1.

Introduction 2.

Investor protection 3.2 3.3 3.3.1 3.3.2 General compliance concerns Systemic risk Problem Regulatory strategies

4. 4.1 4.1.1 4.1.2

Self-regulation The self-regulation game Interests of regulators Collective interests of the industry

4.1.3 4.2

Interests of individual firms: the problem of enforcement Limits of self-regulation

5. 5.1 5.1.1 5.1.2 5.1.3 5.2 5.2.1 5.2.2 5.2.3 5.2.4

Government regulation Regulatory competition Regulatory arbitrage Regulatory competition as state capture Evaluating regulatory competition Regulatory harmonization Incentives to harmonise The mechanics of harmonization Harmonising hedge fund regulation Evaluating harmonization

6.

Conclusion

Abstract After the global financial crisis, systemic risk regulation has taken centre stage. Many consider hedge funds a potential threat to financial stability. Regulating hedge funds, however, is necessarily a transnational challenge because no national government alone can effectively control the systemic risks affecting its economy. This article takes the example of hedge funds for a case study of emerging transnational regulation. After an introduction to hedge funds and the reasons for regulating them, it considers the possible elements of a transnational regulatory regime for hedge funds: transnational industry self-regulation, including such induced by the government, regulatory competition between government regulators, and harmonisation of government regulation. The main conclusions are: self-regulation cannot substitute fully for government regulation in controlling systemic risks caused by hedge funds. Equally, regulatory competition tends to undercut systemic risk regulation. Effective transnational regulation can only be accomplished through harmonisation of government regulation. Such harmonisation is likely to arise if regulation is needed to control systemic risk in global financial markets.

1. INTRODUCTION The financial crisis has been a powerful reminder of how interconnected financial markets have become. Originating in the US real estate market, the crisis swiftly affected financial institutions in Europe and elsewhere. A steep recession ensued in much of the industrialised world. In view of the dire consequences, policymakers and scholars have begun to devote greater attention to financial crisis prevention. In doing so, they need to acknowledge that causes and effects transgress the boundaries of nation states. As financial markets are converging, regulatory governance has to keep pace. The term transnational regulation is meant to capture the response to this challenge. Like its sibling transnational law, it starts out from cross-border activities and effects as the object of regulation. Yet it also carries with it the notion that regulation can come in forms other than the conventional one of legal rules imposed and enforced by national

governments.1 Such other modes of regulation include non-binding or less binding rules (soft law) as well as self-imposed or self-enforced rules (private ordering). Even where regulation ultimately remains the business of government, it must reflect the transnational scope of the regulated activity. This can lead governments to coordinate their regulatory strategies, thus adding another layer of policy debate and possibly rules at the international level. The following analysis embraces this broad concept of transnational regulation for a case study of the hedge fund industry.2 Hedge funds are among the most important innovations transforming the financial system during the last decades. Their growth has been staggering. In 1990, assets under management in hedge funds were believed to be little more than 50 billion US dollars. 3 Assets increased to around 400 billion US dollars in 2000, over 1,350 billion US dollars in 2005 and over 2,100 billion US dollars in 2007. The financial crisis caused a decline to a still impressive amount of around 1,500 billion US dollars in 2008, with a recovery to 1,700 billion US dollars in 2009. While this is still a minor fraction of global financial assets, hedge funds are particularly active players and therefore have a much stronger impact on financial markets than their mere volume would suggest. At the same time, they have not been blamed as a (.primary) cause of the recent financial crisis. Of course, hedge funds can still pose a threat to financial stability under different circumstances. The next crisis will almost certainly differ from the last one. If one believes that regulation can reduce the risk of future calamity, it should cover all relevant financial markets and institutions, including hedge funds if necessary. In examining the particular area of hedge funds, this article aims at providing a comprehensive account of the interests involved and mechanisms at work in transnational regulation. Its main contribution lies in combining and evaluating the different elements of a transnational regulatory regime for hedge funds, as well as in analysing their interaction. These elements consist of industry self-regulation, including such induced by the government, regulatory competition between government regulators, and harmonisation of government regulation. Covering the full spectrum of regulatory arrangements is essential for a research agenda in transnational regulation. Even though . G.-P. Calliess and P. Zumbansen, Rough Consensus and Running Code: A Theory of Transnational Private Law (Oxford, Hart 2010); C. Scott, Transnational Law as Proto-Concept: Three Conceptions, 10 German Law Journal (2009) p. 859; C. Tietje and K. Nowrot, Laying Conceptual Ghosts of the Past to Rest: The Rise of Philip C. Jessup's Transnational Law in the Regulatory Governance of the International Economic System 2 T. Caldwell, The Model for Superior Performance, in J. Lederman and R.A. Klein, eds., Hedge Funds, Investment and Portfolio Strategies for the Institutional Investor (McGraw-Hill, New York 1995) p. 1. 3 M.R. King and P. Maier, Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks, 5 Journal of Financial Stability (2009) p. 283, at p. 285
1

hedge funds are essentially beyond the reach of individual governments, there is reason to believe that an adequate transnational regulatory response can and will emerge if it is needed. While transnational regulation differs significantly from the traditional model of regulation within a single nation state, regulatory outcomes need not be inferior, on the whole, or biased towards laissez-faire. To reach this conclusion, the study does not take a strong view on whether and how the hedge fund industry should in fact be regulated. More modestly, it looks at the incentives and constraints of the relevant players to determine if transnational regulation is likely to consider available information and reflect the relevant concerns. The aim is to evaluate the process of transnational regulation, not (or only by inference) the outcome. The article starts out with an exposition of hedge funds and their role in financial markets (section 2). It goes on to analyse the need for regulation, which is by no means uncontroversial, at least as regards direct regulation by the government. Proponents have cited the protection of hedge fund investors and a concern for compliance with market regulation and other laws as justification for government oversight. Yet the more important argument, particularly for transnational regulation and in light of the recent financial crisis, is the potential risks hedge funds pose to the stability of the global financial system (section 3). Systemic risks are transnational in that they regularly exceed the scope of any single national jurisdiction. A natural response would be to entrust regulatory responsibility to non-government actors, which are not subject to territorial restrictions. As it turns out, however, market players lack adequate incentives to restrict systemic risk. The industry, collectively, is prepared to establish a self-regulatory scheme, but only to forestall more intrusive government intervention. Even to the extent that the industry succeeds in writing its own rules, enforcement remains deficient without the government taking an active role. In a transnational approach to regulating systemic risk, self-regulation only complements but cannot substitute government regulation (section 4). The burden of mitigating systemic risk thus remains with governments. National regulators, however, face the difficulty that firms in the hedge fund industry can choose the most favourable regulatory environment (regulatory arbitrage). Jurisdictions find themselves competing for hedge fund business by offering less costly regulation or no (direct) regulation at all. Such regulatory competition can improve the quality of regulation provided by governments along certain dimensions, but it deprives national regulators of the ability to adequately control systemic risk (subsection 5.1). To regain power, governments have to coordinate their regulation - they need to

curb regulatory competition by forming a cartel. Accomplishing such regulatory harmonisation requires the consent of all relevant jurisdictions. To exert pressure on other states, an emerging cartel can condition access to its investor base and other relevant resources on participation in the coordination endeavour. Harmonisation thus builds on elements of both persuasion and coercion. While the bargaining process is not a democratic one, it is likely to respond to the concerns that should be relevant for regulation. Accordingly, one can read the ongoing process of harmonising hedge fund regulation as a reaction to lessons from the financial crisis (subsection 5.2). Section 6 summarises and concludes. WHAT ARE HEDGE FUNDS? If hedge funds are to be regulated, one should know what they are. Like the more familiar mutual funds, hedge funds are asset pools for investment purposes operated by an asset management firm the manager for short - and funded by investors with a share in the pooled assets. The difficult part lies in distinguishing hedge funds from other investment vehicles and mutual funds in particular.4Legally speaking hedge funds are defined simply as those investment funds that are not governed by mutual funds regulation. This definition, however, fails to recognise the economic characteristics of hedge funds and hence the potential reasons why they should (or should not) be subject to specific regulation. While it is sometimes said that hedge funds are too diverse to allow for a non-trivial definition,5 they differ in one important aspect from mutual funds even if only by degree. This common characteristic relates to the source of returns that hedge funds are supposed to deliver. There are two basic methods of seeking returns from an investment in asset markets. One option is to invest indiscriminately in a particular class of assets, such as Asian equity, government bonds or copper. For many types of assets, a passive investment strategy can be expected to earn a positive return in the long run because markets are at least somewhat efficient. 6 In asset management lingo, such return from a passive exposure to market risk are referred to as beta.7 Even though most
4

Hedge funds can also be hard to distinguish from private equity funds, see Financial Services Authority (FSA), Private Equity: A Discussion of Risk and Regulatory Engagement (Discussion Paper 06/6, 2006), at para. 3.1-3.144, available at: <http://www.fsa.gov.uk> 5 The Regulatory Environment for Hedge Funds : A Survey and Comparison (2006), at pp. 5 and 22, available at: <http://www.iosco.org>. 6 K.J.M. Cremers and A. Pettajisto, How Active Is Your Fund Manager? A New Measure That Predicts Performance, 22Review of Financial Studies (2009) p. 3329. 7 M.C. Jensen, The Performance of Mutual Funds in the Period 1945-1964, 23 Journal of Finance (1968) p. 389.

mutual fund managers engage in active securities picking, the greater part of mutual fund returns stems from tracking the market.8 It is for this reason that performance is typically presented in relation to a market benchmark (for instance, a stock market index). By contrast, a much more challenging investment strategy consists of betting on mispricings in the market - exploiting gaps between the current market prices and the underlying value of assets (arbitrage 9 ). The returns from such an active approach may be labelled as alpha.10 The basic idea of a hedge fund is to seek only (or mainly) alpha returns and to do without the beta component. Eliminating beta seems attractive because market returns are inexorably linked to market volatility. The key promise of hedge funds is independence from the ups and downs of the market or absolute returns instead of a markup relative to market performance. Of course, alpha does not come without risk either. Whether absolute returns turn out to be positive or negative depends on the skill of the individual asset manager (and on luck, to be sure). Hedge funds should thus be defined as investment funds that aim primarily at alpha returns from actively exploiting mispricings. Alfred W. Jones is credited for having invented the hedge fund in 1949. He pioneered a financial technology to purge beta risk from the fund's returns. While investing in stocks that he considered undervalued, he would hedge this position against market risk by short-selling other securities. This short position would rise when the market went down (and fall when the market went up). Combined with the long position in the stocks that Jones had selected, his fund stood to win if his picks performed better than the market. Today, only a fraction of the hedge fund universe employs this particular method to focus on alpha returns. There is even a large group of hedge funds that intentionally incur market risk. Yet unlike mutual funds, they do so in an attempt to time the market, that is, to go long before an upswing and to go short before a downswing. Over time, such strategies still pursue absolute returns independently of market conditions. Most mutual funds also advertise themselves as being actively managed. Mutual fund regulation in the European Union now widely permits the use of derivatives, 11 which effectively allows
8

