The regulation of hedge funds

This article examines how regulators in the US, UK, and Australia have attempted to address the risks to investors in hedge funds, to parties transacting with these funds, and the impact of their activity on the financial system generally. Investments in hedge funds are regarded as high-risk investments because they focus largely on particular transactional opportunities (interest, currency, corporate control and the like), and rely on high leverage and the use of derivative instruments (options, futures, SWAPS and their variations).1 The use of derivative instruments exposes the user to margin calls and to requirements of high levels of liquidity at times when their resources as well as those of financial markets generally are thinly stretched. Additionally, there is also the issue of liquidity at the investor level, where, e.g., investor funds are tied into the fund for a period of time. 2 Furthermore, as they seek to operate within the cracks of the law and avoid investor protection laws, they limit disclosure of their activities and investment strategies, and consequently generate substantial information asymmetries, asset price volatility and increased risks for investors. These outcomes raise the issue as to what kind of investor would be appropriate to invest in hedge funds, and whether any measures should be taken to make investment in hedge funds less risky. The discussion in the article is structured as follows. The first part discusses the nature and activities of hedge funds. The second part canvasses the arguments for and against the regulation of hedge funds. The third part examines the existing regulatory framework governing fund-raising activity, and the fourth part concludes by examining the need to address the downside from possible ways of addressing the problems identified earlier.