difficulty, the hedge fund industry would likely take precautions to limit systemic

risk. Unfortunately, however, establishing an effective self-regulatory framework is not

costless.44 In addition, hedge fund stakeholders would bear only a certain part of the damage

from a systemic event. It follows that even collectively the hedge fund industry does not have

optimal incentives to reduce its systemic risk impact. Expecting self-regulation to emerge

spontaneously would be too optimistic.45

Yet self-regulation need not arise in isolation. Self-regulation serves as a substitute for

government regulation. Even as the government prefers the industry to write its own rules, it

retains the power to impose conventional, state-made regulation. The latter option will seem

more attractive than not addressing the market failure at all. This possibility, in turn, alters the

incentives of the industry: in deciding for of  against self-regulation, the hedge fund industry also

needs to consider the threat of government regulation. Where self-regulation is not pursued for

44 A.W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008 (2008), available at: <http://ssrn.com/abstract=1301217> (‘central bankers … know it when they see it’); S.L. Schwarcz, ‘Systemic Risk’, 97 Georgetown Law Journal (2008) p. 193, at pp. 196-20445 O. de Bandt and P. Hartmann, Systemic Risk: A Survey (Working Paper No. 35, European Central Bank, Frankfurt 2000), at pp. 10-13

its own sake, it can still be the only way to avert heavy-handed government intervention. The

incentive structure resembles a prisoners' dilemma: the government can decide to either not

regulate (‘cooperate’) or regulate (‘defect’). Likewise, the industry's ‘cooperate’ strategy is to

implement effective self-regulation whereas failure to do so constitutes the ‘defect’ choice.

Given defection by the other party, each player prefers to defect but both players would prefer

mutual cooperation (only self-regulation) to defection (government-imposed regulation and no

self-regulation).46 The self-regulation game between government and industry is a familiar

pattern in the politics of

regulation. It exemplifies the relational and dynamic view of the ‘responsive regulation’ school

of thought and, more particularly, how far-reaching powers in the hands of government - a

‘benign big gun’47 can lead to superior outcomes without actually being used.

Self-regulation in the hedge fund industry conforms to this model. The Managed Funds

Association in the US seems to be the first to have promulgated ‘Sound Practices for Hedge

Fund Managers’. Now in their fifth edition,48 the standards responded directly to a call from the

President's Working Group on Financial Markets (PWG) following the LTCM crisis; around the

same time, Congress was contemplating, but ultimately did not adopt, a ‘Hedge Fund Disclosure

Act’.49 The government's role in stimulating rule-making by the industry became even more

pronounced when the PWG revisited the matter in 2007 after eight years of tremendous growth

in hedge fund assets. The PWG and two other regulators entered into an agreement among

themselves on how to deal with ‘private pools of capital’, including hedge funds. The regulators'

common principles re-emphasised  that ‘in our market-based economy, market discipline of risk-

taking is the rule and government regulation is the exception’. Instead of asking for authority to

regulate hedge funds directly, the agencies agreed to use their existing powers to foster market

discipline on hedge funds. To this end, the agreement often invokes ‘sound practices’ identified

46 R. Craswell and J.E. Calfee, ‘Deterrence and Uncertain Legal Standards’, 2 Journal of Law, Economics and Organization (1986) p. 279. Against this backdrop and given the rarity of litigation, it is exceedingly difficult for courts to set the standard of care so as to avoid over- or underdeterrence.47 K. Pistor and C. Xu, ‘Incomplete Law’, 35 New York University Journal of International Law and Politics (2003) p. 931, particularly at pp. 949-951; see also the broader comparison of regulation and court adjudication in A. Shleifer, Efficient Regulation (NBER Working Paper No. 15651, 2010).48 IOSCO, Hedge Funds Oversight, Final Report (2009), at paras. 50-51, available at: <http://www.iosco.org> (emphasising the need for convergence); FSA, supra n. 93, at p. 28 (recognising international coordination as a ‘significant challenge’); Hedge Fund Working Group, supra n. 91, at pp. 32-3449 Cf. F. Partnoy, ‘Financial Derivatives and the Costs of Regulatory Arbitrage’, 22 Journal of Corporation Law (1997) p. 211, at p. 227

by the industry. This time the PWG went one step further and lent its authority to establish an

Asset Managers' Committee to develop industry standards. The Asset Managers' Committee

published its ‘Best Practices for the Hedge Fund Industry’ in January 2009.

In Europe, industry standards arrived somewhat later. In 2002, the Alternative Investment

Management Association (AIMA) published a ‘Guide to Sound Practices’ specifically for

European hedge fund managers. The AIMA Guide stands out in that it came to life without any

noticeable trigger from government institutions. As a European initiative, it is not tied to a

national jurisdiction or regulator.50 It provides an example of private ordering in relatively pure

form. To understand how such rules emerge without government pressure, one should appreciate

that the systemic risk externality is only one possible reason for self-regulation. While the hedge

fund industry has few incentives to contain systemic risk (other than pleasing regulators),

adopting orderly standards for business conduct helps to garner confidence among investors and

counterparties.51 It is revealing that the AIMA Guide, a truly transnational initiative, seemed

insufficient to appease the relevant regulator: in 2007, major hedge fund managers in the UK set

up the Hedge Fund Working Group. After a consultation period on a draft, it published its

‘Hedge Fund Standards’ in a final report early in 2008 and at the same time instituted the

Hedge  Fund Standards Board to take responsibility for updating the standards and generally to

‘[a]ct as guardian or custodian of the Standards’.52 The Working Group left no doubt about its

motivation to demonstrate responsibility in order to pre-empt more intrusive government

regulation.53 In its last comprehensive report on hedge fund regulation dating to 2006, the UK's

Financial Services Authority (FSA) had expressed support for developing industry ‘good

practice’.More generally, the regulatory environment in the UK is particularly conducive to such

a move. Hedge fund managers in the UK already are subject to FSA oversight so that absolute

freedom from government regulation is not available. At the same time, the FSA has strongly

committed to a principles-based regulatory approach including a prominent role for ‘industry

50 V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 3 (‘Regulatory arbitrage exploits the gap between the economic substance of a transaction and its legal or regulatory treatment’).51 E. Wymeersch, The Regulation of Private Equity, Hedge Funds and State Funds (Universiteit Gent Financial Law Institute Working Paper 2010-06, 2010), at pp. 4-13,52 E. Cauble, Harvard, Hedge Funds, and Tax Havens: Reforming the Tax Treatment of Investment Income Earned by Tax-Exempt Entities (Illinois Program in Law and Economics Working Paper No. LE10-004, 2010), at pp. 9-53 G.J. Stigler, ‘The Theory of Economic Regulation’, 2 Bell Journal of Economics and Management Science (1971) p. 3, at pp. 13-14.

guidance’. Although the Hedge Fund Working Group decided not to seek formal ‘confirmation’

of their standards, the FSA has announced to take them into account in overseeing hedge fund

managers.

 Interests of individual firms: the problem of enforcement

The argument so far has rested on the hedge fund industry's collective interest in regulating its

own activities. But even if the industry as a whole prefers self-regulation to more intrusive

government intervention, firms individually may find it in their interest not to agree to any

restrictions. Preventing burdensome government regulation is a collective good for the industry.

It follows that individual firms have an incentive to take a free ride on the self-regulation effort

by others. Firms can ‘shirk’ by not conforming to the industry's rules, in the form of either open

defiance or covert non-compliance. Enforcement thus poses a challenge for self-regulation if the

rules are not legally binding and if there is no public authority to uphold them.