K.J.M. Cremers and A. Pettajisto, How Active Is Your Fund Manager? A New Measure That Predicts Performance, 22Review of Financial Studies (2009) p. 3329. 9 R.M. Stulz, Hedge Funds: Past, Present, and Future, 21 Journal of Economic Perspectives (2007) p. 175, at pp. 180-181. 10 T. Caldwell, The Model for Superior Performance, in J. Lederman and R.A. Klein, eds., Hedge Funds, Investment and Portfolio Strategies for the Institutional Investor (McGraw-Hill, New York 1995) p. 1. 11 T. Garbaravicius and F. Dierick, Hedge Funds and Their Implications for Financial Stability (European Central Bank Occasional Paper Series No. 34, 2005), at pp. 8-10.

mutual funds to pursue hedge fund strategies.12 The fact that managers can claim - and investors concede - such a sizable share of returns strongly indicates that their skill and effort is the single critical factor in hedge fund performance. 3. WHY REGULATE HEDGE FUNDS? Mutual funds are often sold directly to retail investors. Imposing regulation on them seems uncontroversial.13 By contrast, opinions vary on whether hedge funds and their managers ought to be regulated and, if so, what issues should be addressed. Advocates of hedge fund oversight rely on three different lines of argument: the protection of investors in hedge funds (subsection 3.1), a general concern that hedge funds might be a fertile ground for illegal trading behaviour (subsection 3.2), and a potential threat to the stability of the financial system (subsection 3.3). As systemic stability is at the heart of the current debate, the analysis in later sections will focus on this issue. 3.1 Investor protection Investing in mutual funds generates the returns of the particular market segment, compounded by some deviation due to active securities picking (and, of course, an additional layer of fees and other costs). Insofar as the respective market is relatively efficient, the error risk in selecting a mutual fund is limited. It consists primarily of picking the wrong market segment; the quality of the individual asset manager carries less weight. In this regard, hedge funds differ fundamentally from mutual funds. Because hedge funds are devoted to exploiting inefficiencies in the market, their expected returns fully depend on their managers' ability to spot arbitrage opportunities. A less skilful or unlucky manager will take positions that lose heavily if what he perceived as a mispricing fails to disappear or actually widens. Hence, in the business of chasing alpha returns the quality of the asset manager is the key ingredient. Investors may not be very adept at evaluating asset manager quality. To make matters worse, hedge funds cannot disclose a lot about their strategies because their alpha returns depend on having an informational advantage over other market players. As a consequence, the information asymmetry should be more pronounced for hedge funds than for mutual funds , and so should be the need to prevent an adverse selection of low-quality fund managers.

12

W.K.H. Fung and D.A. Hsieh, Hedge Funds: An Industry in Its Adolescence, 91 Federal Reserve Bank of Atlanta Economic Review (2006) p. 1, at pp. 7-8 13 A. Khorana, et al., Explaining the Size of the Mutual Fund Industry around the World, 78 Journal of Financial Economics (2005) p. 145, at p. 156.

The problem is attenuated by the fact that hedge fund managers tend not to market their services to retail investors.14 In part this is due to regulatory constraints,15 but it arguably also reflects the information asymmetry, which makes hedge funds less suitable for retail investors. 16 Traditionally, hedge funds served mainly wealthy individuals.17 With the tremendous growth of the industry, investor composition shifted towards institutional investors, which are now reported to own 74 percent of hedge fund assets. Both affluent individuals and institutions - funds of hedge funds, pension funds, insurers, banks and endowments - invest significantly larger amounts of money than retail investors and can afford an extensive screening and selection process to cope with the information asymmetry. Because hedge fund investors can be expected to be sophisticated, there appears to be no point in imposing mandatory safeguards. It seems questionable that a regulator should be better able to determine the amount and type of information necessary to evaluate the integrity and skill of a given hedge fund manager. With respect to secrecy, hedge fund managers can feel somewhat more comfortable disclosing information to a limited audience of individual clients and market intermediaries than making the information available to the general public. Also, professional investors should know for themselves whether a particular fee scheme sets the right incentives or whether additional monitoring and constraints are needed. To many, investor protection in hedge funds is therefore no cause for concern, let alone a justification for regulation. 3.2 General compliance concerns Hedge fund managers have potent incentives to deliver large returns in order to attract investors and earn performance fees. Given that alpha returns derive from predicting market prices of financial assets, hedge fund managers may be more tempted than others to engage in illegal investment strategies. Examples of violations or questionable practices include insider

14

H.B. Shadab, Fending for Themselves: Creating a US Hedge fund Market for Retail Investors, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-29. 15 S.M. Davidoff, Black Market Capital, 2008 Columbia Business Law Review (2008) p. 172. 16 T.A. Paredes, On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission, University of Illinois Law Review (2006) p. 975, at pp. 990-998, particularly at pp. 992-99 17 J. Danielson, et al., Highwaymen or Heroes: Should Hedge Funds Be Regulated?, 1 Journal of Financial Stability (2006) p. 522, at pp. 527-528. But see, e.g., R. Sklar, Hedges or Thickets: Protecting Investors from Hedge Fund Managers' Conflicts of Interest, 77 Fordham Law Review (2009) p. 3251 (arguing for investor protection specifically against conflicts of interest).

trading,18 market manipulation.19 and participating in (alleged) fiduciary breaches by other asset managers.20 or investment banks. So-called activist hedge funds have also been criticised for the aggressive tactics they use to influence the corporate governance of publicly traded corporations. Of course, any general laws and regulations, such as those against fraud, insider trading or market manipulation, apply equally to hedge funds and their managers. In this sense, there is no need for regulation directed specifically at hedge funds. At the same time, however, regulatory oversight of market participants can help to ensure compliance with applicable legal rules. It does so through record and filing requirements, organisational mandates such as an independent compliance function and inspections by the supervisor. Facilitating enforcement only for professional market participants - but not for private investors - is a consistent policy choice in that professionals typically handle larger amounts and are more sophisticated, which makes them a greater risk for market integrity. Nonetheless, compliance alone is hardly a compelling argument for transnational attempts at regulating hedge funds. The international debate is instead concerned primarily with controlling potential threats to overall financial stability. 3.3 Systemic risk Problem Even before the financial crisis of 2008, hedge funds had been viewed as a threat to financial stability, with the collapse of Long-Term Capital Management (LTCM) in 1998 providing the quintessential example. What imperils financial stability is referred to as systemic risk. There is no widely accepted definition of the term. The basic idea is that of a chain reaction of failure or large losses in financial institutions or financial markets, with the effect that the supply of capital to the economy is significantly impaired. From a policy perspective, a central feature of systemic risk is that single individuals or firms cannot protect themselves at reasonable cost as long as they participate, directly or indirectly, in financial markets. For example, even the most conservative bank can be bankrupted when depositors lose confidence in the banking system at large or when a
18

R.A. Booth, Who Should Recover What for Late Trading and Market Timing?, 1 Journal of Business and Technology Law(2006) p. 101; P.G. Mahoney, Manager-Investor Conflicts in Mutual Funds, 18 Journal of Economic Perspectives (2004) p. 161, at pp. 173-176; E. Zitzewitz, Who Cares about Shareholders? ArbitrageProofing Mutual Funds, 19 The Journal of Law, Economics and Organization (2003) p. 245. 19 R. Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Fourth Estate, London 2001); F.R. Edwards, Hedge Funds and the Collapse of Long-Term Capital Management, 13 Journal of Economic Perspectives (1999) p. 189, at pp. 197-207. 20 A.W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008 (2008), available at: <http://ssrn.com/abstract=1301217> (central bankers know it when they see it); S.L. Schwarcz, Systemic Risk, 97 Georgetown Law Journal (2008) p. 193, at pp. 196-204 (citing various attempts at defining systemic risk);

great number of debtors collapse all at once. This is not to say that systemic risk is unrelated to individual risk taking. On the contrary, the level of systemic risk follows from individual choices regarding financial risk. Yet the prudence applied by a single individual, firm or institution has little influence on the aggregate amount of systemic risk in the economy. Keeping systemic risk low is therefore a public good.21 The failure of a single market participant alone, however large it may be, is not an instance of systemic risk because it does not affect the working of the financial markets generally. Individual failure causes harm only to creditors, shareholders and other parties dealing directly with the person or entity. The corresponding risk can be managed using the standard legal toolbox, including contractual protections and legal rules from corporation law, securities law and bankruptcy law, among others. These safeguards rest on each actor's incentive to limit his own risk exposure. Only insofar as the damage extends beyond the immediate counterparties do market participants lose their ability, and hence their incentive, to monitor and control risk; only this type of risk qualifies as systemic and as a true externality. Accordingly, if a hedge fund's immediate investors or creditors suffer because the fund's investments turn sour, this does not raise a systemic risk issue. A prominent example is the collapse of Amaranth Advisors, which in 2006 lost over four billion US dollars tallying the largest hedge fund loss on record. Investors had to bite the bullet as the fund was orderly liquidated.22 In theory, a hedge fund may trigger a systemic event if, by bankrupting one of its counterparties, it sets off a chain reaction of additional failures by financial institutions. Hedge funds rely on one or more investment banks as prime brokers for a broad range of services, including brokerage, clearing and settlement. More importantly, prime brokers also extend credit to hedge funds through securities lending, derivative contracts and other transactions.23 While they use the fund's assets as collateral and tend not to lend on an unsecured basis, 24 prime brokers bear a residual credit risk if asset prices fall too quickly to be liquidated in order to cover the fund's liabilities. To further

21

L.B. Chincarini, The Amaranth Debacle: A Failure of Risk Measures or a Failure of Risk Management, 10 Journal of Alternative Investments (2007) p. 91. 22 M.K. Brunnermeier and L.H. Pedersen, Market Liquidity and Funding Liquidity, 22 Review of Financial Studies (2009) p. 2201 23 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220. 24 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220.

reduce credit risk, prime brokers require an additional margin.25 These precautions may be the result of bad experience and pressure from bank regulators.42 But as matters stand, the risk of prime broker failure hinges on the value and liquidity of the collateral. In this regard, hedge fund exposure raises essentially the same issues as the assets held for the bank's own account. Therefore, a systemic event will likely not be the result of a hedge fund default leading to the collapse of a prime broker. Rather, hedge funds cause systemic risk through their impact on market prices. The aim of hedge funds is to make a profit from exploiting mispricings. Irrespective of whether a manager's estimate of fundamental asset value is correct, there is a significant risk that hedge funds suffer losses because fundamentals or the markets turn against them.26 Losses may be realised if the position is liquidated, or they may appear only on paper as assets are marked to market. In either event, the fund's financiers will start worrying. Hedge fund investors are very sensitive to poor performance and react at short horizons by withdrawing money. Managers impose redemption and notice periods to control outflows but investors accept restrictions only to a limited degree. Even when investors cannot withdraw immediately, managers have to prepare for redemptions that will inevitably follow the losses. Large losses therefore often entail a forced liquidation of positions. But there is an even stiffer financing constraint: hedge funds can leverage their positions not just by putting their investors' capital to work but also by borrowing from their prime brokers. As noted above, prime brokers require hedge funds to post collateral in the full amount of the credit exposure plus an additional safety margin. When the market value of the security falls below the required amount, the prime broker will demand additional collateral. If the hedge fund does not meet the margin call, the bank can (and will) sell assets to cover its credit exposure. To avoid losing control of its assets, hedge fund managers will be anxious to maintain an equity cushion and liquidity in excess of current margin requirements, which forces them to liquidate positions well ahead of potential margin calls. In sum, there is a considerable risk that hedge funds lose their financing when they need it most to avoid transforming paper losses into real losses.27 What turns this into a systemic risk is the effect that forced liquidations have on market prices. Hedge funds are smart money that pushes market
25

