If there is one point of contention that still smarts like a fresh wound in hedge fund managers’ hearts it is the global crackdown among policymakers and attorneys general on short-selling.

As the world financial markets were in free-fall in the fall of 2008, the idea at the time was that, to protect banks and financial firms – whose shares were on a one-way trajectory down – and in turn to stabilize financial markets, it would be good policy to ban short-sellers from continuing to bet against their shares.

From the US Securities and Exchange Commission, to the UK Financial Services Authority, to the states of Connecticut and Texas: Short-selling was outright halted. The chart below from Hennessee Group Research illustrates the historical exposure of equity hedge funds through the end of 2008.

Since 2008 and beyond, a host of academics and other naysayers have made clear that, aside from reducing market volatility somewhat, the bans never really worked. (For a more complete overview of the role of short sellers in the marketplace, click here.) They have further argued that the bans only served to imbalance the marketplace and reduce visibility for investors, for the simple reason that no one can truly tell how much a stock might be worth if no one is allowed to place a bet against its decline.

Yet the US Securities and Exchange Commission and other policymakers are marching forward with plans to keep short-selling bans in place, to varying degrees. The SEC last month voted to reinstate the so-called up-tick rule, though only on stocks that experience a one-day 10% decline in value. Meanwhile, Germany, Hong Kong and the European Union are all contemplating new and permanent rules on short-selling activity and disclosure.

From a practical standpoint, the billion-dollar question is how positive an impact the short-selling bans in their various forms and iterations have had on financial markets.

The original “uptick rule” was put in place during the Depression in the 1930s to prevent stocks on a downswing from being hammered by short-sellers. It barred traders from selling short, or betting that a stock would fall, unless there was an uptick in the price. The rule was abolished in 2007 by the SEC after it concluded that advances in trading strategies had rendered the rule ineffective. The new rule by the SEC essentially brings back the uptick rule, with the caveat the rule would stay in effect for only one day and lifted the day after.

According to a report on short selling published by the UK Financial Services Authority in February 2009, the UK ban did produce a “marked volatility decrease to around the still very high levels observed in mid-September before the introduction of the temporary short selling ban.” The graph below shows the volatility levels for the FTSE 350 and the financial sector from July 2008.

Source: FSA

The short answer, so to speak, is that aside from a slight reduction in overall volatility, the bans had little positive impact on the broader markets. In fact, many, UBS Asset Management’s Alexander Ineichen (who is also a regular contributor at AllAboutAlpha.com) and Ian Marsh and Norman Niemer have argued the bans ultimately had a negative impact, by simple virtue of preventing market forces from collectively determining the appropriate value of a particular stock.

The question now is whether the SEC’s compromise – which is a cross between a short-selling ban and the former uptick rule (click here for a pithy Q&A on the new rule, courtesy of the Wall Street Journal – no subscription required) – will in some way help moderate potentially cascading declines while at the same time providing some allowances for short sellers and others to bet on a stock’s decline as they see fit.

The jury is out, but if the research is correct, the answer is it likely won’t help much at all.

Not hedge fund managers, if our social and political climate continues down its current path.  In fact, hedge funds may have to go “commando” if things don’t change – leaving shorts to go to the dogs.

Short-sellers are facing new, more onerous restrictions, most notably a potential mandate to disclose their publicly held short positions on a regular and timely basis, called public short-selling disclosure requirements, or SSDRs.

Problem is, no one has yet proven that forcing managers to disclose their short holdings and / or ban them from taking short positions in select securities has any sort of positive impact on market conditions. Last September AllAboutAlpha.com highlighted a particularly compelling study from the Cass Business School in London showing as much.

Indeed, according to a study published this month by Oliver Wyman, the impact is negative, particularly as managers refrain from actively shorting various securities and markets. The study, entitled, “The effects of short-selling public disclosure regimes on equity markets,” can be downloaded from the Managed Funds Association’s Web site here.

Ganging up on short-sellers in nothing new, particularly in times of market duress. Amid the multiple-billion-dollar bailouts and government rescue plans of mid-September 2008, regulators in the US, the UK and a dozen other countries pulled out the bazookas, issuing outright bans on short-selling of financial stocks and other securities with very limited effect, as the chart from the Oliver Wyman study below shows.