In the hedge fund industry, the problem should prove somewhat less severe than in other areas of

regulation. Hedge funds can only incur risk when investors and  prime brokers equip them with

capital. These counterparties are themselves sophisticated players. Because they have a vital

interest in controlling their own exposure, they can exercise significant pressure on hedge fund

managers to comply with self-regulatory standards.54 In this regard, risk regulation of hedge

funds differs considerably from, for instance, environmental regulation or consumer protection

where there are no such knowledgeable and motivated actors monitoring the regulated

behaviour. Shirking industry rules designed to mitigate risk becomes a much thornier proposition

if managers have to justify themselves before their risk-conscious investors and prime brokers -

even if these counterparties themselves would have imposed less far-reaching restrictions.55

For this reason, self-regulation has early on been directed not just at hedge funds and their

managers but also at investors and prime brokers. In fact, the PWG report of 1999 considered

industry standards under the heading ‘Enhanced Private Sector Practices for Counterparty Risk

Management’ and called primarily on banks to develop such standards. This focus reflected the

special circumstances of the LTCM crisis in which the fund's prime brokers had incurred a very

substantial credit risk, but it was also seen as way to ‘impose greater discipline on

borrowers’. The banking industry reacted by forming the Counterparty Risk Management Policy 54 R. Romano, ‘Empowering Investors: A Market Approach to Securities Regulation’, 107 Yale Law Review (1998) p. 235955 C. Brummer, ‘Stock Exchanges and the New Markets for Securities Laws’, 75 University of Chicago Law Review (2008) p. 1435;

Group (CRMPG), which presented its report only a few months later, in June 1999. The CRMPG

did not confine itself to hedge funds and proposed a set of general recommendations to enhance

credit risk management in securities and derivatives markets. Notably, the CRMPG is partly an

international exercise in that the twelve participating banks included major European institutions

such as UBS and Barclays Bank. The CRMPG has continued to promote higher standards after

its first report. In a second report of 2005, it called on hedge fund managers to follow the

CRMPG recommendations, where applicable, as well as to adopt the Managed Funds

Association's ‘Sound Practices’. Banks themselves seem to have improved their credit risk

management practices following the first CRMPG report. This would be hardly surprising: as

regulated firms, prime brokers are likely to face pressure from regulators to comply with risk

management standards. In addition, there is only a  limited number of major banks offering

prime brokerage services, which facilitates mutual monitoring of conformity with the standards.

After the LTCM disaster, banks appear not to have suffered large losses from their prime

brokerage business with hedge funds.56 To control hedge fund risk further, one needs to look to

investors. Investors in hedge funds should pay even more attention to hedge fund risk because

their stake is the first to bear any losses. Accordingly, the PWG has established an Investors'

Committee to create best practice standards directed at investors as a complement to the

standards set by the Asset Managers' Committee. However, investors are far more numerous and

diverse than prime brokers. Many but not all are themselves subject to regulation. Monitoring

and enforcing self-regulatory standards is therefore a lot more difficult with regard to investors

than with regard to banks.57

Even if a specific self-regulatory regime for investors turns out to be impractical, investors can

still play an important role in enforcing self-imposed rules for hedge fund managers. To help

build such pressure, the UK Hedge Fund Standards seek to make compliance transparent and

indeed salient to investors. Hedge fund managers are asked to become signatories to the

Standards. By endorsing the Standards, managers agree to a ‘comply or explain’ requirement:

they can either adopt the Standards in full or choose to opt out of certain provisions; in the latter

case, managers have to explain to investors why they believe the particular rule should not apply

56 H. Jackson, ‘Centralization, Competition, and Privatization in Financial Regulation’, 2 Theoretical Inquiries in Law (2001) article 4.57 .-W. Sinn, ‘The Selection Principle and Market Failure in Systems Competition’, 66 Journal of Public Economics (1997) p. 247 (arguing that regulatory competition reintroduces the market failure that regulation was intended to cure

to them. The ‘comply or explain’ mechanism is meant to adapt the Standards to the varying

needs and circumstances of different hedge funds  managers (such as the size of under

management). Contrary to an earlier prediction, the  hedge funds Standards have attracted

signatories representing 60% of the   European hedge funds assets under management. The

formal status of a signatory makes it simple for investors to ascertain whether a particular

manager in general adheres to the Standards. Given their widespread acceptance and the ready

disclosure of non-compliance under the ‘comply or explain’ principle, investors may be able to

reduce due diligence costs by using the Standards as a benchmark. If many investors start

focusing on the Standards, they will put pressure on managers to become a signatory and to

comply.

Clear and unambiguous disclosure can also mobilise the power of ‘hard law’ to enforce self-

regulatory standards. If a manager has explicitly announced to conform to certain rules (e.g., by

endorsing the Hedge Fund Standards and not declaring non-compliance with a particular rule),

he exposes himself to liability for misrepresentation, fraud or breach of the investment agreement

if it turns out that he has not abided by those rules.58 Because hedge fund investors hold large

stakes, they will be prepared to bring such claims.59 The threat of private litigation matters

because many deviations from self-regulatory rules remain hidden from investors' views until the

damage is done. For instance, the survival of a hedge fund may at times depend on the valuation

of its assets when potential losses would lead to massive redemptions. In a critical situation like

this, a manager's concern for his reputation may not be enough to prevent him from violating

conflict of interest rules to ensure an independent valuation process. One could strengthen

industry standards further by leaving enforcement to government regulators.Yet as self-

regulation assumes more ‘hard law’ qualities and relies on the enforcement powers of

government regulators, it becomes subject to the limited reach of national regulation. Self-

regulation thus loses its advantage in dealing with the transnational character of systemic risk.

4.2 Limits of self-regulation

58 J.R. Macey, ‘Regulatory Globalization As a Response to Regulatory Competition’, 52 Emory Law Journal (2003) p. 1353, particularly at pp. 1358-1361 (examining regulators' willingness to give up independence in exchange for cooperation);59 E. Colombatto and J.R. Macey, ‘A Public Choice Model of International Economic Cooperation and the Decline of the Nation State’, 18 Cardozo Law Review (1996) p. 925, at pp. 933-935, 943-944 and 951-954

Self-regulation faces constraints in creating as well as enforcing industry standards. As to the

first limitation, the hedge fund industry collectively has only a limited interest in self-imposed

rules beyond the precautions that managers, creditors and investors take anyway. To a

considerable degree, systemic risk remains an external  even at industry level. Therefore,

establishing a self-regulatory regime depends on the ‘benign big gun’, a continuing threat that

the government can step in and impose its own, potentially more burdensome regulation. The

second limitation consists of the enforcement problem. Although prime brokers and investors

can exert pressure on managers to comply with industry standards, market discipline alone

extends only to observable behaviour. To be effective, self-regulation must cover conduct that

counterparties cannot monitor directly, such as adhering to rules on risk management, disclosure

and valuation in critical situations. To some extent, private litigation can enhance compliance if

courts take the standards into account for determining liability. However, because the manager -

usually a limited liability entity - will often not be able to pay large damage awards, the deterrent

effect of litigation remains imperfect.60 In addition, courts may be reluctant to impose liability for

rare events of large losses, especially when it is hard to distinguish legitimate business judgment

from a violation of industry standards.

What would be needed is an institution to enforce industry standards on an ongoing basis.

Without continuous engagement by an independent monitor there is a great risk that self-

regulatory standards will remain vague and ultimately fail to govern behaviour.116 This is

especially true where abstract, high-level standards give firms considerable discretion in how to

comply. Such a flexible, principles-based approach relies even more on a regulating entity to

determine whether individual firms' effort is sufficient to accomplish the regulatory

objectives.61 The monitoring and enforcement task is usually performed by government

regulators. In theory at least, it could also be assumed by a self-regulatory body. The UK Hedge

Fund Standards Board claims to be monitoring compliance with the standards.62 However, a

sufficiently robust enforcement organisation needs considerable funding. Levying a significant

fee would add to the difficulties of winning the endorsement of managers. What is more,

60 B. Liang and H. Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds (2008), available at: <http://ssrn.com/abstract=967788>.61 HM Revenue & Customs, Statement of Practice 1/01 as revised on 20 July 2007,62 Treatment of Investment Managers and Their Overseas Clients (2007), at para. 2, available at: <http://www.hmrc.gov.uk> (noting the importance of the ‘Investment Manager Exemption’ for the UK's attractiveness).

managers would have to concede certain rights to the enforcement   body, for instance, a right to

receive regular reports, to audit the manager's records or to inspect his business on site. It is hard

to believe that many managers would accept such far-reaching demands, particularly with regard

to sensitive information (which may be needed to monitor systemic risk in the sector ). In

addition, an enforcement body operated by the industry itself might well fail to enforce its own

rules vigorously enough without the threat of government intervention.

The main conclusion is that self-regulation can be effective only if the government's ‘benign big

gun’ looms in the background, loaded and ready. While it is still desirable to include elements of

self-regulation in order to tap the industry's superior knowledge, self-regulation cannot fully

substitute for conventional government regulation. For the same reason, self-regulation will not

extend far beyond the scope of national regulation. As the above analysis reveals, three out of

four major industry standards have been developed to pre-empt closer government oversight.

Instead of creating a transnational regulatory regime, they remain bound to two national

jurisdictions, the US and the UK. The enduring relevance of national regulators has led to

multiple standards. Although industry and regulators agree that this is at odds with the global

reach and effects of hedge funds, convergence of self-regulation will hinge on coordination

among national jurisdictions. Government regulation needs to come up with its own response to

the transnational challenge of controlling systemic risk.