M.K. Brunnermeier and L.H. Pedersen, Market Liquidity and Funding Liquidity, 22 Review of Financial Studies (2009) p. 2201. 26 R. Bookstaber, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation (John Wiley, Hoboken 2007), at pp. 212-220. 27 L.H. Pedersen, When Everyone Runs for the Exit, 5 International Journal of Central Banking (2009) p. 177; A.E. Khandani and A.W. Lo, What Happened to the Quants in August 2007? Evidence from Factors and Transactions Data (2008), available at: <http://ssrn.com/abstract=1288988>.

prices towards fundamental value. Their role in policing mispricings includes providing liquidity for other market participants:28 orders from investors can move prices even if fundamental asset values remain the same. Providing liquidity means preventing such an unjustified price change by taking the opposite side of the transaction. Hedge funds are credited with supplying liquidity for a broad variety of financial assets, sometimes to the point that certain markets would not exist without hedge funds. Given that the business model of hedge funds consists of correcting prices and providing liquidity, they often end up as the marginal buyer or seller determining the price of the asset. This is especially likely in asset markets that depend on hedge funds for liquidity. If hedge funds, as marginal buyers or sellers, determine the market valuation of certain assets, prices change when they are forced to sell or buy in order to raise cash or close their positions. As long as hedge funds hold only small positions, other traders may be ready to step in. However, when the market expects a large and extended dissolution of hedge fund holdings, the only rational strategy for other players may be to wait on the sidelines until hedge funds have unloaded their positions. As a consequence, market liquidity dries up and hedge funds' trades move markets more against their positions, causing more losses and hence more forced liquidations.In this way, the vulnerability of individual hedge funds becomes contagious. Price changes translate into book losses which trigger more forced buying or selling, which in turn brings more traders into trouble and prevents them from stemming the tide. The disease is also likely to spread to other markets. In their frantic attempts to raise cash and avoid realising losses, and hedge funds other traders will start selling other assets, thus dragging other markets into the spiral. Recent empirical research points to a common risk factor that shows up in hedge funds returns only in times of crisis, which strongly indicates hedge funds contagion.While the LTCM breakdown in 1998 is the most famous example, the so-called quant meltdown of August 2007 is arguably more illustrative of how hedge funds might contribute to a systemic crisis. In this episode, the emerging subprime mortgage crisis caused a number of hedge funds to unravel in spite of their sophisticated strategies having little if any connection with the troubled mortgage securities. The fire sales led to sudden price swings in various markets.29 Ironically, the threat to systemic stability results precisely from the benefit that hedge funds create for financial markets. Other players get into trouble because
28

H.B. Shadab, The Challenge of Hedge Fund Regulation, 30 Regulation (2007) p. 36, at p. 40; see also generally on hedge fund leverage, Garbaravicius and Dierick, supra n. 17, at pp. 28-32. 29 S. Malliaris and H. Yan, Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices (2009), available at: <http://ssrn.com/abstract=1291872>.

they rely on the liquidity and price efficiency provided by hedge funds. The damage consists of a benefit being withdrawn unexpectedly.

Regulatory strategies
In their very role as arbitrageurs and liquidity providers, hedge funds can cause or amplify potentially devastating disruptions of markets and financial institutions. Because individual hedge fund managers cannot control the amount of systemic risk in the economy, they do not consider the implications of the amount of risk they incur to achieve performance. Of course, no manager positively wants his hedge fund to go bankrupt. Hedge fund managers therefore have incentives to control risk by limiting leverage and hedging their bets. At the same time, however, some probability of failure is inevitable, and higher risks lead to larger returns. As long as financial stability does not enter their calculus, managers will incur risk beyond the social optimum. Internalising the systemic risk externality is a worthy errand for regulation. How it can be accomplished is a more difficult question. A comprehensive discussion is beyond the scope of this article, but it will be helpful to give a basic sense of the regulatory options. Systemic risk is a familiar theme from bank regulation. Prudential oversight of banks, at its core, consists of capital adequacy rules: the rules limit the financial risk which a bank can incur as a function of its capital endowment. Differently put, for a given amount of risk, banks are required to maintain a certain amount of equity to reduce the likelihood of default. The leverage restriction relates to a measure of risk that is both highly sophisticated and complex. It might seem straightforward to adopt this same model for hedge funds, that is, to treat and regulate them as banks. Such a far-reaching proposal, however, is conspicuously absent from the debate, and for good reason.30 Hedge funds differ fundamentally from banks. The key distinctive feature is the composition and nature of hedge funds' financiers. Banks have a large number of weak creditors in the sense that they neither demand security nor monitor the bank's credit standing. This blind trust relies to some degree on prudential oversight, which may well reflect an efficient centralisation of monitoring. It could be valuable economically if the solvency of certain financial institutions is beyond doubt, the paradigmatic example being the use of bank deposits.31 Be this as it may, hedge funds face entirely
30

Professor Stout develops a similar argument for procedural duties under the business judgment rule, see L.A. Stout, In Praise of Procedure: An Economic and Behavioral Defense of Smith v. Van Gorkom and the Business Judgment Rule, 96 Northwestern University Law Review (2002) p. 675, at pp. 688-691;
31

S.J. Choi and J.E. Fisch, How to Fix Wall Street: A Financing Proposal for Securities Intermediaries, 113 Yale Law Journal (2003) p. 269, at pp. 304-306 (analysing the similar problem of financing securities market information intermediaries).

different financing conditions. They borrow from one or very few sophisticated prime brokers. These strong creditors insist on being more than fully secured, thus requiring a minimum amount of equity. As a consequence, hedge funds are effectively prevented from betting their creditors' money.32 Losses fall on the fund's (equity) investors, which are rather sophisticated and can hardly develop a false sense of security. The capital structure of hedge funds thus ensures much stronger incentives for private monitoring than are present for banks. Given how difficult it is to measure risk and to determine adequate limits, it is unlikely that bank style prudential oversight can make any improvement on the private constraints already in place in the hedge fund industry.33 A more promising path for hedge fund regulation is to support and enhance private risk monitoring. While private monitoring, presumably, is superior to imposing direct leverage restrictions, the incentives to control risk are too weak insofar as the main players - hedge fund managers, prime brokers and investors - ignore the systemic risk externality. In addition, many actors make decisions on behalf of others. Agency problems can exacerbate risk-taking because agents tend to exercise less care and may create the appearance of higher returns by incurring larger risks.34 Short of directly regulating the level of permissible risk, a general approach to instil greater caution consists of eliciting more information than the relevant players would either provide or demand on their own. The underlying assumption is that information will be used to reduce risk once it is available. An example of this regulatory approach is imposing a duty on managers to disclose more risk-related information or, conversely, requiring prime brokers or investors to ask for more information before financing the fund's investments. It seems plausible that counterparties will consider specific risks when they rise to their attention. Likewise, regulation can compel managers to devote more time and resources to assessing the fund's risk exposure. Once a risk management function is set up and starts evaluating risk, there is a good chance that decision-makers are going to heed its warnings. Regulation can enhance the information environment for private risk-taking in yet another important respect. In a systemic market event, forced liquidations become contagious because other traders hold similar positions. To assess the risk of a market collapse it is therefore not
32 33

H.B. Shadab, The Challenge of Hedge Fund Regulation, 30 Regulation (2007) p. 36, at p. 40; S. Malliaris and H. Yan, Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices (2009), available at: <http://ssrn.com/abstract=1291872>. 34 L.A. Stout, In Praise of Procedure: An Economic and Behavioral Defense of Smith v. Van Gorkom and the Business Judgment Rule, 96 Northwestern University Law Review (2002) p. 675, at pp. 688-691;

enough to know one's own position and that of one's immediate counterparties. What really matters is the aggregate exposure of all market participants who might be forced into liquidating their holdings, as well as the probability of such an event (indicated, e.g., by the amount of leverage). With regard to such aggregate information, the under incentive to control risk is further aggravated by a collective action problem: market participants are reluctant to disclose their holdings for fear that others could trade against their positions.35 A private data collector would also find it difficult to finance its operation.36 Regulation might help to overcome these impediments.37 4. SELF-REGULATION Systemic risk transcends national borders. As financial institutions rely on financial markets all over the world, those markets become increasingly connected. Systemic risk externalities extend beyond and into the territory of even the largest jurisdictions. It follows that no national (government) regulator, standing alone, has the ability to protect its financial markets and institutions against systemic risk. The task is inevitably a transnational one in the sense that it exceeds the capabilities of any single nation state. Faced with a problem of a transnational nature, regulators must look beyond adopting and enforcing binding rules under national law. Transnational regulation denotes a regulatory challenge as well as a broader array of regulatory means. One way of getting beyond the limitations of national regulators is to pass responsibility to other actors not constrained by jurisdictional boundaries. The market itself cannot overcome the systemic risk externality, but it may sustain institutions to control it. In the following, such marketbased institutions will be referred to as self-regulation. The term is frequently used in the narrower sense of legally binding rules promulgated by market organisations,64 such as the selfregulatory organisations under US securities law.38 Of course, self-regulation may be a lot more effective if it can muster the enforcement powers and mandatory scope of hard law. As it will turn out, this is the critical shortcoming of a self-regulatory approach to hedge funds. Yet, as the regulatory task is a transnational one, the analysis should extend to regulatory strategies that do not
35

S.J. Choi and J.E. Fisch, How to Fix Wall Street: A Financing Proposal for Securities Intermediaries, 113 Yale Law Journal (2003) p. 269, at pp. 304-306 36 H.B. Shadab, Fending for Themselves: Creating a US Hedge Fund Market for Retail Investors, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-290. 37 H.B. Shadab, Fending for Themselves: Creating a US Hedge fund Market for Retail Investors, 11 New York University Journal of Legislation and Public Policy (2008) p. 251, at pp. 279-290.
38

S.M. Davidoff, Black Market Capital, 2008 Columbia Business Law Review (2008) p. 172.

