Most hedge funds, even those domiciled offshore, operate in developed financial markets and utilize the infrastructure of large financial centers to implement their investment strategies. This section describes in greater detail the regulation of hedge funds in the United States and the United Kingdom. The frameworks in these two countries should be seen as examples of rules and surveillance procedures, which are evolving to be sure, but which to date have allowed the operation of hedge funds and other collective investment vehicles while maintaining the integrity of markets.
Hedge funds, like other institutional investors, are potentially subject to three general types of prudential regulations: (1) those intended to protect investors; (2) those designed to ensure the integrity of markets; and (3) those meant to contain systemic risk. In many cases, particular regulations promote multiple objectives.
Investor protection regulations are employed in cases where the authorities perceive that investors lack the sophistication to understand certain kinds of transactions or instruments, or where they lack the information needed to properly evaluate them. Hence, such regulations generally either ensure that sufficient information is properly disclosed or exclude certain types of investors from participating in certain investments. Regulations to protect market integrity seek to ensure that markets are designed so that price discovery is reasonably efficient, that market power is not easily concentrated in ways that allow manipulation, and that pertinent information is available to potential investors. Systemic risk is often the most visible element of the regulation of financial markets because it often requires coordination across markets and across regulatory and geographical boundaries. Regulations to protect market integrity and/or limit systemic risk, which include capital requirements, exposure limits, and margin requirements, seek to ensure that financial markets are sufficiently robust to withstand the failure of even the largest participants.
Regulation of Hedge Funds in the United States
The term hedge fund is not legally defined by financial regulators in the United States. It has typically been a limited partnership that is essentially “defined” by exemptions to certain laws.1 More recently, some hedge funds have been organized as limited liability companies. The term itself is reputed to have entered the financial lexicon in the 1960s when it was used to refer to investment partnerships that used sophisticated arbitrage techniques to invest in equity markets. The adjective “hedge” is due to the fact that at the time a commonly used technique of these vehicles was the simultaneous buying and selling of related securities.
Federal regulation of financial instruments and market participants in the United States is based on a number of acts of Congress (and their subsequent amendments), including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Commodity Exchange Act of 1974. However, by accepting investments only from institutional investors, companies, or high net worth individuals, hedge funds are exempt from most of the investor protection elements of these regulations. This means that hedge funds and their operators, unlike U.S.-regulated mutual funds, are generally not registered and are not required to (and do not) publicly disclose data on their financial performance or transactions (Box 6.1 summarizes the main differences between mutual funds and hedge funds). They are not, however, exempt from reporting requirements applicable to large traders or commodity pools.
Investor Protection Rules
According to the Securities Act of 1933, shares in hedge funds are securities. However, by issuing such securities through a private placement, hedge funds are exempt2 from registering their units of participation. They are therefore not required to make extensive disclosure and commitments in the detailed prospectuses required of registered investment funds. A private placement consists of an offering of securities made to investors on an individual (bilateral) basis rather than through broader advertising. Regulation D offerings are not permitted to offer for sale their securities by any form of general solicitation or advertising—as interpreted by the Securities and Exchange Commission (SEC) to include almost all nonpersonal communication. A private placement can be made to an unlimited number of “accredited investors” but to only 35 or fewer nonaccredited investors.3
Differences Between Mutual Funds and Hedge Funds in the United States
Although mutual funds in the United States are strictly regulated to ensure that they are operated in the interests of their shareholders, hedge funds are private investment pools that are subject to much less regulatory oversight. The key differences between these collective investment vehicles are as follows:
Regulatory requirements. The main objectives of mutual fund regulation under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940 are to ensure that investors are provided with timely and accurate information about management, holdings, fees, and expenses and to protect the integrity of the fund’s assets. To this end, mutual fund holdings and strategies are also regulated. In contrast, hedge funds are typically unregistered private investment pools governed by their partnership agreement that use exemptions under the laws to free themselves of many regulations that apply to registered investment vehicles, including those on the composition of their portfolios and the nature of their investment strategies.
Fees. Federal law requires detailed disclosure and standardized reporting of mutual fund fees and expenses. Also, sales charges and distribution fees are subject to specific limits imposed by the National Association of Securities Dealers. In comparison, there are no rules limiting hedge fund fees, which generally are between 15–20 percent of returns plus about 1–2 percent of net assets.
Leverage. The Investment Company Act restricts the leveraging practices of mutual funds. SEC rules also limit the extent to which they can use derivative products to enhance returns or reduce risks. There are no such restrictions on hedge funds, and the use of leverage is a defining characteristic of many of the funds.
Pricing and liquidity. Although some prices based on fair value as determined by the fund are sometimes allowed, mutual fund shares are generally priced daily to ensure that redemptions and new investments are made at fair values. The law requires that shareholders be allowed to redeem shares on at least a daily basis. No specific rules govern hedge fund pricing, and redemption of shares can also be restricted by the partnership agreement.