5. GOVERNMENT REGULATION

Government regulation is vested in national jurisdictions. As such, its form and intensity reflect

the political preferences, convictions and incentives prevailing in the different countries. If hedge

fund activities were distributed evenly over jurisdictions, one might conjecture that the

patchwork of national regulations restricts systemic risk on average by the right amount. Yet the

mismatch between the national reach of government regulation and the transnational nature of

systemic risk is more serious and complicated. The hedge fund industry responds to differences

in national regulation by engaging in ‘regulatory arbitrage’. Consequently, jurisdictions

find   themselves competing with each other to attract hedge fund business. Instead of balancing

the cost of intervention against the benefit of controlling systemic risk, successful regulators are

biased towards pleasing regulated firms (subsection 5.1). To prevent such ‘state capture’,

government regulation itself has to transcend national jurisdictions. Effective systemic risk

regulation therefore requires harmonising government regulation across states (subsection 5.2).

5.1 Regulatory competition

The term ‘arbitrage’ refers to the exploitation of a price difference between two goods that are

essentially the same. The textbook example is a price disparity between the same good traded at

different market places. When speaking of ‘regulatory arbitrage’, one thinks of regulatory

requirements as a cost (or price) for conducting a certain activity. ‘Regulatory arbitrage’ then

describes a scheme under which a person carries out essentially the same activity but at lower

regulatory cost. Opportunities for regulatory arbitrage arise within a single jurisdiction when the

same economic outcome can be accomplished in two or more ways that the law treats

differently. In addition, regulatory arbitrage can take place between jurisdictions. Interested

parties may be able to shape their activity so that jurisdiction shifts from one national regulator to

another. For the purposes of this analysis, it is such international regulatory arbitrage that is of

interest. In what follows, ‘regulatory arbitrage’ refers only to the international version.

Whether and to what extent market participants engage in regulatory arbitrage depends on

opportunities and the cost of exploiting them. An arbitrage opportunity arises if national

regulators differ in the requirements they impose on a particular type of activity. The rules on

regulatory jurisdiction determine how costly it is to   choose a regulator and thus to exploit

opportunities for regulatory arbitrage. The cost is low when the economic substance of the

activity needs to be modified only slightly or not at all to shift jurisdiction to another state. By

contrast, it may be that taking advantage of a difference in regulation requires fundamental

changes to the contemplated activity, which can make regulatory arbitrage expensive or even

impossible.

When the cost of regulatory arbitrage is low, market participants will be able to exploit relatively

minor differences in regulation. At first glance, financial regulation is particularly vulnerable to

regulatory arbitrage because financial assets have little if any physical presence and therefore can

easily be located anywhere in the world. Yet the financial industry itself is more tangible.

Financial services have to be performed by real people and are ultimately offered to real

customers. In the case of the hedge fund industry, regulation can attach to five categories of

parties: (1) the hedge fund; (2) its manager; (3) the prime broker; (4) other service providers;and

(5) investors. Absent international harmonisation, states have the power to define their own

regulatory jurisdiction.63 Broadly speaking, states typically assume regulatory jurisdiction over

those parties that operate or are located in their territory.64 Once regulatory jurisdiction is

triggered, a state can impose requirements on other aspects of the hedge fund business. For

instance, in exercising oversight of the hedge fund itself, regulators can demand certain

qualifications of the manager as a condition for managing the fund. Likewise, access to a

country's investor base can hinge on requirements at the level of the hedge fund, the manager or

other service providers. Leveraging their jurisdiction over relatively immobile parties provides

states with extraterritorial reach and, by implication, with the opportunity to rein in regulatory

arbitrage. At the same time, however, extending regulatory control is costly because it tends to

stifle cross-border trade. If, for example, a regulator restricts access to investors located in its

territory, it might cut off those investors from the most valuable investment opportunities in the

market, which is hardly consistent with investor protection or other regulatory objectives.

Regulators therefore have to balance the benefits of integration in international markets with the

(perceived) threat of regulatory arbitrage.

At present, many jurisdictions refrain from directly regulating hedge funds - i.e., the entities

holding the assets - as long as shares are not marketed to the public  National regulations thus

barely impede choosing the most advantageous hedge fund jurisdiction. Accordingly, regulatory

and tax arbitrage flourishes: in 2008, around 60% of all hedge funds were domiciled in an

offshore jurisdiction with the Cayman Islands as the market leader attracting 39%. Obviously,

hedge funds find neither their investors nor their managers in the Cayman Islands. They go there

to benefit from differences in regulation and taxes.

Different from hedge funds, their managers are often subject to an authorisation requirement in

their home country. Important exceptions include Switzerland and   (until the most recent

reform) the US. Where a regulatory regime for managers is in place, it usually does not prevent

them from moving to another, unregulated jurisdiction. Still, the cost of engaging in regulatory

arbitrage is likely not as low as it is for hedge funds because managers rely on highly skilled

personnel, which is a significantly less mobile resource than the fund's intangible assets. Also,

hedge fund managers benefit from the proximity to prime brokers and other service providers as

63 D. Cumming and N. Dai, A Law and Finance Analysis of Hedge Funds (2008), at pp. 15-16, available at:

<http://ssrn.com/abstract=946298>; Fung and Hsieh, supra n. 18, at pp. 4-6.64 Regulation of Offshore Hedge Funds: The Failure of the Hedge Fund Registration Requirement’, 92 Cornell Law Review (2007) p. 795, at pp. 807-811

well as to a larger financial community, not least because they need to communicate and meet

with investors on a regular basis. As a consequence, not only are managers relatively less mobile

but they also tend to cluster, preferably in or near a major financial centre. Differences in

regulation must be larger to trigger regulatory arbitrage, and they are more likely to be exploited

when the alternative jurisdiction has a vibrant financial centre to offer. In fact, hedge fund

managers are highly concentrated: two thirds of global hedge fund assets are managed from the

US, 57% alone from New York and two cities in nearby Connecticut (Greenwich and Westport).

Trailing them at 21% is London, capturing roughly three quarters of the European market for

hedge fund managers.65

The remaining parties in the hedge fund business are service providers, most importantly prime

brokers, and investors. Prime brokers need to be investment banks and are invariably regulated

as such. National regulators have not used their  oversight of prime brokers to impose direct

regulation on their hedge fund clients, presumably because hedge funds can easily switch to

prime brokers from other jurisdictions. By contrast, jurisdiction over investors can translate into

requirements for hedge funds and managers. As to retail investors, access to them is often

prohibited altogether or restricted to regulated funds. With regard to affluent and more

sophisticated individuals, there is generally little oversight. Of greater interest is the regulation of

institutional investors such as funds of hedge funds, pension funds and insurance companies. An

example are pension funds under the US Employment Retirement Income Security Act of 1974

(ERISA). If pension or employee benefit plans under ERISA hold more than 25% of equity, the

hedge fund's assets turn into ‘plan assets’. As a consequence, the fund manager is subject to

specific and onerous duties as a ‘plan fiduciary’ under ERISA. In addition, the (principal) plan

fiduciary will urge the hedge fund manager to register with the Securities and Exchange

Commission (SEC) to preclude its own liability for breaches committed by the

manager. Apparently, most hedge fund promoters avoid the ERISA regime by maintaining the

25% threshold.To cite another example, to the limited extent that German insurance companies

can invest their ‘tied assets’ in hedge funds, they are precluded from investing in unregulated

hedge funds (as well as in hedge funds outside the European Economic Area). Generally

speaking, the regulatory framework of institutional investors may be a reason, at least for some

hedge funds and their managers, to seek a regulated status.   Restricting access to investors gives

65 International Financial Services London, supra n. 4, at pp. 2-3; see also Garbaravicius and Dierick, supra n. 17, at pp. 14-15

national regulators some sway over foreign hedge funds and managers. Exercising this power,

however, may deprive investors of the opportunity to invest in the most promising hedge funds.

Absent coordination between regulators, hedge funds might well decide to forgo marketing

opportunities in particular countries in order to retain a level of regulation that they deem more

favourable. In this case, regulating investors to constrain regulatory arbitrage will accomplish

little and cost much.

Regulatory competition as state capture

Regulatory arbitrage describes how participants in the hedge fund industry react to regulation if

they perceive it as costly. But arbitrage opportunities only exist if jurisdictions differ in their

regulatory approach. While such variation can result from random differences in opinion, it

stands to reason that regulatory arbitrage itself also affects government behaviour. Insofar as

hedge funds and their managers can migrate to other, more lenient jurisdictions, imposing stricter

regulation has fewer benefits (because it is avoided) and entails higher costs (because hedge fund

business is lost to other jurisdictions). Focusing on systemic risk, states face a public good

dilemma that mirrors the impediments to industry self-regulation examined above. Regulating

one's own hedge fund industry helps little if other jurisdictions stay idle. Individual countries

enjoy the benefits of curbing systemic risk even if they themselves fail to contribute. At the same

time, states have incentives to engage in regulatory competition by offering less restrictive

regulation and attracting hedge fund business.