rely (or do not rely exclusively) on the binding force of national hard law. For present purposes, therefore, self-regulation should include the mechanisms of private ordering and notably market discipline as an enforcer of soft law rules.39 The self-regulation game Self-regulation implies that those same market participants who cause the market failure should also be in charge of preventing it. A natural question to ask is why the players in the game of regulation should even consider such an unlikely arrangement. Interests of regulators Regulators may have an interest in encouraging self-regulation instead of applying only their own devices. If self-regulation is effective in addressing the transnational nature of the externality, responsible regulators will happily embrace it for this reason alone. But self-regulation has appeal even beyond the promise of greater reach. Historically, private regulation of financial markets predated government oversight. Even after governments decided that more centralised regulation was needed, they often left considerable regulatory responsibility to private or hybrid organisations. There is widespread consensus that self-regulation deserves a significant role.40 In fact, self-regulation commands a unique advantage over government-imposed regulation even in a purely national setting: it can apply the industry's own expertise to accomplish regulatory goals at the lowest possible cost. 41Albeit by no means a new technique, self-regulation fits nicely with the responsive regulation and new governance movements, which perceive regulation as an ongoing and dynamic relationship between the government and private actors.42 New governance emphasises the benefits of letting private actors participate in the regulation of their activities. Giving industry associations and individual firms a role in the process can lead to a cooperative relationship with the government. For instance, a firm's internal governance structure may ensure that public policy objectives are met. In exchange, the regulator refrains from imposing detailed
39

T.A. Paredes, On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission, University of Illinois Law Review (2006) p. 975, at pp. 990-998 40 J. Danielson, et al., Highwaymen or Heroes: Should Hedge Funds Be Regulated?, 1 Journal of Financial Stability (2006) p. 522, at pp. 527-528 41 R. Sklar, Hedges or Thickets: Protecting Investors from Hedge Fund Managers' Conflicts of Interest, 77 Fordham Law Review (2009) p. 3251 (arguing for investor protection specifically against conflicts of interest). R.A. Booth, Who Should Recover What for Late Trading and Market Timing?, 1 Journal of Business and Technology Law(2006) p. 101; P.G. Mahoney, Manager-Investor Conflicts in Mutual Funds, 18 Journal of Economic Perspectives (2004) p. 161, at pp. 173-176; E. Zitzewitz, Who Cares about Shareholders? ArbitrageProofing Mutual Funds, 19 The Journal of Law, Economics and Organization (2003) p. 245. 42 H.T.C. Hu and B. Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 Southern California Law Review (2006) p. 811.

(and less efficient) command and control rules. The key advantage of this kind of relational contracting43 is that the regulator can use non-verifiable information - such as its own evaluation of measures adopted by the industry - which is not available if all that matters is formal compliance with a set of predefined rules. As the cooperative relationship builds on mutual trust, it can also foster a sense of responsibility for the goals of regulation on the part of the industry and of individual firms. In the hedge fund domain, delegating regulation to private actors seems especially attractive. Information on how hedge funds operate is hard to come by because of the exceptional pace of innovation in strategies and practices and because hedge fund managers are extremely secretive to protect their proprietary knowledge. If one adds to this the transnational dimension, encouraging self-regulation is an all the more desirable option for regulators - provided that it effectively addresses the systemic risk externality. Collective interests of the industry Hedge fund managers, investors and prime brokers should themselves take a genuine interest in controlling systemic risk. Hedge funds are the likely first victims of a systemic event caused by other hedge funds. All stakeholders in a hedge fund suffer considerably from a breakdown: investors lose their capital, managers and prime brokers forego future fee revenue. While these players lack incentives to consider systemic risk in their individual risk choices, it is clearly in their collective interest to reduce the expected losses from systemic events. If collective action were without difficulty, the hedge fund industry would likely take precautions to limit systemic risk. Unfortunately, however, establishing an effective self-regulatory framework is not costless.44 In addition, hedge fund stakeholders would bear only a certain part of the damage from a systemic event. It follows that even collectively the hedge fund industry does not have optimal incentives to reduce its systemic risk impact. Expecting self-regulation to emerge spontaneously would be too optimistic.45

43

R. Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Fourth Estate, London 2001); F.R. Edwards, Hedge Funds and the Collapse of Long-Term Capital Management, 13 Journal of Economic Perspectives (1999) p. 189, at pp. 197-207.
44

A.W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008 (2008), available at: <http://ssrn.com/abstract=1301217> (central bankers know it when they see it); S.L. Schwarcz, Systemic Risk, 97 Georgetown Law Journal (2008) p. 193, at pp. 196-204 45 O. de Bandt and P. Hartmann, Systemic Risk: A Survey (Working Paper No. 35, European Central Bank, Frankfurt 2000), at pp. 10-13

Yet self-regulation need not arise in isolation. Self-regulation serves as a substitute for government regulation. Even as the government prefers the industry to write its own rules, it retains the power to impose conventional, state-made regulation. The latter option will seem more attractive than not addressing the market failure at all. This possibility, in turn, alters the incentives of the industry: in deciding for of against self-regulation, the hedge fund industry also needs to consider the threat of government regulation. Where self-regulation is not pursued for its own sake, it can still be the only way to avert heavy-handed government intervention. The incentive structure resembles a prisoners' dilemma: the government can decide to either not regulate (cooperate) or regulate (defect). Likewise, the industry's cooperate strategy is to implement effective self-regulation whereas failure to do so constitutes the defect choice. Given defection by the other party, each player prefers to defect but both players would prefer mutual cooperation (only self-regulation) to defection (government-imposed regulation and no self-regulation).46 The self-regulation game between government and industry is a familiar pattern in the politics of regulation. It exemplifies the relational and dynamic view of the responsive regulation school of thought and, more particularly, how far-reaching powers in the hands of government - a benign big gun47 can lead to superior outcomes without actually being used. Self-regulation in the hedge fund industry conforms to this model. The Managed Funds Association in the US seems to be the first to have promulgated Sound Practices for Hedge Fund Managers. Now in their fifth edition,48 the standards responded directly to a call from the President's Working Group on Financial Markets (PWG) following the LTCM crisis; around the same time, Congress was contemplating, but ultimately did not adopt, a Hedge Fund Disclosure Act.49 The government's role in stimulating rule-making by the industry became even more pronounced when the PWG revisited the matter in 2007 after eight years of tremendous growth in hedge fund assets. The PWG and two other regulators entered into an agreement among
46

R. Craswell and J.E. Calfee, Deterrence and Uncertain Legal Standards, 2 Journal of Law, Economics and Organization (1986) p. 279. Against this backdrop and given the rarity of litigation, it is exceedingly difficult for courts to set the standard of care so as to avoid over- or underdeterrence. 47 K. Pistor and C. Xu, Incomplete Law, 35 New York University Journal of International Law and Politics (2003) p. 931, particularly at pp. 949-951; see also the broader comparison of regulation and court adjudication in A. Shleifer, Efficient Regulation (NBER Working Paper No. 15651, 2010). 48 IOSCO, Hedge Funds Oversight, Final Report (2009), at paras. 50-51, available at: <http://www.iosco.org> (emphasising the need for convergence); FSA, supra n. 93, at p. 28 (recognising international coordination as a significant challenge); Hedge Fund Working Group, supra n. 91, at pp. 32-34 49 Cf. F. Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 Journal of Corporation Law (1997) p. 211, at p. 227

themselves on how to deal with private pools of capital, including hedge funds. The regulators' common principles re-emphasised that in our market-based economy, market discipline of risktaking is the rule and government regulation is the exception. Instead of asking for authority to regulate hedge funds directly, the agencies agreed to use their existing powers to foster market discipline on hedge funds. To this end, the agreement often invokes sound practices identified by the industry. This time the PWG went one step further and lent its authority to establish an Asset Managers' Committee to develop industry standards. The Asset Managers' Committee published its Best Practices for the Hedge Fund Industry in January 2009. In Europe, industry standards arrived somewhat later. In 2002, the Alternative Investment Management Association (AIMA) published a Guide to Sound Practices specifically for European hedge fund managers. The AIMA Guide stands out in that it came to life without any noticeable trigger from government institutions. As a European initiative, it is not tied to a national jurisdiction or regulator.50 It provides an example of private ordering in relatively pure form. To understand how such rules emerge without government pressure, one should appreciate that the systemic risk externality is only one possible reason for self-regulation. While the hedge fund industry has few incentives to contain systemic risk (other than pleasing regulators), adopting orderly standards for business conduct helps to garner confidence among investors and counterparties.51 It is revealing that the AIMA Guide, a truly transnational initiative, seemed insufficient to appease the relevant regulator: in 2007, major hedge fund managers in the UK set up the Hedge Fund Working Group. After a consultation period on a draft, it published its Hedge Fund Standards in a final report early in 2008 and at the same time instituted the Hedge Fund Standards Board to take responsibility for updating the standards and generally to [a]ct as guardian or custodian of the Standards.52 The Working Group left no doubt about its motivation to demonstrate responsibility in order to pre-empt more intrusive government regulation.53 In its last comprehensive report on hedge fund regulation dating to 2006, the UK's Financial Services
50

V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 3 (Regulatory arbitrage exploits the gap between the economic substance of a transaction and its legal or regulatory treatment). 51 E. Wymeersch, The Regulation of Private Equity, Hedge Funds and State Funds (Universiteit Gent Financial Law Institute Working Paper 2010-06, 2010), at pp. 4-13, 52 E. Cauble, Harvard, Hedge Funds, and Tax Havens: Reforming the Tax Treatment of Investment Income Earned by Tax-Exempt Entities (Illinois Program in Law and Economics Working Paper No. LE10-004, 2010), at pp. 953 G.J. Stigler, The Theory of Economic Regulation, 2 Bell Journal of Economics and Management Science (1971) p. 3, at pp. 13-14.

Authority (FSA) had expressed support for developing industry good practice.More generally, the regulatory environment in the UK is particularly conducive to such a move. Hedge fund managers in the UK already are subject to FSA oversight so that absolute freedom from government regulation is not available. At the same time, the FSA has strongly committed to a principles-based regulatory approach including a prominent role for industry guidance. Although the Hedge Fund Working Group decided not to seek formal confirmation of their standards, the FSA has announced to take them into account in overseeing hedge fund managers. Interests of individual firms: the problem of enforcement The argument so far has rested on the hedge fund industry's collective interest in regulating its own activities. But even if the industry as a whole prefers self-regulation to more intrusive government intervention, firms individually may find it in their interest not to agree to any restrictions. Preventing burdensome government regulation is a collective good for the industry. It follows that individual firms have an incentive to take a free ride on the self-regulation effort by others. Firms can shirk by not conforming to the industry's rules, in the form of either open defiance or covert non-compliance. Enforcement thus poses a challenge for self-regulation if the rules are not legally binding and if there is no public authority to uphold them. In the hedge fund industry, the problem should prove somewhat less severe than in other areas of regulation. Hedge funds can only incur risk when investors and prime brokers equip them with capital. These counterparties are themselves sophisticated players. Because they have a vital interest in controlling their own exposure, they can exercise significant pressure on hedge fund managers to comply with self-regulatory standards.54 In this regard, risk regulation of hedge funds differs considerably from, for instance, environmental regulation or consumer protection where there are no such knowledgeable and motivated actors monitoring the regulated behaviour. Shirking industry rules designed to mitigate risk becomes a much thornier proposition if managers have to justify themselves before their risk-conscious investors and prime brokers - even if these counterparties themselves would have imposed less far-reaching restrictions.55 For this reason, self-regulation has early on been directed not just at hedge funds and their managers but also at investors and prime brokers. In fact, the PWG report of 1999 considered industry standards under the heading Enhanced Private Sector Practices for Counterparty Risk
54

R. Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 Yale Law Review (1998) p. 2359 55 C. Brummer, Stock Exchanges and the New Markets for Securities Laws, 75 University of Chicago Law Review (2008) p. 1435;

Management and called primarily on banks to develop such standards. This focus reflected the special circumstances of the LTCM crisis in which the fund's prime brokers had incurred a very substantial credit risk, but it was also seen as way to impose greater discipline on borrowers. The banking industry reacted by forming the Counterparty Risk Management Policy Group (CRMPG), which presented its report only a few months later, in June 1999. The CRMPG did not confine itself to hedge funds and proposed a set of general recommendations to enhance credit risk management in securities and derivatives markets. Notably, the CRMPG is partly an international exercise in that the twelve participating banks included major European institutions such as UBS and Barclays Bank. The CRMPG has continued to promote higher standards after its first report. In a second report of 2005, it called on hedge fund managers to follow the CRMPG recommendations, where applicable, as well as to adopt the Managed Funds Association's Sound Practices. Banks themselves seem to have improved their credit risk management practices following the first CRMPG report. This would be hardly surprising: as regulated firms, prime brokers are likely to face pressure from regulators to comply with risk management standards. In addition, there is only a limited number of major banks offering prime brokerage services, which facilitates mutual monitoring of conformity with the standards. After the LTCM disaster, banks appear not to have suffered large losses from their prime brokerage business with hedge funds.56 To control hedge fund risk further, one needs to look to investors. Investors in hedge funds should pay even more attention to hedge fund risk because their stake is the first to bear any losses. Accordingly, the PWG has established an Investors' Committee to create best practice standards directed at investors as a complement to the standards set by the Asset Managers' Committee. However, investors are far more numerous and diverse than prime brokers. Many but not all are themselves subject to regulation. Monitoring and enforcing selfregulatory standards is therefore a lot more difficult with regard to investors than with regard to banks.57 Even if a specific self-regulatory regime for investors turns out to be impractical, investors can still play an important role in enforcing self-imposed rules for hedge fund managers. To help build such pressure, the UK Hedge Fund Standards seek to make compliance transparent and indeed salient to
56

H. Jackson, Centralization, Competition, and Privatization in Financial Regulation, 2 Theoretical Inquiries in Law (2001) article 4. 57 .-W. Sinn, The Selection Principle and Market Failure in Systems Competition, 66 Journal of Public Economics (1997) p. 247 (arguing that regulatory competition reintroduces the market failure that regulation was intended to cure

investors. Hedge fund managers are asked to become signatories to the Standards. By endorsing the Standards, managers agree to a comply or explain requirement: they can either adopt the Standards in full or choose to opt out of certain provisions; in the latter case, managers have to explain to investors why they believe the particular rule should not apply to them. The comply or explain mechanism is meant to adapt the Standards to the varying needs and circumstances of different hedge funds managers (such as the size of under management). Contrary to an earlier prediction, the hedge funds Standards have attracted signatories representing 60% of the European hedge funds assets under management. The formal status of a signatory makes it simple for investors to ascertain whether a particular manager in general adheres to the Standards. Given their widespread acceptance and the ready disclosure of non-compliance under the comply or explain principle, investors may be able to reduce due diligence costs by using the Standards as a benchmark. If many investors start focusing on the Standards, they will put pressure on managers to become a signatory and to comply. Clear and unambiguous disclosure can also mobilise the power of hard law to enforce selfregulatory standards. If a manager has explicitly announced to conform to certain rules (e.g., by endorsing the Hedge Fund Standards and not declaring non-compliance with a particular rule), he exposes himself to liability for misrepresentation, fraud or breach of the investment agreement if it turns out that he has not abided by those rules.58 Because hedge fund investors hold large stakes, they will be prepared to bring such claims.59 The threat of private litigation matters because many deviations from self-regulatory rules remain hidden from investors' views until the damage is done. For instance, the survival of a hedge fund may at times depend on the valuation of its assets when potential losses would lead to massive redemptions. In a critical situation like this, a manager's concern for his reputation may not be enough to prevent him from violating conflict of interest rules to ensure an independent valuation process. One could strengthen industry standards further by leaving enforcement to government regulators.Yet as self-regulation assumes more hard law qualities and relies on the enforcement powers of government regulators, it becomes subject to the

58

J.R. Macey, Regulatory Globalization As a Response to Regulatory Competition, 52 Emory Law Journal (2003) p. 1353, particularly at pp. 1358-1361 (examining regulators' willingness to give up independence in exchange for cooperation); 59 E. Colombatto and J.R. Macey, A Public Choice Model of International Economic Cooperation and the Decline of the Nation State, 18 Cardozo Law Review (1996) p. 925, at pp. 933-935, 943-944 and 951-954

limited reach of national regulation. Self-regulation thus loses its advantage in dealing with the transnational character of systemic risk. 4.2 Limits of self-regulation Self-regulation faces constraints in creating as well as enforcing industry standards. As to the first limitation, the hedge fund industry collectively has only a limited interest in self-imposed rules beyond the precautions that managers, creditors and investors take anyway. To a considerable degree, systemic risk remains an external even at industry level. Therefore, establishing a selfregulatory regime depends on the benign big gun, a continuing threat that the government can step in and impose its own, potentially more burdensome regulation. The second limitation consists of the enforcement problem. Although prime brokers and investors can exert pressure on managers to comply with industry standards, market discipline alone extends only to observable behaviour. To be effective, self-regulation must cover conduct that counterparties cannot monitor directly, such as adhering to rules on risk management, disclosure and valuation in critical situations. To some extent, private litigation can enhance compliance if courts take the standards into account for determining liability. However, because the manager - usually a limited liability entity - will often not be able to pay large damage awards, the deterrent effect of litigation remains imperfect.60 In addition, courts may be reluctant to impose liability for rare events of large losses, especially when it is hard to distinguish legitimate business judgment from a violation of industry standards. What would be needed is an institution to enforce industry standards on an ongoing basis. Without continuous engagement by an independent monitor there is a great risk that self-regulatory standards will remain vague and ultimately fail to govern behaviour.116 This is especially true where abstract, high-level standards give firms considerable discretion in how to comply. Such a flexible, principles-based approach relies even more on a regulating entity to determine whether individual firms' effort is sufficient to accomplish the regulatory objectives.61 The monitoring and enforcement task is usually performed by government regulators. In theory at least, it could also be assumed by a self-regulatory body. The UK Hedge Fund Standards Board claims to be monitoring compliance with the standards.62 However, a sufficiently robust enforcement organisation needs
60

B. Liang and H. Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds (2008), available at: <http://ssrn.com/abstract=967788>. 61 HM Revenue & Customs, Statement of Practice 1/01 as revised on 20 July 2007, 62 Treatment of Investment Managers and Their Overseas Clients (2007), at para. 2, available at: <http://www.hmrc.gov.uk> (noting the importance of the Investment Manager Exemption for the UK's

considerable funding. Levying a significant fee would add to the difficulties of winning the endorsement of managers. What is more, managers would have to concede certain rights to the enforcement body, for instance, a right to receive regular reports, to audit the manager's records or to inspect his business on site. It is hard to believe that many managers would accept such farreaching demands, particularly with regard to sensitive information (which may be needed to monitor systemic risk in the sector ). In addition, an enforcement body operated by the industry itself might well fail to enforce its own rules vigorously enough without the threat of government intervention. The main conclusion is that self-regulation can be effective only if the government's benign big gun looms in the background, loaded and ready. While it is still desirable to include elements of self-regulation in order to tap the industry's superior knowledge, self-regulation cannot fully substitute for conventional government regulation. For the same reason, self-regulation will not extend far beyond the scope of national regulation. As the above analysis reveals, three out of four major industry standards have been developed to pre-empt closer government oversight. Instead of creating a transnational regulatory regime, they remain bound to two national jurisdictions, the US and the UK. The enduring relevance of national regulators has led to multiple standards. Although industry and regulators agree that this is at odds with the global reach and effects of hedge funds, convergence of self-regulation will hinge on coordination among national jurisdictions. Government regulation needs to come up with its own response to the transnational challenge of controlling systemic risk. 5. GOVERNMENT REGULATION Government regulation is vested in national jurisdictions. As such, its form and intensity reflect the political preferences, convictions and incentives prevailing in the different countries. If hedge fund activities were distributed evenly over jurisdictions, one might conjecture that the patchwork of national regulations restricts systemic risk on average by the right amount. Yet the mismatch between the national reach of government regulation and the transnational nature of systemic risk is more serious and complicated. The hedge fund industry responds to differences in national regulation by engaging in regulatory arbitrage. Consequently, jurisdictions find themselves competing with each other to attract hedge fund business. Instead of balancing the cost of intervention against the benefit of controlling systemic risk, successful regulators are biased
attractiveness).

towards pleasing regulated firms (subsection 5.1). To prevent such state capture, government regulation itself has to transcend national jurisdictions. Effective systemic risk regulation therefore requires harmonising government regulation across states (subsection 5.2). 5.1 Regulatory competition The term arbitrage refers to the exploitation of a price difference between two goods that are essentially the same. The textbook example is a price disparity between the same good traded at different market places. When speaking of regulatory arbitrage, one thinks of regulatory requirements as a cost (or price) for conducting a certain activity. Regulatory arbitrage then describes a scheme under which a person carries out essentially the same activity but at lower regulatory cost. Opportunities for regulatory arbitrage arise within a single jurisdiction when the same economic outcome can be accomplished in two or more ways that the law treats differently. In addition, regulatory arbitrage can take place between jurisdictions. Interested parties may be able to shape their activity so that jurisdiction shifts from one national regulator to another. For the purposes of this analysis, it is such international regulatory arbitrage that is of interest. In what follows, regulatory arbitrage refers only to the international version. Whether and to what extent market participants engage in regulatory arbitrage depends on opportunities and the cost of exploiting them. An arbitrage opportunity arises if national regulators differ in the requirements they impose on a particular type of activity. The rules on regulatory jurisdiction determine how costly it is to choose a regulator and thus to exploit opportunities for regulatory arbitrage. The cost is low when the economic substance of the activity needs to be modified only slightly or not at all to shift jurisdiction to another state. By contrast, it may be that taking advantage of a difference in regulation requires fundamental changes to the contemplated activity, which can make regulatory arbitrage expensive or even impossible. When the cost of regulatory arbitrage is low, market participants will be able to exploit relatively minor differences in regulation. At first glance, financial regulation is particularly vulnerable to regulatory arbitrage because financial assets have little if any physical presence and therefore can easily be located anywhere in the world. Yet the financial industry itself is more tangible. Financial services have to be performed by real people and are ultimately offered to real customers. In the case of the hedge fund industry, regulation can attach to five categories of parties: (1) the hedge fund; (2) its manager; (3) the prime broker; (4) other service providers;and (5) investors. Absent