Characteristics of investors. Typically, the minimum initial investment in a mutual fund is between $1,000–2,500 and much smaller amounts can be added subsequently. To own shares in an unregulated investment pool, an investor has to make a much higher initial commitment, commonly in excess of $1 million. Since much weaker investor protection rules apply to hedge funds, such measures are designed to restrict share ownership to sophisticated and/or high net worth individuals.
Source: Investment Company Institute.This exemption does not free the fund from all reporting requirements. They must still provide investors with all material information about their securities and will generally do so in an offering memorandum. Moreover, nonaccredited investors would have to be given essentially the same information that would have been provided had the offering been conducted as a registered offering. For that reason, hedge funds generally do not accept investments from nonaccredited investors.
The Securities Exchange Act of 1934 regulates broker-dealers and requires them to become members of a registered national securities exchange or registered national securities association to ensure that they are part of the self-regulatory structure of the brokerage industry.4 Registered broker-dealers must maintain an extensive set of records of their own financial position and customer transactions, maintain segregated accounts in approved custodians, file detailed financial reports with the SEC and their self-regulatory organization, satisfy minimum qualifications, and satisfy a minimum capital adequacy requirement, among other conditions. However, most hedge funds are considered to be traders, and not “dealers,” and are exempt from broker-dealer registration.5 This exemption is available to entities that trade securities solely for their own investment account and not on behalf of other entities and do not carry on a public securities business.6
Although the Securities Act does not limit the number of potential investors in an unregistered hedge fund, until recently the Investment Company Act did. It provided an exception from the definition of an investment company for funds that (1) had no more than 100 beneficial owners and (2) were not making, and did not intend to make, a public offering of their securities.7 For hedge funds, not being deemed an investment company is extremely important, since registered investment companies are required to have a board of directors—at least 60 percent of the members must be independent—and the board must approve the investment advisory contract, custodial arrangements, and other matters of fund operation. Investment company status would also preclude certain types of transactions, including certain affiliated transactions, the use of “leverage,” and other elements of hedge fund strategies. Hence, it is the exception from the definition of an investment company that provides the latitude in setting investment strategies, a freedom that is the hallmark of hedge funds.
In April 1997, the SEC implemented provisions of the National Securities Markets Improvement Act of 1996 that introduced a new exception from the definition of an investment company under the Investment Company Act to funds that (1) sold their securities only to “qualified purchasers” and (2) were not making, and did not intend to make, public offerings of their securities.8 A “qualified purchaser” is defined by the act to include natural persons or family-owned companies with investments of at least $5 million; trusts not formed for the specific purpose of acquiring the securities offered and whose trustees and all settlors and contributors to the trust are qualified purchasers; and any other investor acting for its own account or for other qualified purchasers, with investments of at least $25 million. Hence, by raising the qualification standard, the act has eliminated the quantitative limit on the potential number of participants in a hedge fund.
The Investment Advisers Act of 1940 seeks to protect shareholders in collective investment vehicles by regulating the activities of the adviser. It restricts the ability of registered investment advisers to receive performance-based compensation and imposes certain disclosure requirements. Some hedge fund managers are required to register under this act, while others use an exemption from registration that applies if the adviser does not solicit business from the general public and if in the preceding year the hedge fund had fewer than 15 clients.9 All antifraud rules embodied in the act, of course, always apply.
In the United States, most hedge funds operators and advisers are likely to be subject to regulation under the Commodity Exchange Act, because of their activity as commodity pool operators and/or as large traders in the exchange-traded futures markets. This act and the Commodity Futures Trading Commission (CFTC) regulations have no general exemptions for privately offered funds comparable to those under the securities laws. Also, the definition of a “commodity pool” is quite encompassing and includes any entity that solicits or accepts funds or other property for investment purposes and uses them to take positions in futures contracts and commodity options.10 However, some investment vehicles that are subject to regulation under the Commodity Exchange Act may qualify for exemptions from certain disclosure and reporting requirements, either because of the sophistication of their investors or to avoid duplicate or inconsistent regulation of vehicles set up primarily for trading securities. Also, certain offshore funds that do not market or sell to U.S. participants and that are not operated by U.S. persons need not register with the CFTC.
The registration, disclosure, and reporting requirements for commodity pools and commodity pool operators (CPOs) can be summarized as follows:
Registration. (1) The Commodity Exchange Act precludes persons with a criminal record or civil disciplinary history from being a CPO or its salesperson; (2) applications for registration are processed by the National Futures Association (NFA), a self-regulatory organization, under authority delegated by CFTC; (3) a CPO applicant or associated person (AP) must generally pass an NFA-administered proficiency exam.
