The Law and Economics of Hedge Fund Regulation : a Comparison Between the U.S. and the EU

Abstract

This doctoral dissertation seeks to assess and address the potential contribution of the hedge fund industry to financial instability. In so doing, the dissertation investigates three main questions. What are the contributions of hedge funds to financial instability? What is the optimal regulatory strategy to address the potential contribution of hedge funds to financial instability? And do the new regulations in the U.S. and the EU address the contribution of hedge funds to financial instability while conforming to the efficiency criterion? To answer the above questions, three aspects of hedge funds and their activities that may potentially give rise to market failure are analyzed. The theories offered in explaining those market failures are compared with the existing empirical evidence. Analyzing the three above sources of market failure, potential problems in the operation of hedge funds were identified. With respect to systemic risk concerns which are the main focus of the thesis, the dissertation argues that despite their benefits, hedge funds can potentially pose risks to financial systems and contribute to financial instability. Although their contribution to financial instability is highly contested, hedge funds’ size and leverage, their interconnectedness with Large Complex Financial Institutions (LCFIs), and the likelihood of herd behavior in the industry are among the features that can undermine financial stability. Nonetheless, the data on the size and leverage of hedge funds suggest that these features are far from being systemically important. In contrast, the empirical evidence on the interconnectedness of hedge funds with LCFIs and their herding behavior is mixed and they remain to be a major concern for regulators. Based on this finding, in studying the regulatory strategies to address the potential systemic implications of hedge funds for financial markets, the dissertation focuses on one particular aspect of hedge fund regulation: direct vs. indirect regulation. In this respect, a major contribution of the dissertation to the literature consists in the explicit discussion of the relationships between hedge funds and other market participants. Specifically, the thesis locates the domain of indirect regulation in the inter-linkages between hedge funds and prime brokers. The main aim of the dissertation is to move the existing debate on hedge fund regulation a step forward, namely from “whether” to “how” to regulate hedge funds. Accordingly, the thesis argues that the indirect regulation is likely to address the contribution of hedge funds to systemic risk without compromising their benefits to financial markets. The dissertation further conducts a comparative study of the regulatory responses to potential contribution of hedge funds to financial instability through studying the EU Directive on Alternative Investment Fund Managers (AIFMD) and the hedge fund-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Although the Dodd-Frank Act remains highly controversial with respect to achieving its objectives, this thesis suggests that, compared to its European counterpart, the regulation of hedge funds in the U.S. can better address the potential contribution of hedge funds to financial instability while not compromising their perceived benefits to financial markets.