Hedge funds dodge a bullet, likely to remain ‘lightly regulated’

By Darrell Delamaide, FinReg21 contributor

Hedge funds have often been described in the financial press as “lightly regulated,” and that is likely to continue to be the case even with all the talk of regulatory reform. Though European leaders are always looking for more regulation of hedge funds, the Group of 20 heads of state and government meeting in London this week let them off, well, lightly.

It looks like the worst that is going to happen to hedge funds, at least for now, is that they will have to register with the Securities and Exchange Commission, and probably only the very biggest fund advisers will have to do that.

Given the fact that advisers representing 70% of the $1.5 trillion of assets under management by U.S. hedge funds are already registered with the SEC, and given the fact that hedge funds had already reconciled themselves to registration a few years ago before a federal court overturned SEC rulemaking requiring it, this is not terrible news for the industry.

In fact, market discipline – in this case an even greater wariness on the part of investors – is more likely to push hedge funds towards registration than new laws from Congress.

The head of the Managed Funds Association, longtime congressman Richard Baker, was quick to call this week for registration of hedge fund advisers, rather than the hedge funds themselves. What the industry most fears is that once the wedge of registration is driven in, the SEC will seek further disclosure or restrictions. Having the focus on the advisers could help limit this accretive regulation, the industry believes.

Those hedge fund advisers who have already registered have done so as part of the SEC’s general registration for investment advisers. The ill-fated SEC rule that sought to bring all hedge funds under surveillance also sought registration of advisers, not of individual funds. So there is little reason to think that either Congress or the SEC will want to go a different route this time.

And it may be, given the wording of the G20 communiqué, that only advisers over a certain threshold of assets will face any regulation or registration. It was considered a victory for the U.S. delegation that the wording on hedge funds was so restrained.

As part of their efforts to strengthen the financial system, the G20 leaders agreed “to extend regulation and oversight to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds.”

This declaration dovetails exactly with the regulatory reform plans announced in March by U.S. Treasury Secretary Timothy Geithner.

Hedge funds are eager to avoid any disclosure requirements regarding strategies or positions, as well as any restrictions on capital or leverage. If disclosure to regulators is required, they want it to be shielded from any view by the public.

Senators Carl Levin (D-Mich.) and Charles Grassley (R-Iowa) introduced a bill in January that would require all hedge funds to register with the SEC and make their information publicly available, including details about investors and assets.

“The Hedge Fund Transparency Act of 2009 would clarify current law to remove any doubt that the Securities and Exchange Commission has the authority to require hedge funds to register, so the government knows who they are and what they’re doing,” the two lawmakers said in announcing the legislation.

It would close the loophole used by hedge funds to escape the definition of an “investment company” under the Investment Company Act of 1940. Hedge funds that want to avoid the requirements of the Act would be exempt only if they file basic disclosure forms and cooperate with requests for information from the SEC.

The loophole is the interpretation that the hedge funds themselves, not the end investors, are the clients of the advisers, so that the advisers stay below the customer threshold that requires registration. When the SEC tried to change the interpretation through rulemaking, a federal court said they could not do that on their own authority and overturned the rule.

The MFA’s Baker, who chaired the House Financial Services capital markets subcommittee for 12 years when he was a Republican congressman from Louisiana, should have little trouble lobbying for the confidentiality of the disclosures. Likewise, an exemption from capital and leverage restrictions imposed by any systemic risk regulator is likely for all but the very biggest funds, which then, almost by definition, would cease to be hedge funds in the traditional understanding of the word.

Ultimately, hedge fund advisers are most likely to simply limit the size of the funds they manage in order to avoid any special restrictions for a systemically important fund. The administration has given no indication what that the size threshold will be, but it is likely to be quite high.

Hedge funds are getting away virtually scot free in large part because they were not a direct cause of the current financial meltdown. Whatever role hedge funds played as counterparties in some of the derivatives transactions, the real problems came with the excessive involvement of commercial banks, investment banks, and insurance companies – all of which were quite heavily regulated, though obviously not in the right way.

But market forces themselves are enforcing more discipline on hedge funds. The MFA this week released the latest update for its Best Practices, implementing several recommendations from the President’s Working Group on Financial Markets on valuing of assets and other issues. Client demands and competition are likelier to drive hedge fund reform than Congress or the SEC.

Darrell Delamaide reports exclusively on financial regulation news for FinReg21. Darrell is a veteran financial journalist who has worked for Dow Jones, Bloomberg, Institutional Investor, among others. He is based in Washington, D.C.