Disclosure and reporting. (1) The CPO must file disclosure documents containing specific information with the CFTC and provide prospective participants with copies of the filed disclosure documents before accepting funds for participation in the pool. Such documents include information on risks relevant to the pool; its CPOs’ and CTAs’ historical performance; fees incurred by participants; business background of CPOs, CTAs, and APs; any conflicts of interest on the part of the CPOs, CTAs, and APs; and any legal proceedings against the CPOs, CTAs, and APs; and (2) the pool operator is also required to file with the CFTC and provide participants with periodic account statements and certified annual reports.11 For pools with net assets exceeding $0.5 million at the beginning of the fiscal year, monthly account statements must be distributed; otherwise, these statements must be distributed quarterly.
Maintenance of records. At the head office, CPOs are required to maintain books for inspection by the CFTC and the Department of Justice. Detailed records, in many cases for every transaction conducted for each pool operated by the CPO, transactions of the CPO, and for the personal trading accounts of its principals,12 are required.
In general, exemptions are authorized mainly to avoid unnecessary or duplicative regulation and to allow certain small and limited commodity pools, operated by family members or run as informal clubs, greater relief from the disclosure, reporting and record-keeping requirements. In particular, the rules exempt CPOs with all of the following characteristics from registration: those who receive no compensation other than for administrative expenses; operate only one pool; do not otherwise fall under the registration requirement; are not affiliated with any person who is required to be registered with the CFTC; and do not engage in advertising the commodity pool. An exemption also applies to CPOs who operate pools with 15 or fewer participants each and whose aggregate gross capital contribution is less than $200,000.
While most operators of hedge funds engaged in futures transactions are likely to be registered with the CFTC, relief from certain disclosure, reporting, and record-keeping requirements is granted if a commodity pool’s futures activities are limited in nature or because of the sophisticated nature and the magnitude of financial resources needed to be a participant. Disclosure, reporting, and record-keeping requirements are weaker for pools that (1) fall under the Securities Act of 1933 or an exemption from it; (2) are mainly involved in trading securities; (3) commit less than 10 percent of their assets to taking positions in commodity futures and options; and (4) trade commodity interests solely incidentally to the pool’s securities business. Similar relief is provided to pools that are offered to sophisticated investors, defined legally as qualified eligible participants (or QEPs). CFTC rules classify QEPs generally into three categories: (1) registered commodity and securities professionals; (2) accredited investors as defined in the Securities Act of 1933 with investments in securities and derivatives of $2,000,000; and (3) business entities in which all owners/participants are QEPs.
Most offshore funds, to the extent that they operate in the U.S. futures markets or are managed by CPOs based in the United States, are subject to CFTC registration and other requirements. However, CPOs registered in the United States can obtain relief from certain disclosure and reporting if (1) the pool is organized and operated outside the United States; (2) no participant is a U.S. citizen; (3) no U.S. sources, directly or indirectly, commit capital to the pool; and (4) the pool is not marketed in the United States. It should be noted that offshore funds remain subject to anti-fraud, certain reporting, and large trader reporting requirements.
Regulations to Protect Market Integrity
Although hedge funds can opt out of many of the registration and disclosure requirements of the securities laws, they are subject to all the laws enacted to protect market integrity. The main purpose of such laws is to minimize the potential of market manipulation by increasing transparency and limiting the size of positions that a single participant may establish in a particular market. Many of these regulations also help in containing the spillovers across markets and hence in mitigating systemic risks.
The Treasury monitors “large” participants in the foreign exchange market. Holdings of five major currencies—Canadian dollar, deutsche mark, Japanese yen, Swiss franc, and pound sterling—are reported to the relevant Federal Reserve Banks, which act as the fiscal agents for the Treasury.13 Besides spot transactions, these reports contain information on derivative instruments used to establish positions in the foreign exchange market, including foreign exchange forwards and futures bought and sold, and one half of the notional amount of foreign exchange options bought and sold. The exchange of principal under cross-currency interest rate swaps is also reported, as part of purchases and sales of foreign currencies. Participants covered by this reporting requirement include U.S.-based banking institutions, subsidiaries and branches of foreign banking institutions, domestic corporations and nonprofit institutions, subsidiaries and branches of foreign nonbanking concerns, broker-dealers, mutual funds, and hedge funds. U.S.-based institutions file a consolidated statement for domestic and foreign subsidiaries and branches, while U.S.-based subsidiaries and branches of foreign institutions file individually or on a U.S. consolidated basis, and not for the foreign parent.