Like any unprovoked blow, the first wave of shock following the 2008 bans quickly turned to anger and defiance, followed shortly thereafter by promises of retribution. Most agreed at the time that the swift yanking of the short-sale plug and more broadly the collective glare the hedge fund industry endured as the culprit behind the reason for the bans in the first place was, to say the least, unfair and unwarranted.

The phrase du jour back then was “moral hazard.”

Needless to say, the dust settled. But now, a year and a half on and with regulators once again talking about imposing both limits and reporting requirements on short-selling, the question of how effective SSDRs are has come back to the fore.

The answer, according to the Oliver Wyman report, is not very. In addition to reducing liquidity, the information to be disclosed by investors is “sufficiently sensitive that they limit their activities to avoid making disclosures.”

The report examines a wide variety of indicators of market health as it tries to determine how disclosure of short positions affects market mechanics.  For example, the study found that average daily volumes fell from (pre-ban) levels for stocks requiring short-selling disclosure (“test group” consists of stocks falling under new disclosure rules)…

In addition, average bid-ask spread jumped for stocks in the “test group” (those facing the new disclosure rules) after the disclosure rules were implemented.

In response to falling volumes and rising spreads, hypothesizes the report, intraday volatility rose for stocks falling under the disclosure rules…

In other words, put enough speed bumps on the road and eventually people will get out of their cars and walk.

Or pick a different route. The report also notes that SSDRs would likely encourage investors to move into equity markets with “more palatable regulatory frameworks” – read: less developed markets with less oversight and protections and more latitude.

The notion that market participants in general could choose a less-onerous path certainly isn’t specific to the hedge fund industry. The response to a lengthy SEC “concept document” on equity market structure released earlier this month has, to put it mildly, been less than enthusiastic.

That hedge funds are facing social and political backlash related to recent historical market moves isn’t surprising. After all, it was only 12 years ago that a now-infamous hedge fund brought on the last systemic financial system maelstrom and officially became a not-so-nice acronym for what happens when extreme bets go wrong.

It will be interesting to see who ultimately ends up wearing the shorts once all is said and done: regulators & policymakers or managers & investors…or just a goofy-looking Chihuahua looking for his next meal.

If 2008 was characterized by meltdown and 2009 was characterized by thaw, 2010 will be noted as the year hell finally froze over, at least when it comes to hedge fund and investment banking oversight.

For years, hedge funds have been threatened with tighter borrowing and lending practices, more scrutiny and less flexibility to hide behind the veil of being a private investment for the accredited. The gauntlet never quite came down, thanks to Goldstein, Madoff and a global financial crisis, allowing hedge funds to continue doing what they have always done. More…

Time and again the US Securities and Exchange Commission has looked to impose additional oversight on hedge funds, and time again their efforts have either failed, been thwarted or taken a back seat to more pressing issues, such as the potential end of the financial system as we know it.

Assuming the world is indeed back on its financial axis, the SEC in 2010 is going to be getting back to its focus on regulating hedge funds and other private investment vehicles that it believes need to be more transparent and accountable. Indeed, the SEC’s 2009 annual report notes a significant increase in examinations, with more to come this year. More…

The rush is on this year for alternative investment firms to set up and launch both offshore and onshore versions of Undertakings for Collective Investments in Transferable Securities, or UCITS- and NEWCITS-based funds.

According to a late-December report by London-based KdK Asset Management, some 80% of hedge funds, and in particular funds of funds surveyed by the firm expect to launch a UCITS-based this year (see graph by KdK below) as a way to ensure they are on a regulatory par with more traditional, and accessible, European vehicles. More…

The world is full of middle-men: Walk into a car dealership to purchase a car and you go through a salesperson, who takes a cut for showing you the car; walk through a house or apartment and the real estate broker takes a cut for opening the doors and closets.

Like it or not, and as counter-intuitive as it sometimes may be, it is the way transactions work.

So it’s been with the securities, or “sec” lenders: institutions that have access to “lendable” securities. Asset managers who have securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian have for years taken a nice slice of the pie to lend back out stocks to others who need them. More…

Back in 2007, we told you about a paper (and subsequent presentation to CAIA’s Swiss Chapter by one of the authors) that explored the pathways followed by so-called “hedge fund contagion”.

Then, last August, we told you about a paper by John Dai and Suresh Sundaresan of Capula Investment Management called “Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage”.  In it, Dai and Sundaresan argue that a hedge fund essentially sells an option to each of its investors and lenders (e.g. prime brokers) since both parties are free to pull the plug on their support (although investors often face extensive waiting periods).

