Friday, June 19, 2009

The rapidly shifting hedge fund regulation

Here is a thorough write-up from PWC on hedge fund regulation changes in the various jurisdictions. They particularly focus on issues with the new European hedge fund regulation. Three items are worth discussing:

1. The new EU regulations will require funds to have an independent valuation agent every time there is a subscription or redemption from a fund. It’s a great rule in theory, but good luck finding expert valuation agents in Europe for the less liquid fixed income assets. This will blow out most illiquid funds, putting macro players on top.

2. All funds need to have a depository for all the assets that is an EU credit institution. This will exclude most existing prime brokers – there are only 4 that are based in EU. That means you have to go to some sleepy European bank and ask them to be an intermediary between you (the hedge fund) and a real prime broker. Good luck reconciling margin, cash, and positions on a daily basis. Ouch.

3. There is a requirement to disclose leverage. Assuming there are sensible rules to do so, it wouldn’t be an issue. However no rules are provided. Here is an example: you are a payer of floating on a 3-year interest rate swap and a payer of fixed on a 10-year swap (at different nationals that make you duration neutral). It’s what’s called a “steepener” trade. How should you measure leverage on something like this? – good luck getting a sensible consistent answer from a regulator.

Those who find a way to cope with these will quickly dominate the space.

And just a quick note for all of you out there that want to regulate everything. Hedge funds and private equity firms did not cause the financial crisis. Many were hurt by it, a few got destroyed.

Citibank was regulated by the Fed, Lehman was regulated by the SEC, and AIG was regulated by the states of NY and CT, the Office of Thrift Supervision, and by the UK FSA.

So here is the ultimate question: how did these regulators do?
We need smart and consistent regulation, not more of it.

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