Weekly and monthly reports are required of large participants defined as players with more than $50 billion equivalent in foreign exchange contracts at the end of any quarter (that is, end-March, June, September, December) during the previous year, calculated using exchange rates prevailing at the time. Quarterly reports must be filed by participants who had more than $1 billion equivalent of foreign exchange contracts at the end of any quarter in the previous year. Exemptions from monthly and weekly reporting are available to banking institutions that file certain other reports. In addition to these entities, major nonbank players are allowed exemptions to the quarterly submission requirement if they are already filing monthly and weekly reports. The Treasury puts out the aggregate data in its monthly bulletin14 but the disaggregated data by participant are not published or revealed to the public.
For government securities, the Government Securities Act and amendments allow the U.S. Treasury to impose reporting requirements on entities having large positions in to-be-issued or recently issued treasury securities. Such information is deemed necessary for monitoring large positions in treasury securities and making sure that large players are not squeezing other participants and are in accord with the Securities Exchange Act. The reports are filed with the Federal Reserve of New York and provided to the SEC and Treasury on a timely basis.
The Securities Exchange Act also requires the reporting of sizable investments in registered securities.15 It obliges any person who, directly or indirectly, acquires more than 5 percent of the shares of a registered security to notify the SEC within 10 days of such an acquisition. It also makes institutional investment managers exercising investment discretion over accounts containing more than $100 million in exchange-traded and NASDAQ-quoted securities on the last trading day of any month to provide (on a quarterly basis) information on the securities in the portfolio, the names of the issuers, and the number of shares or principal amounts.16
Market integrity is also protected by regulations such as margin requirements on stock purchases imposed by the Federal Reserve Board and the self-regulatory organizations. These requirements insulate registered broker-dealers against losses stemming from customer defaults on borrowing. Clients are generally also required to maintain collateral in excess of the amount borrowed, with excess collateral being determined by the nature of the investment and the associated market risk. At the larger brokerage houses, credit committees manage exposure of the firm by overseeing the extension of credit to customers and counterparties. Transactions exceeding certain preassigned levels need to have special approval. The SEC monitors the risk management policies and discusses the methodologies adopted at the major U.S. securities firms. Futures exchanges and intermediaries are regulated to prevent market manipulation and ensure against disruptions in the face of dramatic price movements. Investors, including hedge funds, must respect position limits imposed by the CFTC, futures exchanges, or self-regulating organizations that restrict the number of contracts that an investor or group of investors can own or control.
In overseeing the futures markets, the CFTC attempts to identify large traders in each market, their positions, interaction of related accounts, and, sometimes, even their trading intentions: (1) CFTC rules require that all futures positions above certain pre-specified thresholds be reported daily. Although the futures position of hedge funds cannot always be distinguished from those of other commodity pools, the CFTC seeks to monitor selected hedge funds as well as the aggregate position of all identified money managers; (2) With respect to large traders, the CFTC also has extensive inspection powers. For reportable futures positions, the rules require complete details of all transactions, positions, inventories and commitments, and names and addresses of all individuals involved. Such records can at any time be inspected by the CFTC and the Department of Justice; (3) To prevent the distortion of futures markets, the CFTC or the exchanges also have rules to limit the speculative positions of market participants in a number of markets. Exemptions to such rules are given only if the participant can satisfy the CFTC or the appropriate exchange that it has risks associated with cash positions that need to be hedged or that the arbitrage being effected is eligible for exemption. In certain markets—for example, the U.S. treasury bond, foreign exchange, and precious metals futures—speculative position limits have been replaced by “position accountability rules.” For large positions, these rules permit the exchange to request information, including cash market information, from the trader.
To reinforce CFTC surveillance, each exchange is required to have its own system for identifying large traders. For example, the Chicago Mercantile Exchange requires position reports for all traders with more than 100 S&P 500 contracts, while CFTC rules require such reporting if the trader has more than 600 contracts. Market disruptions from large price declines are limited by CFTC- and SEC-approved circuit breaker rules that halt trading in securities, options on securities, and stock index futures and options when the Dow Jones Industrial Average falls by prespecified amounts.17 The regulators have the authority to take emergency action if they suspect manipulation, cornering of a market, or any hindrance to the operation of supply and demand forces.
Futures clearing organizations are regulated by the CFTC to ensure clearance and settlement. Customers’ positions on an exchange are bolstered by the segregation of customers from house funds and the capital of the clearing member, which in turn assesses the customers’ ability to meet the incurred obligations. Clearing organizations generally impose capital requirements on members that are much higher than those required by CFTC rules. Credit risk is alleviated by daily marking-to-market and allocation of gains and losses on all positions; most exchanges collect margins on an intraday basis and all exchanges have the authority to do so in volatile markets. Also, the CFTC can change the initial and maintenance margins for stock index futures and options.
Reducing Systemic Risk
The key systemic question is to what extent are large, and possibly leveraged, investors, including hedge funds, a source of risk to the financial institutions that provide them with credit and to the intermediaries, such as broker-dealers, who help them implement their investment strategies.