international harmonisation, states have the power to define their own regulatory jurisdiction.63 Broadly speaking, states typically assume regulatory jurisdiction over those parties that operate or are located in their territory.64 Once regulatory jurisdiction is triggered, a state can impose requirements on other aspects of the hedge fund business. For instance, in exercising oversight of the hedge fund itself, regulators can demand certain qualifications of the manager as a condition for managing the fund. Likewise, access to a country's investor base can hinge on requirements at the level of the hedge fund, the manager or other service providers. Leveraging their jurisdiction over relatively immobile parties provides states with extraterritorial reach and, by implication, with the opportunity to rein in regulatory arbitrage. At the same time, however, extending regulatory control is costly because it tends to stifle cross-border trade. If, for example, a regulator restricts access to investors located in its territory, it might cut off those investors from the most valuable investment opportunities in the market, which is hardly consistent with investor protection or other regulatory objectives. Regulators therefore have to balance the benefits of integration in international markets with the (perceived) threat of regulatory arbitrage. At present, many jurisdictions refrain from directly regulating hedge funds - i.e., the entities holding the assets - as long as shares are not marketed to the public National regulations thus barely impede choosing the most advantageous hedge fund jurisdiction. Accordingly, regulatory and tax arbitrage flourishes: in 2008, around 60% of all hedge funds were domiciled in an offshore jurisdiction with the Cayman Islands as the market leader attracting 39%. Obviously, hedge funds find neither their investors nor their managers in the Cayman Islands. They go there to benefit from differences in regulation and taxes. Different from hedge funds, their managers are often subject to an authorisation requirement in their home country. Important exceptions include Switzerland and (until the most recent reform) the US. Where a regulatory regime for managers is in place, it usually does not prevent them from moving to another, unregulated jurisdiction. Still, the cost of engaging in regulatory arbitrage is likely not as low as it is for hedge funds because managers rely on highly skilled personnel, which is a significantly less mobile resource than the fund's intangible assets. Also, hedge fund managers benefit from the proximity to prime brokers and other service providers as well as to a larger
63

D. Cumming and N. Dai, A Law and Finance Analysis of Hedge Funds (2008), at pp. 15-16, available at:

<http://ssrn.com/abstract=946298>; Fung and Hsieh, supra n. 18, at pp. 4-6.

64

Regulation of Offshore Hedge Funds: The Failure of the Hedge Fund Registration Requirement, 92 Cornell Law Review (2007) p. 795, at pp. 807-811

financial community, not least because they need to communicate and meet with investors on a regular basis. As a consequence, not only are managers relatively less mobile but they also tend to cluster, preferably in or near a major financial centre. Differences in regulation must be larger to trigger regulatory arbitrage, and they are more likely to be exploited when the alternative jurisdiction has a vibrant financial centre to offer. In fact, hedge fund managers are highly concentrated: two thirds of global hedge fund assets are managed from the US, 57% alone from New York and two cities in nearby Connecticut (Greenwich and Westport). Trailing them at 21% is London, capturing roughly three quarters of the European market for hedge fund managers.65 The remaining parties in the hedge fund business are service providers, most importantly prime brokers, and investors. Prime brokers need to be investment banks and are invariably regulated as such. National regulators have not used their oversight of prime brokers to impose direct regulation on their hedge fund clients, presumably because hedge funds can easily switch to prime brokers from other jurisdictions. By contrast, jurisdiction over investors can translate into requirements for hedge funds and managers. As to retail investors, access to them is often prohibited altogether or restricted to regulated funds. With regard to affluent and more sophisticated individuals, there is generally little oversight. Of greater interest is the regulation of institutional investors such as funds of hedge funds, pension funds and insurance companies. An example are pension funds under the US Employment Retirement Income Security Act of 1974 (ERISA). If pension or employee benefit plans under ERISA hold more than 25% of equity, the hedge fund's assets turn into plan assets. As a consequence, the fund manager is subject to specific and onerous duties as a plan fiduciary under ERISA. In addition, the (principal) plan fiduciary will urge the hedge fund manager to register with the Securities and Exchange Commission (SEC) to preclude its own liability for breaches committed by the manager. Apparently, most hedge fund promoters avoid the ERISA regime by maintaining the 25% threshold.To cite another example, to the limited extent that German insurance companies can invest their tied assets in hedge funds, they are precluded from investing in unregulated hedge funds (as well as in hedge funds outside the European Economic Area). Generally speaking, the regulatory framework of institutional investors may be a reason, at least for some hedge funds and their managers, to seek a regulated status. Restricting access to investors gives national regulators some sway over foreign hedge funds and managers. Exercising this power, however, may deprive
65

International Financial Services London, supra n. 4, at pp. 2-3; see also Garbaravicius and Dierick, supra n. 17, at pp. 14-15

investors of the opportunity to invest in the most promising hedge funds. Absent coordination between regulators, hedge funds might well decide to forgo marketing opportunities in particular countries in order to retain a level of regulation that they deem more favourable. In this case, regulating investors to constrain regulatory arbitrage will accomplish little and cost much. Regulatory competition as state capture Regulatory arbitrage describes how participants in the hedge fund industry react to regulation if they perceive it as costly. But arbitrage opportunities only exist if jurisdictions differ in their regulatory approach. While such variation can result from random differences in opinion, it stands to reason that regulatory arbitrage itself also affects government behaviour. Insofar as hedge funds and their managers can migrate to other, more lenient jurisdictions, imposing stricter regulation has fewer benefits (because it is avoided) and entails higher costs (because hedge fund business is lost to other jurisdictions). Focusing on systemic risk, states face a public good dilemma that mirrors the impediments to industry self-regulation examined above. Regulating one's own hedge fund industry helps little if other jurisdictions stay idle. Individual countries enjoy the benefits of curbing systemic risk even if they themselves fail to contribute. At the same time, states have incentives to engage in regulatory competition by offering less restrictive regulation and attracting hedge fund business. Jurisdictions are likely to differ in the relative weight they attach to financial stability on the one hand and to competing for hedge fund business on the other. One might expect countries with a larger financial industry to be more affected by systemic events and to have a greater interest, all else equal, in reducing their probability. As the recent financial crisis testifies, however, systemic risk also affects economies with a smaller financial sector. Therefore, the concern for financial stability should be more or less common to all jurisdictions. It follows that incentives for hedge fund regulation diverge primarily because of differences in the potential gains from regulatory competition. The greater a country's chance of attracting hedge fund business, or the larger a country's existing share in the global hedge fund market, the more reluctant it will tend to be to control systemic risk. In public choice theory, regulatory capture refers to a situation in which a regulatory agency conforms to the demands of the regulated industry at the expense of its public interest mission. A state can also be said to have been captured by a particular industry if it forsakes the broader, transnational public good for the special interests of the industry. The degree of state capture should depend on the economic benefits, potential or real, from attracting

hedge fund activities. Benefits include the employment and revenue generated by hedge fund managers and other service providers, specific taxes and fees levied from hedge funds,148 and the potential spillover and network effects for other financial industries. Once a hedge fund sector has taken root, state capture intensifies further as the industry starts lobbying the regulator and national politics. Forming a small but prosperous interest group, the hedge fund industry is well positioned to influence governments, especially because it can bolster voice with the threat of exit. The concentration of hedge fund activities suggests a loose taxonomy of three degrees of state capture: a state can be said to be fully captured if the concern for the hedge fund industry (or financial services generally) dominates most other economic considerations, which implies that the financial sector is very large relative to the overall economy. The offshore financial centres, including Luxembourg and Liechtenstein, fall into this category. In the Cayman Islands, financial services account for roughly half of the total economic output. In Luxembourg, the financial industry directly contributed 25% to the country's gross domestic product in 2008, after 37% before the financial crisis in 2007. For these fully captured jurisdictions, the gains from attracting or retaining financial activities dwarf any potential benefits from trying to regulate systemic risk especially in view of the fact that they have little effective control over systemic risk in global financial markets. A second group of countries takes a pronounced interest in hedge funds and the financial industry generally but without giving them absolute priority. The US and the UK are the primary examples of this group of half captured states. Their financial industries are relatively larger than those of other developed countries: in 2007, the share of the gross domestic product amounted to 7.9% for the US and to 8.3% for the UK, as compared to 6.7% for Japan, 4.7% for France and 4.0% for Germany. The US and UK financial industries do not just serve their own hinterland but provide a hub for international and global financial services. Presumably, their competitive advantage over offshore jurisdictions lies in their more diversified economy: to the extent that major international banks need a lender of last resort as a credible backup, they cannot move to smaller jurisdictions that lack a large real economy. As to hedge funds, the US and the UK host almost nine tenth of all hedge fund managers, which constitute the key intellectual factor and entrepreneurial driver of the industry. According to industry estimates, hedge funds in the UK provide employment for 40,000 people. Because of its profitability and relevance for New York and London as financial centres, the industry's political clout should be even greater than suggested by its immediate economic

weight. Regulatory policies of both the US and the UK have proven responsive to the industry's needs and to competitive threats. At the same time, one should expect neither the UK nor the US government to side with the hedge fund industry at any price. In the current crisis, both countries have shown some willingness to consider stricter financial regulation to protect the economy from systemic events.Serving as the ultimate backup for a large number of global financial institutions, they are more exposed to financial instability than other countries. Controlling systemic risk is in their national interest. Most countries belong to the third group. To the extent that a financial industry exists, it has few if any global ambitions. Given the geographical concentration of hedge funds and their managers, these countries have only a very small share or none at all in the global hedge fund market. For most of them, there is no point in competing for hedge fund business. Industry interests are only weakly represented in politics. Because these countries have no stake in the industry's success, they can claim a status of non-capture. At the same time, their economies are affected both by the systemic risk externality and by the benefits that hedge funds create for financial markets in terms of price efficiency and liquidity. In theory at least, they should have the right incentives to determine the optimal amount of regulation to control systemic risk. The trouble with noncaptured states is that they lack expertise. They have no experience in regulating hedge funds and little if any interaction with the industry. As a consequence, they are more prone to populism and scapegoating. To some extent, the German position on hedge funds may be considered an example. Germany advanced hedge fund regulation as a key issue of its presidency of the G8 in 2007, only to earn a lukewarm mention in the summit declaration. The US and the UK were not receptive to lecturing from a jurisdiction with virtually no hedge fund business. Evaluating regulatory competition There is an extensive debate on the merits of regulatory competition in general and specifically with regard to financial market regulation.Looking at regulation as a service supplied by governments, one may very well imagine that - just like in markets for other goods - competition has the potential to enhance the quality of the service. If regulators have incentives to compete, they will operate more efficiently (e.g., speed up responses to inquiries and filings) and will be prepared to tailor regulatory solutions to novel activities, thus fostering innovation.Insofar as sophisticated investors in hedge funds demand regulatory protection, managers face competitive pressure to choose a jurisdiction that provides sufficient investor protection. In such a setting,

