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.

But comments from officials at this year’s World Economic Forum in the cold, snowy mountains of Davos seem to suggest that the rhetoric may finally be snowballing into something a bit more onerous, and that banks, private equity firms and hedge funds may be looking at a new type of landscape with more stringent standards – at least if they want to remain in business.

Regulators from the world’s developed countries told bankers far and wide in Davos that greater regulation is indeed on the way – a defensive move aimed at avoiding a repeat of last year’s financial meltdown that dragged most of the world into recession. The remarks came on the back of President Barack Obama’s suggestion – dubbed the Volker rule (because it was former Federal Reserve Chairman Paul Volcker’s idea) of forcing banks to divest their private equity and hedge fund holdings as well as their prop trading desks to reduce their financial footprint and limit systemic risk.

Untangling banks, especially big ones, from proprietary trading and alternatives strategies is no small feat, judging from the prop-trading market segment chart shown below from a slideshow by the CME Group.

Of course, Davos and many other forums have heard talk like this before: After the technology bust, after the Russian debt default, the Asian financial crisis, Long Term Capital Management and even after Amarynth blew up. AllAboutAlpha wrote about how hedge funds were on the “Global Agenda” in Davos back in 2007.

The key difference this time around is that governments, after spending billions to bail out the banking and financial services industries, are now calling the shots, and are more likely than ever to push through reforms that will make investing a much more different space in 12 months time. Even former Treasury Secretary Hank Paulson is on the hell-needs-to-freeze-over warpath, noting on CNBC in the past week that he approached his former Goldman Sachs cronies “numerous times” about the crazy casino that is Wall Street.

For their part, the banks still appear to be very, very deep in denial. They have already come out swinging, arguing everything from prop trading and hedging is only a small portion of their businesses to liquidity will all but dry up if such activities are made extracurricular.

Source: The Wall Street Journal

Elizabeth Warren, the woman in charge of the Troubled Assets Relief Program, or TARP, gave a passionate “now or never” diatribe on the “Daily Show” with Jon Stewart late last month, making plain that Wall Street is facing two choices: Either continue along the path of ever larger booms and busts that eventually turn into a financial atomic bomb, or make drastic changes that ensure the global financial system remains intact for at least the next 50 years.

Stewart called attention to a great quote she had, noting the lack of downside to the shenanigans of Wall Street in the 21st century: “Capitalism without bankruptcy is like Christianity without Hell.”

On the flip side, all the talk could actually end up being positive for hedge funds and other prop-trading shops, who presumably will find other places beyond the banks to get what they need.

Fire, or ice? The hedge fund industry, which rightly or wrongly is inexorably linked to the investment banking business, is likely in for both. One thing is for sure: Melt it, freeze it or pack it into a ball and whip it, it’s still the same thing.

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.

Of course, many both within and outside the alternatives industry have heard this song and dance before. And many have watched in bemusement as the SEC’s bark has proved once and again to be much worse than its bite.

So what’s going to be different this time around?

For one, money – lots of government money that the agency plans to use to hire key talent to conduct examinations and troll for evil doers in the non-public investment world. A recent study by Heidrich and Struggles found that the SEC is focused on nabbing veteran hedge fund and markets professionals as it seeks to beef up its new Division of Risk, Strategy, and Financial Innovation, as well gear up for increased government enforcement.

Funds particularly vulnerable to poaching are those with less than $1 billion under management, according to the report, which surveyed more than 400 portfolio managers and studied more than 100 hedge fund firms.

One of the key issues the SEC has faced for many years has been its lacking ability to hire the quantity and quality of professionals it needs to conduct routine blitzes of managers. For long, the biggest complaint among hedge funds that did fall under the cross-hairs of the SEC wasn’t so much that they were being examined, but that the examiners were young, inexperienced and didn’t know what they were looking for.

That appears to be about to change. Already Washington D.C. is being described as the new place to be for young, educated investment professionals either pining to get into the alternatives space, or unceremoniously booted out thanks to the events of 2008.

And judging by the both the SEC’s mandate and budget, it appears that this year will finally be the year it is able to do what it finally wants to do: create an army of sophisticated examiners and bright minds who know what to look for when it comes to smoking bad hedge fund managers, broker dealers and anyone in between up to no good out of their respective foxholes – before the press does.