Banks provide many services to hedge funds, including foreign exchange trading facilities, repo arrangements and other collateralized credit lines, uncollateralized direct credit, custodial services, and sometimes even advice on fund management. These banks accept hedge funds as customers because they view the relationship as profitable and the associated risks as controllable. Banks assess to what extent and in which products they will trade with a particular client. They examine the structure of the collective investment vehicle, the disclosure documents submitted to regulators and those offered to clients, the financial statements, and the fund’s performance history. They also often carry out onsite inspections of risk management systems and capabilities.
Generally, a large proportion, if not all, of the credit extended by banks to hedge funds consists of collateralized lending. Market risk assumed by the sale of foreign exchange or other products would as a matter of course be hedged. However, if the contract moved in favor of the bank, there would be an “implicit” extension of credit to the client that would be settled at the maturity of the contract. Such credit risk is collateralized against and banks monitor collateral values on a daily basis. If margin calls are not met, and on occasion for other reasons, banks have the right to close out the contracts. For established customers, banks sometimes set “loss thresholds” that allow the extension of (uncollateralized) credit up to the amount of the limit set. But once such thresholds are breached, clients are expected to post collateral or settle their outstanding positions in cash. It is possible when margin calls are not met that banks could be saddled with collateral worth less than expected, resulting in a loss for the bank. Such “potential” credit exposures are monitored by banks and tolerance limits set to contain it.
Credit exposures of broker-dealers are monitored by the SEC and there are regulations to promote broker-dealer stability during intervals of systemwide stress. The net capital rule fortifies a broker-dealer against defaults by setting minimum net capital standards and requiring it to deduct from its net worth the value of loans that have not been fully collateralized by liquid assets. Margin rules based on market risk provide similar insulation to broker-dealers and through them to the wider financial system.
Following the Market Reform Act of 1990, the SEC has strengthened its examination of the risk management practices of broker-dealers.18 Reporting rules enable a periodic assessment and, at times, continuous monitoring of the risks posed to broker-dealers by their material affiliates, including those involved in over-the-counter (OTC) derivatives. Every quarter, on a confidential basis, broker-dealers provide the SEC with certain information on the volume of the derivatives business done by their affiliates. If credit risk exposure exceeds a materiality threshold of $100 million or 10 percent of net capital, they are expected to report a counterparty break-down of certain OTC derivative products.
Large firms also have the information systems capable of analyzing credit risk by product, counterparties, and other categories to assess concentrations in exposure. The SEC also reviews credit risk controls used by major U.S. securities firms. It evaluates the capacity to do credit analysis, setting of credit limits for clients, authorization procedures for large transactions, calculation and monitoring of overall credit exposure, and provisioning for defaults. Along with the bank and broker-dealer credit structures that protect against excessively large uncollateralized positions, the Treasury and CFTC large position and/or large trader reporting requirements, by automatically soliciting information, provide continuous monitoring of large players in key markets and hence allow early detection of stresses in the system.
Regulation of Hedge Funds in the United Kingdom19
In the United Kingdom, the Financial Services Act of 1986 “draws a fundamental distinction between authorized U.K. unit trusts and recognized overseas collective investment schemes, on the one hand, and ‘unregulated’ schemes on the other.”20 The first category of funds are granted promotional freedom, reflecting the regulatory discipline to which they are subject—disclosure of scheme particulars, restrictions on permissible investments, and restrictions on the pricing of units or shares and the management and constitution of such trusts. In contrast, unregulated schemes are not subject to such rules and as a consequence cannot be promoted to the general public.21
The Financial Services Act, however, allows exemptions for business and professional investors, experienced investors, established customers, existing participants, and other exempted persons.22 An exacting test is applied to determine whether a customer qualifies for “experienced investor” status. Also, such status is relative to a particular type of investment and a particular type of transaction. It can be conferred only if the investor has frequently conducted a certain type of transaction over some time period that it can be expected to be cognizant of the risks involved, is made aware of the investor protection implications, and on being notified by the firm has not declined to be regarded as an experienced investor. Further, this exemption does not apply unless the investor is deemed to be an experienced investor for each category of transaction that an investment vehicle may conduct for it. The “established customer” exemption as interpreted by the SIB allows promotion only to known clients with whom a firm has a “settled, ongoing” relationship. The “existing participant” exemption allows sales of additional units to persons “reasonably believed to be a participant in a scheme already.” It prohibits the promotion of schemes that are not substantially similar to one in which the person has already participated.
If an unregulated scheme or hedge fund sought to issue securities, it would be subject, where applicable, to the Public Offer of Securities Regulations 1995, Listing Rules of the London Stock Exchange, and the admission rules of the exchange on which the securities are traded. Any advertising of such securities would be subject to the rules of the Financial Services Act.