Jurisdictions are likely to differ in the relative weight they attach to financial stability on the one

hand and to competing for hedge fund business on the other. One might expect countries with a

larger financial industry to be more affected by systemic events and to have a greater interest, all

else equal, in reducing their probability. As the recent financial crisis testifies, however, systemic

risk also affects economies with a smaller financial sector. Therefore, the concern for financial

stability should be more or less common to all jurisdictions. It follows that incentives for hedge

fund regulation diverge primarily because of differences in the potential gains from regulatory

competition. The greater a country's chance of attracting hedge fund business, or the larger a

country's existing share in the global hedge fund market, the more reluctant it will tend to be to

control systemic risk. In public choice theory, ‘regulatory capture’ refers to a situation in which a

regulatory agency conforms to the demands of the regulated industry at the expense of its

public  interest mission. A state can also be said to have been ‘captured’ by a particular industry

if it forsakes the broader, transnational public good for the special interests of the industry. The

degree of ‘state capture’ should depend on the economic benefits, potential or real, from

attracting hedge fund activities. Benefits include the employment and revenue generated by

hedge fund managers and other service providers, specific taxes and fees levied from hedge

funds,148 and the potential spillover and network effects for other financial industries. Once a

hedge fund sector has taken root, state capture intensifies further as the industry starts lobbying

the regulator and national politics. Forming a small but prosperous interest group, the hedge fund

industry is well positioned to influence governments, especially because it can bolster ‘voice’

with the threat of ‘exit’.

The concentration of hedge fund activities suggests a loose taxonomy of three degrees of state

capture: a state can be said to be ‘fully captured’ if the concern for the hedge fund industry (or

financial services generally) dominates most other economic considerations, which implies that

the financial sector is very large relative to the overall economy. The ‘offshore financial centres’,

including Luxembourg and Liechtenstein, fall into this category. In the Cayman Islands,

financial services account for roughly half of the total economic output. In Luxembourg, the

financial industry directly contributed 25% to the country's gross domestic product in 2008, after

37% before the financial crisis in 2007. For these ‘fully captured’ jurisdictions, the gains from

attracting or retaining financial activities dwarf any potential benefits from trying to regulate

systemic risk - especially in view of the fact that they have little effective control over systemic

risk in global financial markets.

  A second group of countries takes a pronounced interest in hedge funds and the financial

industry generally but without giving them absolute priority. The US and the UK are the primary

examples of this group of ‘half captured’ states. Their financial industries are relatively larger

than those of other developed countries: in 2007, the share of the gross domestic product

amounted to 7.9% for the US and to 8.3% for the UK, as compared to 6.7% for Japan, 4.7% for

France and 4.0% for Germany. The US and UK financial industries do not just serve their own

hinterland but provide a hub for international and global financial services. Presumably, their

competitive advantage over offshore jurisdictions lies in their more diversified economy: to the

extent that major international banks need a lender of last resort as a credible backup, they

cannot move to smaller jurisdictions that lack a large real economy. As to hedge funds, the US

and the UK host almost nine tenth of all hedge fund managers, which constitute the key

intellectual factor and entrepreneurial driver of the industry. According to industry estimates,

hedge funds in the UK provide employment for 40,000 people. Because of its profitability and

relevance for New York and London as financial centres, the industry's political clout should be

even greater than suggested by its immediate economic weight. Regulatory policies of both the

US and the UK have proven responsive to the industry's needs and to competitive threats. At the

same time, one should expect neither the UK nor the US government to side with the hedge fund

industry at any  price. In the current crisis, both countries have shown some willingness to

consider stricter financial regulation to protect the economy from systemic events.Serving as the

ultimate backup for a large number of global financial institutions, they are more exposed to

financial instability than other countries. Controlling systemic risk is in their national interest.

Most countries belong to the third group. To the extent that a financial industry exists, it has few

if any global ambitions. Given the geographical concentration of hedge funds and their

managers, these countries have only a very small share or none at all in the global hedge fund

market. For most of them, there is no point in competing for hedge fund business. Industry

interests are only weakly represented in politics. Because these countries have no stake in the

industry's success, they can claim a status of ‘non-capture’. At the same time, their economies

are affected both by the systemic risk externality and by the benefits that hedge funds create for

financial markets in terms of price efficiency and liquidity. In theory at least, they should have

the right incentives to determine the optimal amount of regulation to control systemic risk. The

trouble with ‘non-captured’ states is that they lack expertise. They have no experience in

regulating hedge funds and little if any interaction with the industry. As a consequence, they are

more prone to populism and scapegoating. To some extent, the German position on hedge funds

may be considered an example. Germany advanced hedge fund regulation as a key issue of its

presidency of the G8 in 2007, only to earn a lukewarm mention in the summit declaration. The

US and the UK were not receptive to lecturing from a jurisdiction with virtually no hedge fund

business.

  Evaluating regulatory competition

There is an extensive debate on the merits of regulatory competition in general and specifically

with regard to financial market regulation.Looking at regulation as a service supplied by

governments, one may very well imagine that - just like in markets for other goods - competition

has the potential to enhance the quality of the service. If regulators have incentives to compete,

they will operate more efficiently (e.g., speed up responses to inquiries and filings) and will be

prepared to tailor regulatory solutions to novel activities, thus fostering innovation.Insofar as

sophisticated investors in hedge funds demand regulatory protection, managers face competitive

pressure to choose a jurisdiction that provides sufficient investor protection. In such a setting,

governments must be eager to build a reputation for reliable safeguards. Rather than erode

regulation, competition likely results in more effective regulation at lower costs. As hedge funds

and managers concentrate in few locations, a small number of jurisdictions gain expertise. In

effect, these national jurisdictions ascend to becoming the global regulators for hedge funds just

as Delaware is providing the corporation law for most of the US. The arrangement has the

advantage of specialised regulators. In spite of centralisation, regulatory competition continues to

discipline leading regulators and restrains regulatory slack.

The available empirical evidence supports the view that vigorous competition does not harm

hedge fund investors: Liang and Park compare the performance of hedge funds domiciled in the

US with those domiciled offshore (but reporting their returns in US dollars). They find

significantly higher risk-adjusted returns for   onshore funds. However, they show that this result

is due to the greater percentage of onshore funds with lock-up provisions, which, in turn, is

attributable to differences in tax treatment and regulation. If only funds with lock-up provisions

are taken into account, offshore-domiciled hedge funds appear superior to their onshore peers.

Government regulation can complement private contracting through enhanced monitoring and

enforcement on behalf of investors.Regulation, in this regard, is ‘enabling law’: it extends the

amount of cooperation that private parties can attain on their own. The enabling role of

regulation remains largely intact even under regulatory competition. What regulatory

competition does hamper is the ability of government regulation to correct market (contracting)

failures, particularly due to asymmetric information or externalities. Systemic risk is an

externality. It falls essentially on all market participants, who can neither control it nor charge a

differential risk premium for bearing it. As an externality, private parties will not take systemic

risk into account in writing their contracts. By the same token, investors and prime brokers have

no reason to consider systemic risk in their due diligence. Under competitive pressure to increase

returns, managers will seek to reduce regulatory costs and to avoid restrictions on their

behaviour. The leading hedge fund jurisdictions will be eager to provide just that. Under

conditions of regulatory competition, the national interest of ‘captured’ states diverges markedly

from the global common good.

5.2 Regulatory harmonisation

Regulatory arbitrage may well result in a few jurisdictions acting as global regulators of the

hedge fund industry. If most hedge funds demand the same type of regulation, competitive forces

will drive the leading jurisdictions to adopt similar regulatory approaches. By contrast,

regulatory harmonisation is a conscious and coordinated attempt to assimilate regulation across

jurisdictions. It can enable jurisdictions  collectively to attain regulatory outcomes that would not

be sustainable under regulatory competition.

 Incentives to harmonise

Why would national regulators and legislators wish to harmonise their regulatory approaches?

