Hedge funds' wings clipped as regulation takes centre-stage

For the hedge fund industry it looks like that finally it has been caught up in the ever drifting financial regulatory net. Tougher regulation for hedge funds has been on government agencies and supervisor authorities for some time now but the day of dawning is almost here. The global financial crisis highlighted the lack of regulation of hedge funds and hedge fund firms. They have been caught up in the criticism of the entire financial sector, being blamed along side the banks for excessive leverage, reckless trading and investment activity, poor controls and weak risk management. High profile hedge fund collapses, culminating in the demise of the large and prominent Madoff Investments through a fraudulent scheme, has certainly, and justifiably, highlighted the shortcomings of supervision of alternative investments. To a large degree, however, hedge funds have been unfairly demonised. Hedge funds were far from being the perpetrator of the credit crisis and were mainly peripheral to the main causes. Certainly, at the height of the volatility in the banking sector, some hedge funds exacerbated the stock price fall and confidence of listed banks through concerted short-selling strategies. Hedge funds do carry leverage but certainly far lower than the leverage levels seen at banks. For many hedge funds, they were also far ahead of the credit curve than banks. The governments of the main financial markets, from the US to the UK and Europe, have jumped on the bandwagon to bring the hedge funds, particularly large or 'important' ones, under the regulatory spotlight. More crucially, this area was one of the main agreement issues at the G20 meeting. The commitment to regulate hedge funds for the first time received unanimous support. As with players in the financial markets, regulation is a necessary part of the system in order to help create and maintain an efficient, transparent and effective trading and investment market. Tighter regulation will not kill off the hedge fund industry. However, it will certainly restrict and curb some activities and strategies. Many hedge funds seek niche investment areas with trading strategies based on flexibility. The current open flexibility may be curbed but well-managed and smart managers will still successfully trade. The additional oversight will provide a further challenge to the hedge funds, already fighting against liquidity pressure, large redemption calls, difficult markets and lower borrowing options. The question remains as to what structure this new supervision will take. A common theme from world leaders is a global approach to financial supervision is necessary and an international regulatory framework for hedge funds looks likely. A global approach, and a tough one at that to what has been called the 'shadow banking industry' – although this premise does not really stack up in activity profile, has been vigorously pursued by the French and German governments. This is in some ways a back-handed compliment to the hedge fund industry. However, it belies the fact that the vast majority of hedge funds are not large, certainly not on a global scale, and nearly all do not have the reach of causing any systemic problems. The main financial centres of the world, including London and New York, will certainly now enforce tough supervision on hedge funds. However, they need to tread a fine line between appropriate and effective supervision, and driving hedge funds further offshore. The latter will be more difficult as consensus for global financial regulation includes countries from China and Russia to the US; the G20 represents 85 per cent of the world's economy. A uniformed, international supervisory approach to all major players in the financial markets has been put in play. As with all regulatory moves, the impact will be in the detail which is still to be fully outlined. The new systemic risk regulator may have power to force companies to increase their capital or cut their borrowing, and authorities would be able to seize them if they came unstuck. However, the type of enforcement mechanism to be used to empower any proposed international regulator is still to be decided.