Financial Regulation and the Hedge Fund Industry Part 2


The Hedge Fund industry is often perceived as unregulated. It is actually not the case. In fact, since the onset of the financial crisis, major regulatory measures in the US and Europe have completely modified the industry landscape. AIFMD (Europe) and Dodd-Frank (US) have defined the basis for regulation of the Industry and have led to an unprecedented set of rules and costs for what was once a close to non-regulated industry. This has considerably impacted the costs of running a hedge fund. The average costs for implementing the most recent rules has been 700000$ for a small fund manager, 6m$ for medium-sized one and 14m$ for the largest. Hedge funds have spent 4bn$ meeting compliance costs associated with new regulations since 2008, equating to roughly a 10 percent increase in their annual operating costs. This sounds like large amounts but those investments will pay off from a competitive standpoint in the future.

In parallel to those regulatory changes and corresponding costs incurred by the funds, the industry’s investor base has changed dramatically, shifting from high-net-worth individuals to institutions such as pension funds and endowments. The industry’s new investors are more conservative in nature and more inclined to invest with managers with proven track records and compliant regulatory oversight.

In the US, with the new provisions in the Dodd-Frank reforms, the largest overhaul of US financial regulation since the 1940s, hedge funds must register with the Securities and Exchange Commission for the first time. Complying with the SEC, Dodd-Frank and AIFMD directives means that investors will feel more confident investing on those hedge funds that are up-to-speed with the new regulatory frameworks. However, for smaller hedge fund firms, the opportunity of compliance is less easily grasped. Indeed, large managers can better absorb the costs of new regulations but smaller managers may find this task more challenging. It is fair to say that the industry and investors actually need large, medium and small hedge fund managers. Often, the small boutiques are the ones that actually drive innovation. In a way, it is a balance between the “too-big-to fail” players (those with established track records and that can raise funds more easily) and the “too-small-to-succeed” ones (those that struggle to survive but that are often more innovative and cost-effective). Overall, the new regulations have heightened barriers to entry into the Industry.

This trend is actually reflected into the direction taken by money inflows. In fact, the largest hedge fund money managers have captured the biggest chunk of money inflows since the financial crisis of 2007-2008 whereas starting up a hedge fund has never been so difficult (the 2.4 tn$ in global assets of the hedge fund industry is managed by just 389 funds in a universe of more than 7000).

Hedge Funds are now strictly regulated by a range of methods worldwide.

In the US, Dodd Frank Wall Street Reform and the Consumer Protection Act of 2010 change the regulatory structure of the financial services industry. Hedge funds with more than 150 MUSD in assets are now required to register with the SEC. Most Commodity pool operators and commodity trading advisers must register with CFTC. In this regulatory environment, it is interesting to mention the Jumpstart Our Business Startups (JOBS) Act of 2012, which removes a prior ban on general solicitation and advertising by companies conducting private offerings – including hedge funds, provided the funds are only sold to sophisticated investors with net worth over 2.5MUSD.

Counterparties, such as banks and insurance companies, that are trading over-the-counter (“OTC”) derivatives with hedge funds may be deemed a “swap dealer”, “security-based swap dealer”, “major swap participant” or “major security-based swap participant” and thus would be subject to registration with, and comprehensive derivatives regulation by, the Commodity Futures Trading Commission (CFTC) for “swaps” and by the SEC for “security-based swaps”.

Relevant Posts: 

Financial Regulation and the Hedge Fund Industry – Part 1