The majority of states have lost the competition for hedge fund regulation. Participating in a

quest for harmonisation presents an opportunity for these jurisdictions to reclaim some indirect

authority over hedge funds. One can think of more or less benign motives for seeking such

influence. Systemic risk is a transnational externality. Jurisdictions may have a genuine interest

in protecting their economy against the potential fallout from a systemic event. Regulatory

harmonisation would be the appropriate response to the systemic risk externality and its

transnational character. An alternative and less favourable view is that self-interested regulators

strive to preserve their power because they derive private benefits from it, such as commanding

more resources or prestige. For the losers of regulatory competition, harmonisation may be a

strategy to avoid falling into obsolescence. Regulators may be able to enlist political support in

their countries by exaggerating the risk that harmonised regulation is (allegedly) meant to

control. A public choice analysis thus explains why ‘non-captured’ states might pursue

harmonisation even if there were no significant systemic risk externality.66

On the surface, ‘captured’ states should take little or no interest in harmonising regulation.

Harmonisation is meant to reduce differences in regulation, thus diminishing arbitrage

opportunities. It seems that successful regulators should be loath to confine the very foundation

of their success, the ability to compete.67 Yet the incentive structure of leading hedge fund

jurisdictions is in fact more complex. ‘Half captured’ and even ‘fully captured’ states are not 66 V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 367 V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 3

indifferent to systemic risk. As their economy is tilted towards the financial industry, systemic

events affect them more strongly than other countries. ‘Captured’ states thus share the

transnational public interest in controlling systemic risk. While this concern shows only a little or

not at all in competitive behaviour, it may influence their stance on harmonising hedge fund

regulation: harmonisation amounts to a state cartel against regulatory   competition. Market

leaders may be no less inclined to restrain competition in order to obtain or increase market

power. In the context of regulation, market power confers the ability, among other things, to

impose regulation that firms or the industry would like to avoid, including attempts at regulating

externalities.68 In this regard, there is a chance that ‘captured’ states wrench themselves from the

industry's clutch. Harmonisation provides an opportunity for states to pursue the transnational

common good rather than their narrower national interest.

 The mechanics of harmonisation

Harmonising regulation across sovereign states requires universal agreement. Similar to the

industry's difficulties in enforcing self-regulation, however, states have to overcome a collective

action problem to arrive at common standards. Under regulatory competition, individual

jurisdictions will be tempted to refrain from harmonisation and to exploit other states' self-

imposed constraints. This incentive becomes even stronger as more states join the harmonisation

effort. Regulatory harmonisation therefore cannot build on voluntary consent alone. At the same

time, the ability to engage in regulatory competition depends on the possibility and costs of

regulatory arbitrage. Other states can try to restrict regulatory arbitrage by claiming jurisdiction

over the activity or over particular actors, such as investors in hedge funds. While the leverage of

individual states remains rather limited for all but the largest of them, the balance of power is

tipped when a considerable number of jurisdictions agree to coordinate their regulatory

approach. Besides harmonising rules, a coalition of states can cut off hedge funds from a sizable

share of investors. A state cartel not only restrains the competitive behaviour of its members but

also has more leverage to suppress regulatory arbitrage. 69The prevalent method is to require

adherence to harmonised standards in the form of either domestic or ‘equivalent’ foreign

regulation as a condition for doing in-state business, e.g., for marketing hedge fund shares to

68 Cf. F. Partnoy, ‘Financial Derivatives and the Costs of Regulatory Arbitrage’, 22 Journal of Corporation Law (1997) p. 211, at p. 2269 M.G. Warren, ‘Global Harmonization of Securities Laws: The Achievements of the European Communities’, 31Harvard International Law Journal (1990) p. 185, at pp. 189-190.

investors. If the cartel commands a sufficiently large part of the relevant markets, it can

effectively coerce other states to adopt the harmonised rules.

  Overall, the process of regulatory harmonisation combines consent and coercion.

Harmonisation cannot be accomplished without voluntary agreement among states that, together,

control a sufficiently large amount of critical resources, particularly investors and sophisticated

prime brokers. When such a coalition is forming, other states may want to influence the

emerging standard. Although they would favour different regulation or no regulation at all, they

will be ready to compromise to participate in the harmonised market. Of course, states differ

greatly not just in their incentives towards harmonisation but also in the bargaining power they

bring to the table. The process is not a democratic one. It ensures, however, a certain degree of

deliberation and sensitivity to information: cartelisation only begins when enough states perceive

a need for harmonised regulation. ‘Captured’ states are prone to play a prominent role because

excluding them from a harmonised regime would be particularly conflict-laden. This implies that

industry interests and the expertise of leading regulators receive attention.

 Harmonising hedge fund regulation

Hedge fund regulation may become a prime example of how a state of nonharmonisation can

quickly turn into a harmonisation equilibrium. Financial regulators have formed international

organisations, which, among other things, serve as institutional fora where coalitions are

forged. Accordingly, one can observe the emergence of harmonisation by looking at the

pronouncements of these organisations on common regulatory ‘standards’ or ‘principles’. Hedge

fund activity mostly concerns bank regulators and securities regulators. The former are organised

in the Basel Committee on Banking Supervision under the auspices of the Bank for International

Settlements, the latter in the International Organization of Securities Commissions (IOSCO).

Following the LTCM crisis of 1998, hedge fund regulation   appeared on the agenda of these

organisations as well as of the Financial Stability Forum, which, in addition to bank and

securities regulators, includes the countries' finance ministries.70 In spite of the LTCM shock, US

regulators quickly concluded that enhanced market discipline - bolstered by prime broker

oversight and elements of self-regulation - was sufficient to control systemic risk. At the time,

the hedge fund industry was even more concentrated in the US than it is today. International

organisations largely followed the US lead in rejecting direct regulation of hedge funds. Yet

70 A.S. Fraser, ‘The SEC's Ineffective Move toward Greater Regulation of Offshore Hedge Funds: The Failure of the Hedge Fund Registration Requirement’, 92 Cornell Law Review (2007) p. 795, at pp. 807-811;

remarkably, already in 1999, IOSCO recommended that regulators ‘encourage direct disclosure’

by hedge funds.This suggestion appears more assertive than the PWG's position in the US.

After the heightened attention in 1999 and 2000, interest in systemic risk from hedge funds

subsided at the international stage. Only around 2005 did the topic begin to regain international

prominence, mostly because of the massive growth in hedge fund assets. The renewed interest

did not lead to a change of direction. The US and the UK as the dominant hedge fund

jurisdictions continued to favour self-regulation  and market discipline, bolstered by prime

broker oversight. It took the global financial crisis to reverse this position. When the crisis hit,

governments reacted through the Group of Twenty (G-20) - 19 major countries and the EU

comprising 90% of the world's gross national product. From their first summit in November

2008 in response to the crisis, the G-20 vowed to invigorate financial market regulation. One key

tenet of this new resolve is to ‘ensure that all financial markets, products and participants are

regulated or subject to oversight, as appropriate to their circumstances’. The main implication is

that ‘systemically important’ hedge funds or their managers should become subject to direct

regulation. Securities regulators in the IOSCO were quick to carry out the political will of the G-

20 leaders. Shortly after the November 2008 summit, IOSCO established three task forces, one

of which devoted primarily to hedge funds.71 It released its final report ‘Hedge Funds Oversight’

already in June 2009 promulgating six ‘high-level principles’ on hedge fund regulation. The first

of these principles marks the breakthrough in the harmonisation process: ‘Hedge funds and/or

hedge fund managers/advisers should be subject to mandatory registration.’

The new approach is presently working its way through the legislative process in the major

jurisdictions. In July 2010, US President Obama signed into law the Dodd-Frank Act, a broad-

ranging financial market reform. Among many other measures, the Dodd-Frank Act requires

‘private fund’ managers (‘advisers’) to register with the SEC and to provide systemic risk-related

information. It does not, however, impose restrictions on leverage. As one would expect based

on the above analysis, Congress proved wary of regulatory arbitrage and, accordingly, imposed

domestic regulation not only on advisers located in the US but also on advisers with more than 

investors in the US or more than 25 million US dollars of assets either in private funds

established in the US or stemming from US private fund investors. At variance with other pieces

71 G.J. Stigler, ‘The Theory of Economic Regulation’, 2 Bell Journal of Economics and Management Science (1971)

p. 3, at pp. 13-14.

of the US financial market reform package, hedge fund manager registration appeared to be

uncontroversial in the legislative process.