In addition, hedge funds’ transactions in markets operated by recognized investment exchanges (the London Stock Exchange, London International Financial Futures Exchange (LIFFE), the London Metal Exchange, the International Petroleum Exchange, OMLX, and Tradepoint) are subject to the rules and transparency requirements of those exchanges. If a hedge fund is also a member of the exchange, it must satisfy the relevant exchange rules in addition to the rules of the self-regulating organization that authorizes it to do investment business. Under the Financial Services Act, recognized investment exchanges are required to meet specific regulations. These requirements cover financial resources, rules to ensure proper and orderly markets, transaction recording and settlement, monitoring and enforcement rules, the investigation of complaints, and cooperation with other regulators. It appears that because of the capital requirements, few hedge funds are members of organized exchanges and generally conduct their business through other exchange members.
In the United Kingdom, dealing in currencies (including gold and silver bullion) or commodities for spot delivery does not, in general, constitute investment business.23 However, dealing in other instruments of interest to hedge funds is construed as investment business, such as dealing in commodity and currency futures, and options. In order to operate in these markets, hedge funds would therefore need authorization or exemption under the Financial Services Act and would be subject to the relevant conduct of business regulations and financial resource rules covering prudential capital and reserve requirements.24
Laws with general application to U.K. markets and the investment business also apply to hedge funds. These include the laws on insider dealing and market manipulation in the Criminal Justice Act 1993 and the Financial Services Act 1986; the law in the Companies Act 1985 pertaining to disclosure of interests in company shares, which requires the disclosure of any interest of 3 percent and each percentage point thereafter; and the Takeover Code and the jurisdiction of the Panel of Takeovers and Mergers if acquiring a U.K. public company.
Regulation of Hedge Funds in the European Union
Directives of the Council of the European Communities have led to some harmonization of rules and regulations in the European Union (EU). The approach has been to effect essential harmonization only to the extent that it is required for the “mutual recognition of authorization (of institutions) and prudential supervision systems” and establishing a minimum common framework. If warranted, individual member countries are generally allowed to adopt rules that are stricter than those specified in the directives.
The coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS)—broadly corresponding to mutual funds in the United States—has been accomplished by a 1985 directive (85/61 I/EEC) and subsequent amendments in 1988 and 1995.25 More recently, the directive on investment services in the securities field further defined the authorization of investment firms by home country competent authorities, the different requirements for protection of various categories of investors, and rules to ensure the smooth operation of markets in money market instruments and transferable securities (93/22/EEC). Pending coordination of laws that apply to categories of collective investment vehicles not covered by these directives, national authorities of EU member countries lay down the specific rules to which such undertakings are subject to while doing business within their territory.
Directive 88/627/EEC covers information that is required to be published when a major holding in a listed company is acquired or disposed of. It requires a natural person or legal entity that acquires or disposes of, directly or through intermediaries, a holding in a listed company that exceeds or falls below any one of the thresholds of 10, 20, 33⅓, 50, and 66⅔; percent to notify the company and the competent authorities within seven calendar days of crossing a threshold.26 This directive does not apply to the acquisition or disposal of holdings in collective investment vehicles.
Limits and reporting of large exposures of credit institutions are addressed by the directive on the monitoring and control of large exposures of credit institutions (92/121/EEC). A credit institution’s exposure to a client or group of connected clients is considered to be large if it equals or exceeds 10 percent of the institutions’ own funds.27 The law requires credit institutions to follow one of the following methods of reporting:
report all large exposures at least four times a year,
report all large exposures at least once a year and report during the year all new large exposures and any increases in existing large exposures greater than 20 percent from previously reported levels.
The limit on large exposures of credit institutions to a client or group of connected clients is defined to be 25 percent of the institutions’ own funds. This limit is reduced to 20 percent if the client is the parent undertaking or a subsidiary of the credit institution and/or one of the subsidiaries of the parent undertaking. Exemptions from this limit can be obtained for these clients if the institution puts in place specific monitoring procedures and informs the European Commission and the Banking Advisory Committee of these procedures. A credit institution is prohibited from incurring large exposures which in total exceed 800 percent of its own funds.28
Views of Regulators
Regulators in the United States and the United Kingdom are of the view that hedge funds do not pose any unique challenges as far as systemic risk is concerned and that the current regulatory apparatus combined with the surveillance procedures is sufficient to ferret out any problems in this regard. However, the introduction of new financial instruments and the changing nature of existing instruments in an evolving technological environment demand keen surveillance and a regulatory structure that can be continually adapted to new realities. Regulators recognize that some financial intermediaries may not have the sophistication to satisfactorily assess the risks involved in dealing with hedge funds, especially given the lack of information on such investment vehicles. They also acknowledge that while the position of large traders operating through organized exchanges is routinely available, information on the operations of such traders in other markets is not always available and hence, at times, it is difficult to determine to what extent problems in other markets—for example, the unregulated OTC market—could spill over into the regulated markets. Such risks, though normally small, are difficult to quantify, and vigilance is required to ensure that they do not cumulate and give rise to systemic problems.