governments must be eager to build a reputation for reliable safeguards. Rather than erode regulation, competition likely results in more effective regulation at lower costs. As hedge funds and managers concentrate in few locations, a small number of jurisdictions gain expertise. In effect, these national jurisdictions ascend to becoming the global regulators for hedge funds just as Delaware is providing the corporation law for most of the US. The arrangement has the advantage of specialised regulators. In spite of centralisation, regulatory competition continues to discipline leading regulators and restrains regulatory slack. The available empirical evidence supports the view that vigorous competition does not harm hedge fund investors: Liang and Park compare the performance of hedge funds domiciled in the US with those domiciled offshore (but reporting their returns in US dollars). They find significantly higher risk-adjusted returns for onshore funds. However, they show that this result is due to the greater percentage of onshore funds with lock-up provisions, which, in turn, is attributable to differences in tax treatment and regulation. If only funds with lock-up provisions are taken into account, offshore-domiciled hedge funds appear superior to their onshore peers. Government regulation can complement private contracting through enhanced monitoring and enforcement on behalf of investors.Regulation, in this regard, is enabling law: it extends the amount of cooperation that private parties can attain on their own. The enabling role of regulation remains largely intact even under regulatory competition. What regulatory competition does hamper is the ability of government regulation to correct market (contracting) failures, particularly due to asymmetric information or externalities. Systemic risk is an externality. It falls essentially on all market participants, who can neither control it nor charge a differential risk premium for bearing it. As an externality, private parties will not take systemic risk into account in writing their contracts. By the same token, investors and prime brokers have no reason to consider systemic risk in their due diligence. Under competitive pressure to increase returns, managers will seek to reduce regulatory costs and to avoid restrictions on their behaviour. The leading hedge fund jurisdictions will be eager to provide just that. Under conditions of regulatory competition, the national interest of captured states diverges markedly from the global common good. 5.2 Regulatory harmonisation Regulatory arbitrage may well result in a few jurisdictions acting as global regulators of the hedge fund industry. If most hedge funds demand the same type of regulation, competitive forces will drive the leading jurisdictions to adopt similar regulatory approaches. By contrast, regulatory

harmonisation is a conscious and coordinated attempt to assimilate regulation across jurisdictions. It can enable jurisdictions collectively to attain regulatory outcomes that would not be sustainable under regulatory competition. Incentives to harmonise Why would national regulators and legislators wish to harmonise their regulatory approaches? The majority of states have lost the competition for hedge fund regulation. Participating in a quest for harmonisation presents an opportunity for these jurisdictions to reclaim some indirect authority over hedge funds. One can think of more or less benign motives for seeking such influence. Systemic risk is a transnational externality. Jurisdictions may have a genuine interest in protecting their economy against the potential fallout from a systemic event. Regulatory harmonisation would be the appropriate response to the systemic risk externality and its transnational character. An alternative and less favourable view is that self-interested regulators strive to preserve their power because they derive private benefits from it, such as commanding more resources or prestige. For the losers of regulatory competition, harmonisation may be a strategy to avoid falling into obsolescence. Regulators may be able to enlist political support in their countries by exaggerating the risk that harmonised regulation is (allegedly) meant to control. A public choice analysis thus explains why non-captured states might pursue harmonisation even if there were no significant systemic risk externality.66 On the surface, captured states should take little or no interest in harmonising regulation. Harmonisation is meant to reduce differences in regulation, thus diminishing arbitrage opportunities. It seems that successful regulators should be loath to confine the very foundation of their success, the ability to compete.67 Yet the incentive structure of leading hedge fund jurisdictions is in fact more complex. Half captured and even fully captured states are not indifferent to systemic risk. As their economy is tilted towards the financial industry, systemic events affect them more strongly than other countries. Captured states thus share the transnational public interest in controlling systemic risk. While this concern shows only a little or not at all in competitive behaviour, it may influence their stance on harmonising hedge fund regulation: harmonisation amounts to a state cartel against regulatory competition. Market leaders may be no less inclined to restrain competition in order to obtain or increase market power. In the
66

V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 3 67 V. Fleischer, Regulatory Arbitrage (University of Colorado Law Legal Studies Research Paper No. 10-11, 2010), at p. 3

context of regulation, market power confers the ability, among other things, to impose regulation that firms or the industry would like to avoid, including attempts at regulating externalities.68 In this regard, there is a chance that captured states wrench themselves from the industry's clutch. Harmonisation provides an opportunity for states to pursue the transnational common good rather than their narrower national interest. The mechanics of harmonisation Harmonising regulation across sovereign states requires universal agreement. Similar to the industry's difficulties in enforcing self-regulation, however, states have to overcome a collective action problem to arrive at common standards. Under regulatory competition, individual jurisdictions will be tempted to refrain from harmonisation and to exploit other states' self-imposed constraints. This incentive becomes even stronger as more states join the harmonisation effort. Regulatory harmonisation therefore cannot build on voluntary consent alone. At the same time, the ability to engage in regulatory competition depends on the possibility and costs of regulatory arbitrage. Other states can try to restrict regulatory arbitrage by claiming jurisdiction over the activity or over particular actors, such as investors in hedge funds. While the leverage of individual states remains rather limited for all but the largest of them, the balance of power is tipped when a considerable number of jurisdictions agree to coordinate their regulatory approach. Besides harmonising rules, a coalition of states can cut off hedge funds from a sizable share of investors. A state cartel not only restrains the competitive behaviour of its members but also has more leverage to suppress regulatory arbitrage. 69The prevalent method is to require adherence to harmonised standards in the form of either domestic or equivalent foreign regulation as a condition for doing in-state business, e.g., for marketing hedge fund shares to investors. If the cartel commands a sufficiently large part of the relevant markets, it can effectively coerce other states to adopt the harmonised rules. Overall, the process of regulatory harmonisation combines consent and coercion. Harmonisation cannot be accomplished without voluntary agreement among states that, together, control a sufficiently large amount of critical resources, particularly investors and sophisticated prime brokers. When such a coalition is forming, other states may want to influence the emerging standard. Although they would favour different regulation or no regulation at all, they will be ready
68

Cf. F. Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 Journal of Corporation Law (1997) p. 211, at p. 22 69 M.G. Warren, Global Harmonization of Securities Laws: The Achievements of the European Communities, 31Harvard International Law Journal (1990) p. 185, at pp. 189-190.

to compromise to participate in the harmonised market. Of course, states differ greatly not just in their incentives towards harmonisation but also in the bargaining power they bring to the table. The process is not a democratic one. It ensures, however, a certain degree of deliberation and sensitivity to information: cartelisation only begins when enough states perceive a need for harmonised regulation. Captured states are prone to play a prominent role because excluding them from a harmonised regime would be particularly conflict-laden. This implies that industry interests and the expertise of leading regulators receive attention. Harmonising hedge fund regulation Hedge fund regulation may become a prime example of how a state of nonharmonisation can quickly turn into a harmonisation equilibrium. Financial regulators have formed international organisations, which, among other things, serve as institutional fora where coalitions are forged. Accordingly, one can observe the emergence of harmonisation by looking at the pronouncements of these organisations on common regulatory standards or principles. Hedge fund activity mostly concerns bank regulators and securities regulators. The former are organised in the Basel Committee on Banking Supervision under the auspices of the Bank for International Settlements, the latter in the International Organization of Securities Commissions (IOSCO). Following the LTCM crisis of 1998, hedge fund regulation appeared on the agenda of these organisations as well as of the Financial Stability Forum, which, in addition to bank and securities regulators, includes the countries' finance ministries.70 In spite of the LTCM shock, US regulators quickly concluded that enhanced market discipline - bolstered by prime broker oversight and elements of self-regulation - was sufficient to control systemic risk. At the time, the hedge fund industry was even more concentrated in the US than it is today. International organisations largely followed the US lead in rejecting direct regulation of hedge funds. Yet remarkably, already in 1999, IOSCO recommended that regulators encourage direct disclosure by hedge funds.This suggestion appears more assertive than the PWG's position in the US. After the heightened attention in 1999 and 2000, interest in systemic risk from hedge funds subsided at the international stage. Only around 2005 did the topic begin to regain international prominence, mostly because of the massive growth in hedge fund assets. The renewed interest did not lead to a change of direction. The US and the UK as the dominant hedge fund jurisdictions continued to favour self-regulation and market discipline, bolstered by prime broker oversight. It
70

A.S. Fraser, The SEC's Ineffective Move toward Greater Regulation of Offshore Hedge Funds: The Failure of the Hedge Fund Registration Requirement, 92 Cornell Law Review (2007) p. 795, at pp. 807-811;

took the global financial crisis to reverse this position. When the crisis hit, governments reacted through the Group of Twenty (G-20) - 19 major countries and the EU comprising 90% of the world's gross national product. From their first summit in November 2008 in response to the crisis, the G-20 vowed to invigorate financial market regulation. One key tenet of this new resolve is to ensure that all financial markets, products and participants are regulated or subject to oversight, as appropriate to their circumstances. The main implication is that systemically important hedge funds or their managers should become subject to direct regulation. Securities regulators in the IOSCO were quick to carry out the political will of the G-20 leaders. Shortly after the November 2008 summit, IOSCO established three task forces, one of which devoted primarily to hedge funds.71 It released its final report Hedge Funds Oversight already in June 2009 promulgating six high-level principles on hedge fund regulation. The first of these principles marks the breakthrough in the harmonisation process: Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration. The new approach is presently working its way through the legislative process in the major jurisdictions. In July 2010, US President Obama signed into law the Dodd-Frank Act, a broadranging financial market reform. Among many other measures, the Dodd-Frank Act requires private fund managers (advisers) to register with the SEC and to provide systemic risk-related information. It does not, however, impose restrictions on leverage. As one would expect based on the above analysis, Congress proved wary of regulatory arbitrage and, accordingly, imposed domestic regulation not only on advisers located in the US but also on advisers with more than investors in the US or more than 25 million US dollars of assets either in private funds established in the US or stemming from US private fund investors. At variance with other pieces of the US financial market reform package, hedge fund manager registration appeared to be uncontroversial in the legislative process. In Europe, legislation seems to be on the home stretch at EU level. The European Parliament had demanded strict regulation of hedge funds and private equity funds already starting in 2007. Resistance by the European Commission crumbled only under pressure created by the financial crisis. The Commission presented its proposal for an Alternative Investment Fund Managers Directive (AIFM Directive) in April 2009. Like the Dodd-Frank Act, the EU legislation
71

G.J. Stigler, The Theory of Economic Regulation, 2 Bell Journal of Economics and Management Science (1971) p. 3, at pp. 13-14.

will cover managers not just of hedge funds but also of any other investment vehicles except the investment funds already regulated under the UCITS Directive. The EU draft contains disclosure and reporting duties towards investors and regulators. In addition, and going beyond the US proposals, it also imposes requirements on hedge fund operations, inter alia,to establish risk and liquidity management systems and to retain independent valuation providers and depositaries. The proposed AIFM Directive authorises regulators to collect information on systemic risk and share it with other national and European authorities; it even empowers them to impose specific limits on hedge fund leverage. While legislation is still in progress, the making of the AIFM Directive illustrates the competing interests involved in regulatory harmonisation. In line with the EU's central goal of creating a single financial market, the draft contains the familiar passport mechanism to allow managers authorised in one Member State to do business in another. This pattern of coordination in the EU conforms to the logic of harmonisation: opening one's national market by recognising foreign regulation may be the reward offered to other states for participating in harmonisation (which, in the EU, can be forced on individual Member States through majority decision-making). Hedge fund managers are primarily interested in gaining access to the investor base in other jurisdictions. In this regard, the current proposals of the Council and the European Parliament differ significantly. Both legislative bodies agree that alternative investment funds should be admitted for marketing to professional investors throughout the EU if the manager is authorised under the Directive and if the fund is established in a Member State. As to funds established in a third country, the Council would leave it to individual Member States to admit them for marketing in their territories. Refusing to issue a European passport to third-country funds (even those operated by European managers) deviates markedly from both the Parliament's and the original Commission proposal. Equally against the Commission's and the Parliament's view, the Council refuses to offer a European passport to non-European managers. The ability to pass binding laws enables the EU to accomplish harmonisation among its Member States, but also to wield considerable power in relation to other jurisdictions. The biggest prize the EU has to offer in the international harmonisation game is unrestricted access to its large investor base. Offering an EU passport to foreign managers and hedge funds, as intended by the Commission and the European Parliament, would maximise European clout. At first blush, one would expect the UK to strongly favour this approach in order to curb regulatory arbitrage.