In Europe, legislation seems to be on the home stretch at EU level. The European Parliament had

demanded strict regulation of hedge funds and private equity funds already starting in

2007. Resistance by the European Commission crumbled only under pressure created by the

financial crisis. The Commission presented its proposal for an Alternative Investment Fund

Managers Directive (AIFM Directive) in April 2009. Like the Dodd-Frank Act, the EU

legislation will cover managers not just of hedge funds but also of any other investment vehicles

except the investment funds already regulated under the UCITS Directive. The EU draft contains

disclosure and reporting duties towards investors and regulators. In addition, and going beyond

the US proposals, it also imposes requirements on hedge fund operations, inter alia,to establish

risk and liquidity management systems and to retain independent valuation providers and

depositaries. The proposed AIFM Directive authorises regulators to collect information on

systemic risk and share it with other national and European authorities; it even empowers them

to impose specific limits on hedge fund leverage.

While legislation is still in progress, the making of the AIFM Directive illustrates the competing

interests involved in regulatory harmonisation. In line with the EU's central goal of creating a

single financial market, the draft contains the familiar ‘passport’ mechanism to allow managers

authorised in one Member State to do business in another. This pattern of coordination in the EU

conforms to the logic of  harmonisation: opening one's national market by recognising foreign

regulation may be the reward offered to other states for participating in harmonisation (which, in

the EU, can be forced on individual Member States through majority decision-making). Hedge

fund managers are primarily interested in gaining access to the investor base in other

jurisdictions. In this regard, the current proposals of the Council and the European Parliament

differ significantly. Both legislative bodies agree that alternative investment funds should be

admitted for marketing to professional investors throughout the EU if the manager is authorised

under the Directive and if the fund is established in a Member State. As to funds established in a

third country, the Council would leave it to individual Member States to admit them for

marketing in their territories. Refusing to issue a European passport to third-country funds (even

those operated by European managers) deviates markedly from both the Parliament's and the

original Commission proposal. Equally against the Commission's and the Parliament's view, the

Council refuses to offer a European passport to non-European managers.

The ability to pass binding laws enables the EU to accomplish harmonisation among its Member

States, but also to wield considerable power in relation to other jurisdictions. The biggest prize

the EU has to offer in the international harmonisation game is unrestricted access to its large

investor base. Offering an EU passport to foreign managers and hedge funds, as intended by the

Commission and the European Parliament, would maximise European clout. At first blush, one

would expect the UK to strongly favour this approach in order to curb regulatory arbitrage.

Surprisingly, however, the UK is opposing detailed requirements for admitting non-European

managers to Member State markets and was even voted down on the issue - a rare event in the

Council. The reason seems to be a concern that, instead  of spreading its own standards, the EU

will risk a trade conflict with the US. There is no doubt that retaliatory exclusion by the US

would seriously hurt the Londonbased hedge fund industry. While other EU Member States will

also want to avoid such a conflict, the UK is most loath to incur such a risk. 209 This is an

implication of the UK being ‘captured’ by its hedge fund industry. As ‘captured’ states tend to

overrate industry interests, the majority in the EU has better incentives to secure a sufficient

amount of regulatory precautions on behalf of systemic stability. Meanwhile, ‘non-captured’

states may be prone to populist overreaching.

 Evaluating harmonisation

As the dispute over the AIFM Directive lingers on, it is not yet certain that governments will be

able to harmonise hedge fund regulation on a global scale. Bargaining over common standards

could well collapse and give way to underregulation or divergent regulation with mutual

exclusion and market fragmentation. If harmonisation is accomplished, reasonable minds can

disagree on whether governments have applied the right kind and dosage of regulation. This

article is concerned not with particular outcomes but more generally with the modes of

transnational regulation. The question to ask is if harmonisation is likely to produce government

regulation that deals efficiently with systemic risk and withstands regulatory arbitrage without

inhibiting cross-border investment.

The harmonisation process differs conspicuously from regulation within a single state. Decisions

are made through multilateral bargaining and coalition building among states. For national

constituencies it can be difficult to observe what position their representatives take and how well

they negotiate at the international stage. Democratic accountability is hence attenuated.

However, this does not imply that harmonisation is less responsive to relevant concerns than a

regulator or the legislature would be within a single democratic state. Specifically, there is no

compelling reason to assume a bias for laxity. While regulatory competition

favours  deregulation, harmonisation is a way for national governments to reassert their

regulatory powers. As noted above, even jurisdictions that are fully or partly ‘captured’ have

some interest in harmonising regulation to control systemic risk (or, more broadly, market

failure). Also, they alone typically cannot block harmonisation if it is driven by a coalition of

powerful states. What they can do is to contribute their expertise in dealing with hedge funds as

well as, being the target of particularly strong lobbying efforts, to give the industry a voice in

international negotiations. ‘Captured’ states tend to make regulatory harmonisation more

informed, without dominating the outcome. From a public choice perspective, concentrating

interest group activity on a few ‘captured’ jurisdictions might even help to mitigate their

influence, leaving the remaining states relatively unaffected.

One objection to this sanguine assessment is the special role of the US. In fact, it is hard to

imagine regulatory harmonisation without US leadership, although there are important

counterexamples. The US is particularly powerful in the harmonisation process because of its

outsized financial markets and national economy. Those very same reasons, however, raise the

US' exposure to systemic risk and tend to align its national interest with that of the broader world

community. It is true that, for quite some time, US resistance has been a principal impediment to

direct hedge fund regulation. The push towards harmonisation occurred only in the wake of the

financial crisis. Yet the same pattern obtains within nation states. More often than not, regulatory

advances occur when a crisis serves as a catalyst. The resolve to regulate hedge funds is a

remarkable example in that hedge funds clearly did not cause the global financial crisis.  The

crisis did create a painful awareness of   systemic risk, in the US and worldwide, which led

governments to reassess financial regulation generally and the need to regulate hedge funds in

particular. Perhaps financial stability should have been higher on the agenda even before the

crisis struck. The point is not that international politics is perfectly rational in the sense of fully

considering the available evidence at all times. Rather, it is that regulatory harmonisation need

not be inferior to national regulation, which might as well respond to accidental stimuli.

Signs of a new approach?

Recently, there have been some signs that the regulatory interest in hedge funds is changing.

This rising interest relates largely to the question of hedge funds being offered to retail investors.

One sign of the increasing international regulatory interest in hedge funds is the amendments

to   the UCITS Directive, which were adopted by the European Union a year ago. It was agreed

that the Commission will forward a report to the European Parliament and the Council on the

application of the amended Directive, no later than February 13, 2005. In this report the

Commission will review the scope of the Directive in terms of how it applies to different types of

products, including hedge funds. In particular this study should focus on the size of the market

for such funds, the regulation of these funds in the Member States and the need for further

harmonisation of these funds.Thus, in a couple of years, we may be facing an effort towards the

harmonisation of hedge funds at European level.

At its meeting in April 2002 in Oviedo, Spain, the Council of Finance Ministers of the European

Union (ECOFIN) discussed the possible actions to be taken in Europe following the Enron affair.

The ECOFIN decided to invite the Committee of European Securities Regulators (CESR) to

report on supervisory issues (related to the increased complexity of derivatives and derivative

trading) and on the implications for the regulation of European financial markets. Particular

emphasis was placed on financial engineering techniques and hedge funds.

The Financial Stability Forum, in its latest assessment report on HLIs, noted the marketing of

hedge funds to retail investors as one of the fresh concerns in this field. According to the report

this is a new aspect that raises, from an investor protection perspective, questions about the

extent to which retail customers understand these products and the risks involved. The report

recommends that the IOSCO be encouraged to study the investor protection concerns that may

arise in connection with hedge fund products and retail investors.

The US Securities and Exchange Commission has also recently announced that it will determine

whether the present lack of hedge fund regulation is in the public interest. According to the SEC,

the factors that have to be taken into account here are the booming growth of these investments,

incidents of fraud and the fact that hedge funds are marketed directly or indirectly to retail

investors.

In the United Kingdom, the Financial Services Authority (FSA) has recently published a

discussion paper on hedge funds. The FSA is currently seeking views from industry and

consumer groups on whether hedge funds are suitable products to be marketed to the retail

sector, and, if so, what strategies should be adopted to provide retail consumers with appropriate

information regarding the risk profile of such hedge funds.

Difficulties Regarding hedge funds Investments for Retail Investors: Hedge funds Versus

Mutual Funds

This section will analyse the difficulties relating to hedge funds  from the retail investor's

perspective, comparing the characteristics of  hedge funds to the traditional regulated

mutual  funds such as the European UCITS, which have generally been seen as a good form of

investment for retail investors.