A quick look at some numbers in the SEC’s 2009 annual report confirm that the agency is ramping up its focus on market oversight, with enforcement management and examinations at the top of the to-do list.

Sorry Goldstein. It was a valiant effort, and much appreciated, but the days of pushing back on the SEC are over, as are the days of not being completely and utterly transparent and compliant. A new era indeed.

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.

At the same time, many alternative investment shops have been rushing to create what are called “NEWCITS:” onshore, regulated UCITS funds.

Why the rush to UCITS and NEWCITS? For starters, UCITS funds are already regulated, they offer the comfort of a trustee or depo bank as holder of the assets while some of the counterparty risk concerns raised by the role of the prime broker in a typical hedge fund can be mitigated with a custody agreement.

For NEWCITS in particular, the survey noted than 90% of fund of funds believe they will have lower returns than their equivalent offshore versions, with a quarter expecting the shortfall to be greater than 3 percentage points a year.

Beyond that, many see the move as mainly being motivated by the ambition to gather more assets from sources that are no longer accessible through offshore funds or managed accounts, thanks to either new or pending regulations.

According to various media reports, including this one, the reasons are somewhat different than the survey suggests – that managers are setting up UCITS and NEWCITS funds because of uncertainty surrounding the Alternative Investment Fund Managers (AIFM) Directive from the EU. (You can read all about the directive and the industry’s response to it here.)

Why else would a firm establish a fund with higher costs and more limited investment parameters?

Either way, the funds have their work cut out for them in terms of delivering performance. Among other things, they are:

• Prohibited from directly investing in commodities and physical shorting, which can limit a hedge fund manager’s ability to deliver its investment strategy in full.
• A UCITS is not allowed to borrow for investment purposes. It can only obtain (limited) leverage through derivatives.
• The maximum redemption period for a UCITS is 14 days and redemptions must be made in principle at the fund’s net asset value, limiting the ability of managers to take positions in illiquid assets or illiquid strategies.

UCITS funds have a formal market risk management process which must be in place due to restrictions on the way value at risk is calculated and there must be regular stress testing. Additionally, they must offer, as they Brits say, fortnightly liquidity, at the very least.

Among the firms to have taken this approach include: Brevan Howard, GLG Partners, Man Group and Odey Asset Management – four large London-based managers. And more are expected to follow.

Three quarter of the survey respondents confirmed there is demand for such funds from retail networks and fund platforms or fund distributors. Interestingly, more than two thirds also had demand coming directly or indirectly from high-net-worth individuals, which is significantly more than the demand coming from institutional investors. And many aren’t convinced that they do any better a job of allaying investors’ concerns than managed accounts do, as the chart below shows.

Whether part of a bid among larger hedge fund firms to get ahead of the EU directive or just another way to offer a regulatory compliant fund with that fits with the new era of risk management, it remains to be seen how many of these funds survive and thrive. We’ll be interested to read the results of KdK’s survey in December 2010.

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…

Imagine if you will a guarded velvet rope in front of famed Tiffany & Co.’s flagship Fifth Avenue store, where the only way to gain access to even peek in the windows and see the shiny merchandise is to prove you have a large enough bank balance to buy something.

Don’t have six figures in the bank, or audited financial statements to prove it? Then no peeking at the goods, thank you very much.

That, in essence, is what Phil Goldstein, principal of New York-based Bulldog Investors and famed champion of sidelining the US Securities and Exchange Commission’s efforts to require all hedge fund managers to register, has been arguing is not only a violation of his and other hedge fund managers’ First Amendment rights, but outright stupid.

Goldstein has refined his analogies over the years spent fighting the SEC and other regulators, including Massachusetts Secretary of State William Galvin, to illustrate how asinine he feels various marketing and solicitation rules governing private funds are.

“You don’t have to be accredited to call up Rolls Royce and ask for a brochure or go to their Web site to get information about a car,” Goldstein has said. “Why do you need to be accredited to do the same thing with a hedge fund?”

