Over the years, we’ve often marvelled at the sheer volume of failed hedge fund regulations at the state, national or international level. It’s enough to make you ask why?
A recent paper written recently by Paulo Robotti of the Institut Barcelona D’estudis Internacionals (IBEI) proposes a reason for this apparent string of failures. Robotti draws on political theory that he says was first developed in the early 1970’s called “regulatory capture”.
Robotti divides the sordid history of hedge fund regulation into two distinct phases. The first phase (1998-2003) was a response to LTCM and was marked by attempts to govern the potential systematic risk posed by hedge funds. The President’s Working Group (PWG) and Financial Stability Forum (FSF) were the legacies of this era.
The second phase (2003-present) was motivated by consumer protection and was motivated mainly by the mutual fund timing scandal. This fiasco, argues Robotti, forced the SEC to resurrect its objective to register hedge funds.
Regulatory initiatives developed in both phases seemed to meet the same fate, however. The legislative response to the PWG’s 1999 findings was the Hedge Fund Disclosure Act. But the Act died on the operating table at the close of Congress the next year.
Fast forward to 2004 and not much had changed. The SEC felt that the definition of “client” had been warped beyond recognition and that the original spirit of the Advisers Act of 1940 should govern hedge funds too. However, the SEC’s hedge fund registration rule was unceremoniously vacated by the Phil Goldstein case in 2006.
The common element in these two phases, says Robotti, is a form of “regulatory capture”. Regulatory capture is a situation that develops once a constituency comes under the influence of regulators or government officials. The mere proximity between the regulators and the regulated creates ties that influence the regulation itself.
Cynics would call this the typical cozy relationship between legislators and big business. But Robotti also suggests that this can counterbalance the tendency for legislators to channel populist anger and hysteria.
Whether or not it has any redeeming qualities, however, regulatory capture has the effect of actually bringing regulators and regulated closer together. This is ironic since what many advocates of greater edge fund regulation actually pine for is a more active and adversarial relationship between the regulators and hedge funds.
Robotti blames the failure of hedge fund regulation on a version of regulatory capture called “self-capture” whereby regulators effectively sabotage their own regulations in order to elicit some kind of self-regulatory response (a.k.a. “private regulation”).
In other words, Robotti says that regulators were actually a lot more shrewd than they let on. By scaring the industry into action, the Hedge Fund Disclosure Act and the SEC registration drive invoked industry standards from AIMA, the UK’s Hedge Funds Working Group (/Standards Board), the Managed Funds Association (MFA) and the President’s Working Group’s Investors and Managers Committees.
Robotti says that several elements of the SEC’s registration drive were so obviously flawed from the start that it could only mean the SEC was purposefully making a half hearted effort in hopes that it would scare industry into action:
“First, it was not clear what the new rule was adding in terms of SEC authority to monitor hedge funds…Second, plenty of loopholes were left in the provisions of the rule, let alone in the procedural issues, which did not follow a thorough consultation with all interested governmental bodies…Finally, the SEC did not consider whether the initiative was legitimate and within the limits of its mandate.
While this might sound like a conspiracy theory, consider this: half of all US hedge funds remain voluntary registered to this day. Indeed, Robotti points out that when told of its crushing defeat at the hands of Phil Goldstein, the SEC was remarkably sanguine – electing not to appeal the decision.
Robotti outlines two forms of self-capture:
- Legislation without enactment and,
- Rule making without implementation.
But in the end, neither legislation nor rule-making actually came to pass before the hedge fund industry was prompted into action.
These failed regulatory antics amounted to a kind of regulatory goading. The effect was much like a doctor trying to stimulate a patient’s immune system by introducing a small amount of some pathogen into their body.
It may be working. As we wrote in May, both AIMA and the MFA testified in front of Congress that they were now okay with some kind of registration.
But as Robotti warns, the immune response can only last so long:
“…private actors will relax their self-imposed rules and good practices once the storm is over and competitive pressures are mounting again…”
“…the failing of public regulation leads to the bypassing of the traditional sites of political legitimization and insulates financial decisions from popular sovereignty and accountability.”