That said, the existence of risks does not automatically justify new regulations. The regulators are not convinced that a case can be made for introducing regulations specifically targeted at hedge funds. Further, any imposition of disclosure and reporting requirements needs to balance the timeliness of the data one might receive with the impact such requirements may have on the privacy of the participants and therefore on the liquidity of markets. Less timely but more extensive data collection is possible but may be useless for many problems. On the other hand, timely data is expensive for the industry to produce and may make participants less likely to use a particular market.
See Holum (1994) and La Ware (1994).
Section 4(2) of the Securities Act exempts private offerings of securities from registration.
Rule 506 under SEC Regulation D is a nonexclusive safe harbor provided to issuers relying on the Section 4(2) exemption of the Securities Act. An accredited investor is defined to include any saving and loan association; any broker-dealer; any employee benefit plan with total assets in excess of $5 million; any private business development company; any organization, corporation, trust, or partnership not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million; any natural person with individual net worth, or joint net worth with that person’s spouse, of $1 million; any natural person with individual income of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of these years, and with a reasonable expectation of reaching the same income level in the current year; and any entity in which all of the equity owners are accredited investors. Generally, any nonaccredited investor would be counted toward the 35 investor maximum.
Currently, the National Association of Securities Dealers, Inc. is the only registered national securities association.
A dealer may deal directly with public investors and may also provide other services such as quoting a market and being willing to buy and sell securities on a continuous basis.
It is possible, however, that a general partner of the fund, or an independent solicitor, whose primary function is to raise money from investors might have to register as a broker. For further discussion see Roth (1995).
These exemptions are contained in Section 3(c)l of the Investment Company Act. In applying the 100-investor rule, fund managers must in some cases “look through” an entity investor and count the number of investors in that entity. The act (and, through past decisions, the SEC) provides guidance on when a look-through would be required.
Section 3(c)(7) of the Investment Company Act.
Advisers can count a bona fide limited partnership as a single client.
Section 1(a) of the Commodity Exchange Act (CEA) defines a commodity pool operator (CPO) as any person engaged in a business that is of the nature of an investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in any commodity for future delivery or commodity option on or subject to the rules of any contract market, except that the term does not include such persons not within the intent of the definition of the term as the CFTC may specify by rule, regulation, or order. The same section defines a commodity trading advisor (CTA) as any person, who for compensation or profit engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in any contract of sale of a commodity for future delivery made or to be made on or subject to the rules of a contract market, any commodity option authorized under [CEA] Section 4(c) or any leverage transaction authorized under Section 10, or who for compensation or profit and as part of a regular business, issues or promulgates analyses or reports concerning any of the above. An associated person (AP) of a commodity pool operator is defined by CFTC Rule 1.3(aa) to be any partner, officer, employee, consultant, or agent (or any natural person occupying a similar status or performing similar functions) who is involved in any capacity involving solicitation of funds, securities, or property for participation in a commodity pool or the supervision of any person or persons so engaged (see Commodity Exchange Act, September 1997).
Note that neither the CEA nor the CFTC rules impose any capital requirement on the CPO. Hence, the reports concern the operations of the commodity pool and not those of the commodity pool operator.
The CFTC rules define a Principal to include key persons such as directors, officers, branch managers, and persons contributing 10 percent or more of the CPO’s capital.
Filing is required by law (31 U.S.C. 5315; 31 C.F.R. 128, Subpart C).
See, for example, U.S. Department of the Treasury (1997).
The SEC has considered the idea of a large trader reporting system for equities, and a dialogue with market participants is still continuing. Under such a system, a “large trader” would be required to file a notification with the SEC, inform its broker-dealer of such a filing and the SEC identification number assigned, and thereafter would be obligated to update the notification over some time interval. The broker-dealer would be required to maintain a record of all transactions on such an account. This activity-based system would capture information on all large traders irrespective of the size of end-of-day positions. However, it should be noted that this system would apply only to entities transacting through registered broker-dealers and in securities listed on an exchange or quoted on NASDAQ.
Section 13(f) of the Securities Exchange Act.
However, theoretically the New York Stock Exchange could reopen with no price limit after a trading halt triggered by a decline in the Dow Jones Industrial Average in the prespecified amount.
See Levitt (1994).