But no analogy in the world could help him with his latest free speech case against Galvin, which a judge last month ruled that Bulldog couldn’t allow unqualified investors to access information on its Web site.

Bulldog argued in the case that an email request from an unaccredited potential investor was “insignificant” because “no actual injury occurred in that (the individual) did not purchase any securities, and was never interested in doing so,” the judge wrote in the lengthy ruling.

However, “No actual securities transaction is required to constitute injury; the injury in issue is the violation of Massachusetts law against offering unregistered securities, with its potential for erosion of regulatory protection of the capital markets that this Court discussed at length in its preliminary injunction decision.”

“On the facts alleged, Bulldog’s contact with Massachusetts was not fortuitous, attenuated, or involuntary, but was deliberate and intentional, despite notice of the potential consequences. The Secretary’s assertion of jurisdiction based on that contact imposes no unfairness.”

Bull-dog, says Goldstein, who on Sunday sent out an email noting that the case is more based on Galvin’s need to attack Bulldog, so to speak, than on any basis of fact, and who took some time out earlier this week to talk to at least one trade rag about why he is being wronged.

“Galvin’s rush to sue us without any meaningful investigation, his refusal to enter into settlement discussions even though no one was harmed, and his agreement in our separate civil rights action to stipulate that we did not say anything misleading or attempt to enter into an illegal transaction as a quid pro quo for us not deposing him or calling as a witness (presumably to avoid being subjected to potentially embarrassing questioning), suggest that his true motive from the beginning was to silence an ideological opponent,” Goldstein said, noting he will appeal the court’s decision.

Said Goldstein: “As Thomas Paine said: ‘the harder the conflict, the more glorious the triumph.’”

Perhaps being up 27% year to date is glorious enough?

Click here to read Goldstein’s full brief.

Click here to read the full court response to Galvin’s allegations.

Click here for more AllAboutAlpha.com coverage of Phil Goldstein.

By: Dr. Ranjan Bhaduri, CAIA, AllAboutAlpha.com Editorial Board and Hannah Wendling, AlphaMetrix Alternative Investment Advisors.

As recently examined here on AllAboutlpha.com, hedge fund regulation is a topic that has been discussed frequently throughout the past decade, with little material change in the United States.  Triggered by the 2008 financial crisis, however, hedge fund legislation seems imminent, and with hedge fund regulation pending in legislative bodies of the United States, European Union, and elsewhere, some experts anticipate an outflow of capital to countries with less stringent regulations.  In light of this, it may be useful to examine some of the current and pending regulatory laws in the US and beyond:

One Small Paragraph

The United States is reacting to calls for greater regulation through proposed bills to more closely monitor activities of alternative investment fund managers (AIFMs). Based on the bills which have been proposed thus far, the consensus on Capitol Hill seems to be that SEC registration (to increase transparency) is the preferred method to keep private advisors in check.

Current policies were put in place in the Investment Advisers Act of 1940, nine years before A.W. Jones created the first hedge fund, and few legislative changes have occurred in the past six decades to keep pace with the evolving financial industry. Most hedge funds are exempt from regulation due to one small paragraph: Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) states that an adviser need not register if he has fewer than 15 clients, and “client” can be interpreted to mean “fund.”

Notably, this provision, known as the “private adviser exemption” was upheld in 2006 in Goldstein v SEC, a lawsuit brought against the SEC in 2005 for its attempt to re-interpret the meaning of “clients” to mean “investors,” out of accordance with the rest of the 1940 Act. This provision in particular has been targeted by proposed legislation.

Regulatory flood gates opening

From the Oval Office is the proposed Private Fund Investment Advisers Registration Act of 2009. If enacted as proposed, it would eliminate the “private adviser exemption” and require registration with the SEC by investment advisors to private funds with $30 million or more assets under management. It contains an additional caveat which would allow the SEC to define a “client” however it wishes, effectively overruling Goldstein v SEC.

Of the bills introduced in Congress, the Senate’s Private Fund Transparency Act of 2009 (introduced by Sen. Jack Reed (D-RI)), closely mirrors the Oval Office proposal. It reflects it almost word-for-word, notably with the same elimination of the private adviser exemption and broadened power of the SEC to define terms, including “clients,” how it wishes.