The UCITS is a widely used, harmonised form of investment funds in Europe. The  funds that

follow the minimum harmonisation requirements of the UCITS Directive can be freely marketed

on a cross-border basis to countries of the European Economic Area in accordance with the

single passport principle. After the recently adopted amendments to the Directive have been

transposed to the national legislation of each Member State, the passport will, in addition to the

traditional securities funds, also cover new types of funds such as cash funds, fund of funds,

index funds and derivatives funds. Hedge funds are, however, not even covered by the amended

Directive.

The first basic difference between regulated mutual funds and hedge funds is their investment

strategies. Whereas UCITS have very strict risk-spreading requirements and can only invest in

assets defined by the Directive, hedge funds do not have formal diversification rules nor do they

have limitations on their range of investment assets. Hedge funds can also use high risk

investment strategies such as short selling and leverage, whereas UCITS can either not use these

strategies at all or only to a very limited extent.

UCITS are liquid instruments; investors can usually make a redemption request on any banking

day. Hedge funds, on the other hand, are not open for daily subscriptions and redemptions, but

usually only monthly or quarterly. In addition to this, investors in hedge funds must give the fund

manager advance notice of the redemption request, such notice often being as long as 30 to 40

days before its execution.72

UCITS invest their assets mainly in listed securities and financial derivative instruments. The

valuation of UCITS is, therefore, relatively simple and reliable because it is based on the market 72 International Financial Services London, Economic Contribution of UK Financial Services 2009 (2009), available at: <http://www.ifsl.org.uk>, Chart

prices in the regulated stock exchanges and derivatives markets. The valuation of hedge funds is

much more difficult because they may invest in assets that are not available to UCITS, such as

unlisted securities and commodities. This is why hedge funds normally provide information on

their net asset value only on a monthly basis. Even though many offshore hedge funds are listed

on a recognised stock exchange, they are rarely actually traded there, which means that the

listing cannot usually be used for pricing of units of the hedge funds.

Hedge funds are not directly regulated like mutual funds . The regulatory control over them is

mostly indirect, meaning that the fundmanager is usually located onshore and is subject to

regulation. Also the funds custodian or prime broker and its counter-parties are, mostly,

regulated bodies.

Hedge funds appear to be more vulnerable to fraud than mutual funds . The main reason for this

is their unregulated nature and the opacity of the whole  hedge funds  industry. In this context,

the US Securities and Exchange Commission has recently issued a warning that it has had to deal

with far too many fraud cases in circumstances where the losses to investors have been

substantial.

There have been cases, for instance, where the fund has turned out to be completely fictional,

having never existed in the first place and where the fund manager has used the money invested

for his own personal use. Fund managers have been covering the losses of their investment

strategy in the hope that they can still turn things around if the market moves in a favourable

direction. In order to keep new money coming into the fund they have falsified accounts. Lack of

oversight by an auditor has also been a key issue in some cases.

The minimum level of transparency of the mutual funds' assets is regulated. UCITS must give

detailed information about their assets and liabilities, at least, in their annual and half-yearly

reports. The amended Directive also requires that, in the future, all UCITS offer subscribers a

simplified prospectus, which must include a short definition of the funds’ objective and

investment policy, brief assessment of its risk profile and profile of the typical investor for whom

the  fund is designed.

Hedge Funds  have traditionally lacked this transparency. Their managers are typically unwilling

to give investors much information on the contents of the  Funds’ portfolio because they are

afraid that their competitors would use that information for their own benefit.

In conclusion, hedge funds are totally different instruments from mutual fund , especially from

the retail investor's point of view. Those investors who are used to investing in mutual

funds may, therefore, face big surprises when they invest in hedge funds.

Regulators' Dilemma: Should Marketing of  Hedge funds to the Public be Allowed?

Target group of hedge funds is changing

Hedge Funds investors have traditionally been high-net-worth individuals and institutional

investors. While public marketing of hedge funds is still not possible in most countries, hedge

funds can be offered in many countries, under some exemptions to the general marketing rules,

to limited groups of qualified investors who are considered to be sufficiently sophisticated,

usually based on their wealth.

The minimum subscription to a hedge funds investment has usually been too high for retail

investors--it has been around US$500,000 to US$10 million. However, the latest development

seems to be that hedge funds are lowering their minimum investment requirements to attract

greater numbers of investors. Minimum levels have dropped to as low as US$50,000.19 For

European  hedge- fund based structured products, such as certificates and notes, the minimum

amounts are even lower, often no more than ##5,000-10,000. The Monetary Authority of

Singapore (MAS) has reduced the minimum investment to $10,000 for funds of hedge funds.21

Regulators' choice: to prohibit marketing or to develop the product?

Many countries are currently considering whether to allow hedge funds to be marketed to the

public. The basic question is, should authorities hinder the public from investing in some

investment forms by prohibiting the marketing of those products? Alternatively, if marketing to

the public is allowed, what conditions should be imposed?

There are pros and cons in the matter. In addition to the difficulties listed above, if hedge funds

were to become a mainstream investment form, many fund managers would face the problem of

whether they were still able to invest all of their capital according to their investment

strategies.  Nonetheless, there is another side to the coin. Hedge fund managers promise that they

can help investors to diversify their portfolios, because hedge funds have a relatively low

correlation to mutual funds and market indices. They say that they can, therefore, offer investors

more diversification and downside risk protection than mutual funds, in addition to providing

absolute returns, even under difficult market conditions. While these promises must not be taken

for granted, it should be noted that many of these funds have done very well in recent years.

At the same time, there have been UCITS which have been very actively marketed to retail

investors and which, after the bursting of the dot.com bubble, have lost up to 80-90 per cent of

their capital. This loss has occurred despite them operating strictly under the diversification

requirements of the UCITS Directive. It is, perhaps, beyond the capacity of regulations to

prevent these kinds of crashes in mutual funds when the whole market goes down.

In the end, one can only ask, is it really up to regulators to say what investments are good enough

to be marketed to the public? Is it not more important to take care of transparency, to ensure that

investors have the opportunity of getting hold of enough valid information on the investment

targets so as to make up their own minds on where to invest? Of course, it is also the task of the

authorities to prevent service providers that are not fit and proper from carrying on these kinds of

activities and to minimise chances of fraud. Nonetheless, fraud cannot be totally prevented,

however careful the supervision.73

In today's world of internet and electronic banking, people can easily access information on

different investment opportunities and invest wherever they want, irrespective of their physical

location. This diminishes the meaningfulness of marketing prohibitions. Instead of prohibitions,

therefore, one possible solution for the regulators would be to contribute to hedge funds being

transferred to regulated onshore funds. Furthermore, if it is likely that, in the future, retail

investors will also want to invest in hedge funds and will seek ways to do that, is it not better to

allow the setting up of regulated and supervised funds that meet the demand?

The following section will briefly describe one way of creating regulated hedge fund-type

mutual funds, namely the Finnish system on special mutual funds. This is an example of one way

to deal with the traditional problems regarding hedge funds, such as lack of supervision and

transparency.74

Marketing of Hedge Funds to the Public: the Finnish Case

Background to the regulation of special mutual funds

Mutual funds are a fairly new form of securities investment in Finland. The first ones were

created in 1987 when the Mutual Funds Act came into force. When Finland joined the European

Economic Area in 1994 the legislation was amended to implement the UCITS Directive.

73 J.R. Oppold, ‘The Changing Landscape of Hedge Fund Regulation: Current Concerns and a Principle-Based Approach’, 10 University of Pennsylvania Journal of Business & Employment Law (2008) p. 833, at p. 87474 A.C. Pritchard, London As Delaware? (Michigan Law School John M. Olin Law and Economics Working Paper No. 09-008, 2009), at pp. 29-30, available at: <http://ssrn.com/abstract=1407610>.

The securities markets developed rapidly in the 1990s and market participants started asking for

more developed forms of mutual funds which were not covered by the UCITS Directive.

Because there was no agreement reached inside the European Union on how to develop the

Directive in order to cover these new products, there was a need to have a new class of mutual

funds. Since August 1, 1996 it has been possible to establish special mutual funds.

This development of special mutual funds in Finland as well as their equivalent in many other

countries in Europe means that these funds increasingly have the potential to carry on the same

investment strategies as hedge funds. The Nordic countries, especially Sweden and Finland, have

experienced this kind of development; the Swedish nationella fonder and the Finnish special

mutual funds have many of the qualities of hedge funds. Other examples of national funds in

Europe are the Austrian and German Spezialfonds, the Danishinnovationsforeninger and the

Italian fondi speculativi.