The United Kingdom is currently in the process of creating a new single regulator for the financial system. This organization, the Financial Services Authority (FSA), will eventually combine the regulatory and other functions performed by the Securities and Investments Board (SIB), Supervision and Surveillance Division of the Bank of England, Securities and Futures Authority (SFA), Investment Management Regulatory Organization (IMRO), Personal Investment Authority (PIA), Insurance Directorate of the Department of Trade and Industry, Building Societies Commission (BSC), Friendly Societies Commission (FSC), and the Registry of Friendly Societies (RFS). Two pieces of legislation (currently under preparation) will be instrumental in completing the creation of the FSA—the Bank of England bill will transfer to the FSA the responsibility for supervision of banks, money market institutions, and related clearing houses; and the financial regulatory reform bill will create the statutory regime under which the FSA will become the single financial regulator.
See, for example, Securities and Investments Board (1990).
Section 76(1) of the Financial Services Act prohibits promotion by authorized persons and Sections 3, 57, and certain SIB conduct of business rules prohibit promotion by unauthorized persons.
See Sections 76(2), 76(3), and rules promulgated under these laws by the SIB—Promotion of Unregulated Collective Investment Schemes, 1988, and the Financial Services (Promotion of Unregulated Schemes) Regulations 1991.
It is worth noting that principals and brokers in these markets are covered by the Bank of England’s supervision of wholesale markets.
As end-users of commodity and currency futures and options, hedge funds do not need to be authorized.
Transferable securities are broadly defined as “those classes of securities which are normally dealt in on the capital market, such as government securities, shares in companies, negotiable securities giving the right to acquire shares by subscription or exchange, depositary receipts, bonds issued as part of a series, index warrants and securities giving right to acquire such bonds by subscription.” UCITS are defined as vehicles “whose sole objective is the collective investment in transferable securities of capital raised from the public and which operate on the principle of risk-spreading, and the units of which are, at the request of holders, repurchased or redeemed, directly or indirectly, out of those undertakings’ assets.” These undertakings may be constituted under the law of contracts (as common funds managed by management companies), under trust law (as unit trusts), or under statute (as investment companies). The directive (88/361/EEC) on freedom of capital movements allows the units of collective investment vehicles based in a particular EU member to be sold in other EU member countries. However, member states still retain the power to impose certain constraints based on public good considerations (see Article 14 of directive 93/22/EEC).
A professional dealer in securities, who is a member of a stock exchange approved and supervised by the competent authorities of a country in the EU, may be given an exemption from such a declaration if the acquisition or disposal of a holding is done in the context of dealing in securities and not used for purposes of control or management of a company.
The capital adequacy directive (93/6/EEC) combined with the directive on own funds of credit institutions (89/299/EEC) co-ordinate the definition of own funds of investment firms, the establishment of the amounts of their initial capital and the establishment of a common framework for monitoring the risks incurred by investment firms and credit institutions.
Subject to certain conditions being simultaneously met, the competent authorities may authorize the limits laid down in this directive to be exceeded. See Annex VI of the capital adequacy directive (93/6/EEC).
References
Commodity Exchange Act As Amended and Regulations Thereunder 1997 (Chicago: Commerce Clearing House).
European Union Council 1985, “Directive on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities” (85/611/EEC), Official Journal of the European Communities, No. L 375 (Brussels).
European Union Council 1988a, “Directive for the implementation of Article 67 of the Treaty” (88/361 /EEC), Official Journal of the European Communities, No. L 178 (Brussels).
European Union Council 1988b, “Directive on the information to be published when a major holding in a listed company is acquired or disposed of” (88/627/EEC), Official Journal of the European Communities, no. L 348 (Brussels).
European Union Council 1989, “Directive on the own funds of credit institutions” (89/299/EEC), Official Journal of the European Communities, no. L 124 (Brussels).
European Union Council 1992, “Directive on the monitoring and control of large exposures of credit institutions” (92/121/EEC), Official Journal of the European Communities, no. L 124 (Brussels).
European Union Council, 1993, “Directive on the capital adequacy of investment firms and credit institutions” (93/6/EEC), Official Journal of the European Communities, no. L 141 (Brussels).
European Union Council 1993, “Directive on investment services in the securities field” (93/22/EEC), Official Journal of the European Communities, no. L 141 (Brussels).
Holum, Barbara P., 1994, Testimony Concerning Hedge Fund Activities Before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13.
LaWare, John P., 1994, Testimony Concerning Hedge Fund Activities Before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13.
Levitt, Arthur, 1994, Testimony Concerning Hedge Fund Activities Before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13.
Roth, Paul N., 1995, “Critical Legal and Regulatory Issues,” in Hedge Funds: Investment and Portfolio Strategies for the Institutional Investor, ed. by Jess Lederman Robert A. Klein (New York: McGraw Hill).
Securities and Investments Board 1990, Promotion of Un-regulated Collective Investment Schemes, Consultative Paper 32, January.
U.S. Department of the Treasury 1997, Treasury Bulletin, September, pp. 97–104.