A second Senate bill, the Hedge Fund Transparency Act (Sens. Levin (D-MI) and Grassley (R-IA)), focuses on private fund registration, as opposed to adviser registration. Under this proposal, any private fund with more than $50 million would be required to register with the SEC. Funds would be required to file annual disclosure statements which would be made publicly available, and which would identify investors and state the current value of assets in the fund.

The House of Representatives’ Hedge Fund Adviser Registration Act of 2009 (Reps. Capuano (D-MA) and Castle (R-DE)), is a no-frills proposed amendment to the 1940 Act. It deletes the private advisor exemption from the Investment Advisors Act of 1940, Section 203(b).

Most recently, three legislative discussion drafts were introduced in the House (Rep. Paul Kanjorski (D-PA), with similar regulatory aims, though exempting venture capital firms from its scope.

A flight to Switzerland…

Europe is facing similar legislative pressure. The Directive on Alternative Investment Fund Managers is an EU-wide bill which would, if enacted, tighten regulations on managers with assets greater than 100 million Euro. It has a similar emphasis on transparency, containing registration requirements, detailed reporting, and capital minimums for AIFMs. Proponents of the bill point to the 2008 financial crisis and argue that increased regulation is necessary: that hedge funds have become so entwined in the financial fabric of our society they could pose a systemic risk to the global economy.

However, the Directive is receiving strong resistance. The tougher rules which could result have led managers and industry experts to predict a move to Switzerland, which is not an EU member state, offering softer rules and lower taxes. There is a particular focus on potential flight from London, based on the combination of stringent regulation from the Directive and an unappealing proposal to implement 50% income tax.

…with stops in Jersey and Monaco.

An alternative would be Jersey, the British Crown Dependency, which would not be subject to the EU Directive and which offers regulatory exemptions to funds with solely institutional or professional investors. In addition, Jersey is a low tax location, where the maximum personal income tax rate does not exceed 20%.

The difficulty with relocating to avoid EU regulation, however, is that the Directive contains provisions which would inhibit outside funds from accessing the European market. One solution is EU microstates:  Monaco, for example, may become particularly attractive by virtue of being a French protectorate, and so will not be shut out by the EU directive but still has the benefit of 0% income tax.

Regulatory “Competition”

Alternatively, managers may look to move funds to Asia, and may benefit from the ongoing competition between Asian nations to attract new funds. Regulatory standards vary between countries, but many are offering incentives to lure new managers following the 2008 financial crisis. Asian countries were hit particularly hard—assets managed in Hong Kong shrank from $90 billion in early 2008 to $55 billion today.

The landscape is changing in Taiwan, in which historically tight regulation from the Financial Supervisory Commission is gradually being supplanted in a bid to expand the country’s regional presence. As of October 12^th, for instance, Taiwan will now allow the trading of both stock futures and stock index futures.

In Japan, funds are required to register with the Financial Services Agency, the Japanese equivalent of the SEC. Under a 2008 amendment to the Financial Instruments and Exchange Law, however, the reporting requirements are much reduced for funds which are limited to professional QEP investors.

In China, massive overhaul of investment fund regulations is currently underway, intended to see the China Securities Regulatory Commission’s power expanded to include supervisory oversight of China’s private funds.

Elsewhere in Asia, regulation in Singapore is governed by the Monetary Authority of Singapore, under which managers can be exempt from regulation if they have 30 or fewer clients, all of whom are financially sophisticated. In addition, managers are not required to maintain a physical presence in Singapore, and can instead offer their funds through private banks.

Some managers have estimated operations’ costs in Singapore at one-third the level of London. In contrast, in Hong Kong lawmakers prohibited exemption from licensing when the Securities and Futures Ordinance came into force in April 2003. Since that time, all hedge fund managers engaging in regulated activities must be licensed by the Hong Kong Securities and Futures Commission.

Few places to hide

Whether we will see new legislation cause a migration of managers to less-regulated countries is still uncertain, but it is clear that in regions all over the world, the hedge fund industry is moving toward increased transparency.

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.

Common Element

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.

“Self Capture”

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.

Two Forms

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.”