The scope of investment activities

The new Mutual Funds Act (“the Act”), which came into force on February 1, 1999, was

designed to give management companies more freedom in developing new products. Currently,

special mutual funds' investments are not subject to detailed regulation. The Act sets the

following criteria for them:

• investments must be mainly in securities and derivative instruments;

• the management company of a special mutual fund is responsible for ensuring that the fund's

investment portfolio is diversified in terms of risks;

• the fund's rules are to be approved by the competent authorities unless available information

indicates that the rules would be likely to jeopardise the stability or functionality of the financial

markets.

Rules of special mutual funds and amendments thereto are approved by the Ministry of Finance

(the MoF), which first obtains an opinion fromRahoitustarkastus (the Financial Supervision

Authority), Finland's supervisory authority for banking and capital market activities. In rendering

an opinion on an application, the competent authorities provide interpretation to the above-

mentioned general requirements of the Act. Via administrative decisions, a regime is being

developed regarding the scope of activities of special mutual funds and the provisions that apply

to them.

The Act does not permit the restriction of purchases of domestic funds to limited groups of

investors. All Finnish funds are open to all investors, the only restriction being the fund's own

minimum subscription. Subscription cannot be limited, for example, to sophisticated investors as

in many countries.

The Act also includes provisions on the marketing in Finland of foreign collective investment

schemes that do not meet the criteria of the UCITS Directive. A foreign non-UCITS can market

its units in Finland to the public only with the permission of the MoF.

Such permission requires that unit-holders be afforded protection sufficiently similar to that

prescribed in the Act for investors in Finnish funds. Permission is granted if the structure of the

collective investment activity, the investment principles and the fund's home country legislation

and supervision meet standards set out in the Act.

Control mechanisms

The management companies are under the same kind of supervision irrespective of whether they

manage UCITS or special mutual funds. When seeking a licence they are required to prove that

the company's shareholders and persons responsible for its management are fit and proper, that

the company has sufficient finances, and that it is likely that the company will be managed in a

reliable and professional manner as well as in accordance with sound business principles.

The MoF grants an authorisation to a management company on the basis of a written opinion

from the Financial Supervision Authority, which is also responsible for supervision of the

management companies and both UCITS and the special mutual funds managed by them. The

continuous supervision of the Financial Supervision Authority includes, for example, review of

monthly reports on the funds' portfolios and on-site inspections of the management companies.

In addition to the Financial Supervision Authority's supervision there are several other control

mechanisms in place to ensure that the special mutual funds are managed properly and according

to the law and the fund rules. The unit-holders of the funds managed by a management company

elect at least one third of the members of the board of directors of the company.

A management company must have at least two certified auditors. One is elected by the

shareholders of the company and the other by the unit-holders. At least one auditor must, at

intervals of two months, check the calculation of the value of the fund. This is an essential

mechanism to ensure correct valuation.

The assets of the fund must be entrusted for safekeeping to a depositary. This must be a legally

separate entity from the management company, a licensed credit institution or an investment

firm. It has the same supervisory duties as required by the UCITS Directive of the harmonised

funds' depositary to ensure, for instance, that legislation and the fund rules are complied with in

the valuation, issue and redemption of the fund's units.

More extensive transparency requirements for special mutual funds

As a counterbalance to the special mutual funds' freedoms in investment policy, the Act requires

a simplified prospectus, besides an ordinary full prospectus, that briefly describes the fund's risk

profile and other key information in layman's language. The management company must also

publish quarterly reports of the fund, in addition to the annual and half-yearly reports required by

UCITS. In these reports, detailed information on the assets and liabilities of the fund must be

disclosed.

This information must include an account of the fund's securities and derivatives investments and

the distribution of these investments by sector, market location or other appropriate criteria that

illustrate the application of the fund's investment principles as a percentage of the fund's

investments. The report must include an account of the changes that have taken place in the

profile of the investments during the survey period, and information relating to how extensively

the fund has made use of various derivative instruments, borrowing, lending and repurchase

agreements in its operations.

Special mutual funds are also affected by other rules which are aimed at ensuring that investors

are aware of the special nature of such funds. For instance, the name of the fund must make clear

that the fund is a special mutual fund. The fund's rules and marketing material must clearly state

the reasons why the fund is a special mutual fund.75

In approving a special mutual fund's rules, the MoF may set restrictions and conditions on the

fund's activities. Special conditions may be placed on highrisk funds that engage, for instance, in

short sales and securities borrowing. The prospectuses of such funds must clearly note the fund's

higher risk profile when compared to normal mutual funds.76

75 I. Ayres and S. Choi, ‘Internalizing Outsider Trading’, 101 Michigan Law Review (2002) p. 313, at pp. 328-336.

76 G8 Summit Heiligendamm, Growth and Responsibility in the World Economy (2007), at p. 3, available at:

<http://www.g-8.de/Webs/G8/EN/G8Summit/SummitDocuments/summit-documents. html> (‘we reaffirm the need

to be vigilant’).

Current situation and future prospects

Product development in the area of special mutual funds has been very rapid. The funds have

increasingly taken on the characteristics of hedge funds. These funds--as compared to UCITS--

are marked by less risk diversification, active use of negative/positive derivative leverage, OTC

derivative instruments, short sales and borrowing of securities, and longer intervals between

subscriptions and redemptions. The use of performance fees has become common practice.

Unsurprisingly, the managers of these funds have also labelled them as hedge funds in their

marketing.

Legislation on special mutual funds has worked well. There have not been any significant

regulatory problems with these funds until now. The problem with the ever-accelerating product

development towards hedge funds is that a large majority of Finnish investors are still in the

phase of learning to  grasp the basic features of mutual funds in general. It is clear that a majority

of investors now would have problems in understanding the features of the new hedge fund-type

of funds with their complex strategies.

CONCLUSION

Transnational regulation is different. What distinguishes it from regulation in a purely national

setting is, primarily, the mismatch between the single regulator's authority and the scope of the

market failure. The causes and effects of systemic events cut across the territorial boundaries of

jurisdictions. As national regulation corresponds less and less well to the regulated risks and

activities, it turns into patchwork. Therefore, transnational regulation takes a natural interest in

the full array of private substitutes and complements to government oversight. This broader

perspective aligns itself with certain elements in the theory and practice of regulation within the

nation state, ranging from self-regulatory organisations, notions of responsive or principles-based

regulation, to the high-flying ‘new governance’ theme. Yet as regards the specific aim of

controlling systemic risk from hedge funds, the analysis has led to the somewhat sobering

conclusion that industry self-regulation depends critically on support from the government. A

need for more robust backing emerges at two different levels: without the threat of cumbersome

government intervention, the hedge fund industry as a whole lacks incentives to establish a

stringent self-regulatory regime. Even where the industry creates its own standards, it likely fails

to enforce them sufficiently if it relies only on reputational sanctions, that is, without resort to

government powers.

Governments thus remain indispensable for regulating hedge funds (if such regulation is

considered desirable). Therefore, the specific constraints of multiple government regulators in

dealing with transnational hedge fund activities gain importance. Analogously to the limits of

self-regulation, regulatory competition among national jurisdictions cannot be trusted to provide

for adequate regulation; it implies a slant towards laissez-faire even where stricter systemic risk

regulation is called for. As argued above, governments have to coordinate their policies to

reassert their power to regulate.

A question not considered so far is how harmonised government regulation plays out for self-

regulation. There are benefits to letting the industry write the rules and to giving individual firms

responsibility for accomplishing regulatory objectives, even   if securing these benefits requires a

‘benign big gun’ regulator as a backup. It is less clear, however, if multiple governments - some

of them actively competing for hedge fund business - can be as effective in policing and

sustaining self-regulation. As regulatory harmonisation cannot produce very detailed standards, it

inevitably leaves a lot of discretion to individual governments. National regulators can still

differentiate themselves and compete through their expertise and flexibility in handling the

rules. Accordingly, regulatory harmonisation will tend to concede room for self-regulation to

flourish under the oversight of national regulators.

Yet there remains an inherent tension between regulatory competition and entrusting individual

jurisdictions with monitoring self-regulation. The great advantage of responsive or principles-

based regulation lies in the regulators' ability to condition the use of their ‘benign big gun’ on

non-verifiable information, such as the perceived trustworthiness of regulated firms and insights

from an ongoing dialogue with the industry. It follows that how regulators employ their ‘big gun’

must be equally non-verifiable and discretionary. Predictably, ‘captured’ states will be tempted

to use their discretion to compete for hedge fund business, succumbing to excessively lax self-

regulatory standards and practices by individual firms. To prevent principles-based regulation

from deteriorating into underregulation, government regulators can try to cultivate a relational

network among themselves. Unless they succeed in enforcing informal standards, regulatory

harmonisation might have to forgo some of the benefits of self-regulation in order to be effective.