Hedge funds have traditionally been structured to deliberately sidestep legislative strictures, disclosure and other compliance requirements imposed on institutions raising funds for their activities, and as such have operated within the cracks of the law. Especially in the aftermath of the 2008 Global Financial Crisis, there has been much discussion on whether hedge funds should be regulated. Those disfavouring regulation see hedge fund activity as generating efficiency in the marketplace including securities markets by ‘mitigating price downturns, bearing risks that others will not, making securities more liquid, and ferreting out inefficiencies’ (Shadab, 2007). Those fearful of financial market failure and its contagion effects, however, argue for varying degrees and forms of regulatory intervention aimed at several different levels: the fund itself (as with the case of a corporate entity); the managers of the fund (in respect of their investment strategies); investors into the fund (investment unit holders as well as creditors); and intermediaries such as broker dealers who facilitate the transactions of the fund (‘prime brokers’). My forthcoming paper (The Regulation of Hedge Funds,  Journal of Business Law, Issue 7, 537-564) evaluates these claims, as well as exploring the most effective point of regulatory intervention from an investor perspective.
The recent review of the Australian financial system and its regulatory framework by the Financial System Inquiry 2014 (Murray Inquiry) has recommended the adoption of reforms with respect to consumer protection. If adopted, it will have the capacity to influence the operations of Australian hedge and investment funds. For example, Recommendation 22 of the Report suggests regulators ‘introduce a proactive product intervention power that would enhance the regulatory toolkit available where there is risk of significant consumer detriment.’ The recommended intervention instruments therein are: ‘amendments to marketing and disclosure documents;’ ‘warning to customers, and labelling or terminology changes;’ ‘distribution restrictions;’ and ‘product banning.’ One of the stated goals of the mechanism is to reduce detriment arising from poorly understood products. Indeed, this would be a useful mechanism to manage the risks posed by high-risk hedge and other investment funds. However, to ensure that regulation is commensurate with risk it is necessary to have information on industry practices which arguably can only be accessed from the funds themselves. This requires that there be cooperation between national regulators and the hedge funds industry to achieve high levels of symmetry between regulatory goals and industry practices.
One way to mitigate the high level of risk exposure of investors into hedge funds is to require investors to have well balanced portfolios. Existing approaches to investor protection such as benchmark qualifiers by reference to investor sophistication, cap on the number of investors, or by determination of whether the class of investors needed protection as articulated in the Ralston Purina case, are inadequate measures considering the lack of information disclosure by the funds. Such sophistication standards are far from adequate to navigate the risks posed by funds’ exposure to globalised financial markets dominated by volatility and high frequency and other algorithmic trading strategies as part of their trading strategy. However, attaining balanced portfolios requires extensive search costs which only very large investors could afford. An alternative would be to limit investment in hedge funds to institutional investors (banks, insurance companies, pension funds), and very substantially resourced investment bodies such as mutual funds and investment funds with funds in excess of US$50 million. Correspondingly, entities with less substantial resources should be encouraged to invest through institutional investors or diversified fund of funds.
Recent research has also singled out the high probability of operational risk in hedge funds, given the combination of non-application of investor protection provisions, non-disclosure of their trading strategies or of their investments, and the restrictions on investors’ exit from these funds. Moreover, while each jurisdiction continues to preserve its own regulatory structure in respect of the amount and nature of disclosure required in respect of hedge funds and their activities, hedge funds operate within the cracks of regulatory provisions with more or less borderless financial services markets. This makes co-operation between both national regulators and the hedge fund industry to achieve set regulatory goals all the more imperative.
In this context, a useful approach to limiting the downside of high risk investments would be to require these funds to set up a financial cushion against this eventuality. A much tried and now well received guide for this is found in the capital adequacy standards of the Bank for International Settlements (Basel Accords) as a buffer against financial institutions risk. These Capital Adequacy standards require financial institutions falling within the ambit of each national regulator to have between 8-12% of their risk weighted capital as a buffer against potential credit, market, operational and liquidity risk.
Razeen Sappideen is Foundation Professor of Law at the University of Western Sydney.