Now, a new working paper by Benjamin Klaus and Bronka Rzepkowski  of the European Central Bank called “Risk Spillover Among Hedge Funds” combines these two concepts by blaming hedge fund contagion on both investor redemptions and “tightening financial conditions” precipitated by prime brokers.

Being central bankers, the authors also propose several policy prescriptions.  So you may want to check out this report if you’re trying to forecast how the Europeans – and potentially the Americans – are going to tackle hedge fund regulation. More…

Another day, another complaint about “arrogant” hedge funds charging unfair fees.  This one was from a UK pension fund head to a conference in London.  According to Reuters, Philip Read, the chairman of the British Coal Staff Superannuation Scheme told the audience “If they want money from us they will have to offer … alignment of interests. If hedge funds remain arrogant and not humble, I think money will go elsewhere…”

Read went on to say that he and other pension funds will “gang up” on hedge funds if they don’t eat some humble pie – and quick.

His comments were representative of the love/hate relationship institutional investors have with hedge funds.  They threaten to “go elsewhere,” yet make great efforts to stick around and force changes.

But hedge funds aren’t the only ones being attacked for allegedly exorbitant fees.   It looks like the mutual fund industry is about to undergo another series of attacks.  As Investment News reports, one mutual fund company is being dragged all the way to the U.S. Supreme Court to defend its fee structure.

A couple of individual investors are suing Harris Associates for excessive advisory fees charged to the Oakmark Series of mutual funds.  Rather than complaining about the cost of the funds themselves (a pretty reasonable 1.1% according to Oakmark’s website), they are taking issue with the fees paid by the Oakmark funds (which were created by Harris) to the fund Advisor (Harris itself).

As the Cornell University Law School’s Legal Information Institute (LII)  reports, the advisory fees paid by Oakmark to Harris would range from 1% per annum to 0.75% per annum depending on the eventual size of the fund.   Oddly, Harris was only able to charge 0.75% to 0.35% to arm’s length clients (funds it did not create) such as pension funds or other mutual funds.  (By comparison, eVestment Alliance’s annual fee survey says the average fee for large cap mandates ranges from 60bps to 50bps.)

As the Cornell LII warns: More…

One could be forgiven for thinking a dark pool was an obscurely-lit body of water.

Of course, a dark pool in the context of trading and execution is, as explained by the Securities and Exchange Commission, “a type of alternative trading system (ATS) that does not display quotations to the public.”   They have grown in popularity over the past few years, particularly for alternative investment managers looking to shop around and get a one-up on price — and the competition.

It is largely due to this lack of transparency and their growing proliferation that the SEC has become increasingly concerned with regulating them in some form.   Just two weeks ago, SEC Chairman Mary Schapiro outlined a fairly comprehensive plan on how exactly the commission is looking to gain more oversight over dark pools.

“Although dark liquidity always has existed in one form or another in the equity markets, the commission must assure that the public markets and non-public trading venues operate within a balanced regulatory framework,” Schapiro said in opening remarks before a commission meeting on dark pools, in which James Brigagliano, co-acting director of the SEC’s trading and markets wing, provided testimony. “This means that as markets evolve, the commission must continually seek to preserve the essential role of the public markets in promoting efficient price discovery and investor confidence.”

Uh oh. More…

Galleons have always liquidated quickly

Wire-taps, sting operations and perp walks associated with insider trading allegations and money being funneled to terrorist camps in southeast Asia – all the makings of a John Grisham book, at least one with a financial and Wall Street versus legal bend.

Of interest to AllAboutAlpha.com, however, is that beyond the numerous shocking and not-so-shocking headlines, Galleon Group, which has been in business for more than 12 years and reportedly managed some $3.7 billion in assets, is winding down and shuttering its doors in the span of a scant 45 days.

“I have decided that it is now in the best interest of our investors and employees to conduct an orderly wind down of Galleon’s funds while we explore various alternatives for our business,” Raj  Rajaratam, the 52-year-old billionaire founder of the firm, wrote in a letter to clients.

It’s not so surprising that the firm is winding down. Indeed, as we hit “publish” on this piece, Galleon had already reportedly liquidated practically all of its holdings, mostly large-cap equities like Apple, Google and Bank of America, but also some not-so-liquid securities traded over the counter or in emerging markets. According to sources quoted by Dow Jones Newswires, the firm is on track to pay out investors by January 1, 2010 — at a profit. More…