Surprisingly, however, the UK is opposing detailed requirements for admitting non-European managers to Member State markets and was even voted down on the issue - a rare event in the Council. The reason seems to be a concern that, instead of spreading its own standards, the EU will risk a trade conflict with the US. There is no doubt that retaliatory exclusion by the US would seriously hurt the Londonbased hedge fund industry. While other EU Member States will also want to avoid such a conflict, the UK is most loath to incur such a risk.209 This is an implication of the UK being captured by its hedge fund industry. As captured states tend to overrate industry interests, the majority in the EU has better incentives to secure a sufficient amount of regulatory precautions on behalf of systemic stability. Meanwhile, non-captured states may be prone to populist overreaching. Evaluating harmonisation As the dispute over the AIFM Directive lingers on, it is not yet certain that governments will be able to harmonise hedge fund regulation on a global scale. Bargaining over common standards could well collapse and give way to underregulation or divergent regulation with mutual exclusion and market fragmentation. If harmonisation is accomplished, reasonable minds can disagree on whether governments have applied the right kind and dosage of regulation. This article is concerned not with particular outcomes but more generally with the modes of transnational regulation. The question to ask is if harmonisation is likely to produce government regulation that deals efficiently with systemic risk and withstands regulatory arbitrage without inhibiting crossborder investment. The harmonisation process differs conspicuously from regulation within a single state. Decisions are made through multilateral bargaining and coalition building among states. For national constituencies it can be difficult to observe what position their representatives take and how well they negotiate at the international stage. Democratic accountability is hence attenuated. However, this does not imply that harmonisation is less responsive to relevant concerns than a regulator or the legislature would be within a single democratic state. Specifically, there is no compelling reason to assume a bias for laxity. While regulatory competition favours deregulation, harmonisation is a way for national governments to reassert their regulatory powers. As noted above, even jurisdictions that are fully or partly captured have some interest in harmonising regulation to control systemic risk (or, more broadly, market failure). Also, they alone typically cannot block harmonisation if it is driven by a coalition of powerful states. What they can do is to

contribute their expertise in dealing with hedge funds as well as, being the target of particularly strong lobbying efforts, to give the industry a voice in international negotiations. Captured states tend to make regulatory harmonisation more informed, without dominating the outcome. From a public choice perspective, concentrating interest group activity on a few captured jurisdictions might even help to mitigate their influence, leaving the remaining states relatively unaffected. One objection to this sanguine assessment is the special role of the US. In fact, it is hard to imagine regulatory harmonisation without US leadership, although there are important counterexamples. The US is particularly powerful in the harmonisation process because of its outsized financial markets and national economy. Those very same reasons, however, raise the US' exposure to systemic risk and tend to align its national interest with that of the broader world community. It is true that, for quite some time, US resistance has been a principal impediment to direct hedge fund regulation. The push towards harmonisation occurred only in the wake of the financial crisis. Yet the same pattern obtains within nation states. More often than not, regulatory advances occur when a crisis serves as a catalyst. The resolve to regulate hedge funds is a remarkable example in that hedge funds clearly did not cause the global financial crisis. The crisis did create a painful awareness of systemic risk, in the US and worldwide, which led governments to reassess financial regulation generally and the need to regulate hedge funds in particular. Perhaps financial stability should have been higher on the agenda even before the crisis struck. The point is not that international politics is perfectly rational in the sense of fully considering the available evidence at all times. Rather, it is that regulatory harmonisation need not be inferior to national regulation, which might as well respond to accidental stimuli. Signs of a new approach? Recently, there have been some signs that the regulatory interest in hedge funds is changing. This rising interest relates largely to the question of hedge funds being offered to retail investors. One sign of the increasing international regulatory interest in hedge funds is the amendments to the UCITS Directive, which were adopted by the European Union a year ago. It was agreed that the Commission will forward a report to the European Parliament and the Council on the application of the amended Directive, no later than February 13, 2005. In this report the Commission will review the scope of the Directive in terms of how it applies to different types of products, including hedge funds. In particular this study should focus on the size of the market for

such funds, the regulation of these funds in the Member States and the need for further harmonisation of these funds.Thus, in a couple of years, we may be facing an effort towards the harmonisation of hedge funds at European level. At its meeting in April 2002 in Oviedo, Spain, the Council of Finance Ministers of the European Union (ECOFIN) discussed the possible actions to be taken in Europe following the Enron affair. The ECOFIN decided to invite the Committee of European Securities Regulators (CESR) to report on supervisory issues (related to the increased complexity of derivatives and derivative trading) and on the implications for the regulation of European financial markets. Particular emphasis was placed on financial engineering techniques and hedge funds. The Financial Stability Forum, in its latest assessment report on HLIs, noted the marketing of hedge funds to retail investors as one of the fresh concerns in this field. According to the report this is a new aspect that raises, from an investor protection perspective, questions about the extent to which retail customers understand these products and the risks involved. The report recommends that the IOSCO be encouraged to study the investor protection concerns that may arise in connection with hedge fund products and retail investors. The US Securities and Exchange Commission has also recently announced that it will determine whether the present lack of hedge fund regulation is in the public interest. According to the SEC, the factors that have to be taken into account here are the booming growth of these investments, incidents of fraud and the fact that hedge funds are marketed directly or indirectly to retail investors. In the United Kingdom, the Financial Services Authority (FSA) has recently published a discussion paper on hedge funds. The FSA is currently seeking views from industry and consumer groups on whether hedge funds are suitable products to be marketed to the retail sector, and, if so, what strategies should be adopted to provide retail consumers with appropriate information regarding the risk profile of such hedge funds. Difficulties Regarding hedge funds Investments for Retail Investors: Hedge funds Versus Mutual Funds This section will analyse the difficulties relating to hedge funds from the retail investor's perspective, comparing the characteristics of hedge funds to the traditional regulated mutual funds such as the European UCITS, which have generally been seen as a good form of investment for retail investors.

The UCITS is a widely used, harmonised form of investment funds in Europe. The funds that follow the minimum harmonisation requirements of the UCITS Directive can be freely marketed on a cross-border basis to countries of the European Economic Area in accordance with the single passport principle. After the recently adopted amendments to the Directive have been transposed to the national legislation of each Member State, the passport will, in addition to the traditional securities funds, also cover new types of funds such as cash funds, fund of funds, index funds and derivatives funds. Hedge funds are, however, not even covered by the amended Directive. The first basic difference between regulated mutual funds and hedge funds is their investment strategies. Whereas UCITS have very strict risk-spreading requirements and can only invest in assets defined by the Directive, hedge funds do not have formal diversification rules nor do they have limitations on their range of investment assets. Hedge funds can also use high risk investment strategies such as short selling and leverage, whereas UCITS can either not use these strategies at all or only to a very limited extent. UCITS are liquid instruments; investors can usually make a redemption request on any banking day. Hedge funds, on the other hand, are not open for daily subscriptions and redemptions, but usually only monthly or quarterly. In addition to this, investors in hedge funds must give the fund manager advance notice of the redemption request, such notice often being as long as 30 to 40 days before its execution.72 UCITS invest their assets mainly in listed securities and financial derivative instruments. The valuation of UCITS is, therefore, relatively simple and reliable because it is based on the market prices in the regulated stock exchanges and derivatives markets. The valuation of hedge funds is much more difficult because they may invest in assets that are not available to UCITS, such as unlisted securities and commodities. This is why hedge funds normally provide information on their net asset value only on a monthly basis. Even though many offshore hedge funds are listed on a recognised stock exchange, they are rarely actually traded there, which means that the listing cannot usually be used for pricing of units of the hedge funds. Hedge funds are not directly regulated like mutual funds . The regulatory control over them is mostly indirect, meaning that the fundmanager is usually located onshore and is subject to regulation. Also the funds custodian or prime broker and its counter-parties are, mostly, regulated bodies.
72

International Financial Services London, Economic Contribution of UK Financial Services 2009 (2009), available at: <http://www.ifsl.org.uk>, Chart

Hedge funds appear to be more vulnerable to fraud than mutual funds . The main reason for this is their unregulated nature and the opacity of the whole hedge funds industry. In this context, the US Securities and Exchange Commission has recently issued a warning that it has had to deal with far too many fraud cases in circumstances where the losses to investors have been substantial. There have been cases, for instance, where the fund has turned out to be completely fictional, having never existed in the first place and where the fund manager has used the money invested for his own personal use. Fund managers have been covering the losses of their investment strategy in the hope that they can still turn things around if the market moves in a favourable direction. In order to keep new money coming into the fund they have falsified accounts. Lack of oversight by an auditor has also been a key issue in some cases. The minimum level of transparency of the mutual funds' assets is regulated. UCITS must give detailed information about their assets and liabilities, at least, in their annual and half-yearly reports. The amended Directive also requires that, in the future, all UCITS offer subscribers a simplified prospectus, which must include a short definition of the funds objective and investment policy, brief assessment of its risk profile and profile of the typical investor for whom the fund is designed. Hedge Funds have traditionally lacked this transparency. Their managers are typically unwilling to give investors much information on the contents of the Funds portfolio because they are afraid that their competitors would use that information for their own benefit. In conclusion, hedge funds are totally different instruments from mutual fund , especially from the retail investor's point of view. Those investors who are used to investing in mutual funds may, therefore, face big surprises when they invest in hedge funds. Regulators' Dilemma: Should Marketing of Hedge funds to the Public be Allowed? Target group of hedge funds is changing Hedge Funds investors have traditionally been high-net-worth individuals and institutional investors. While public marketing of hedge funds is still not possible in most countries, hedge funds can be offered in many countries, under some exemptions to the general marketing rules, to limited groups of qualified investors who are considered to be sufficiently sophisticated, usually based on their wealth. The minimum subscription to a hedge funds investment has usually been too high for retail investors--it has been around US$500,000 to US$10 million. However, the latest development

seems to be that hedge funds are lowering their minimum investment requirements to attract greater numbers of investors. Minimum levels have dropped to as low as US$50,000. 19 For European hedge- fund based structured products, such as certificates and notes, the minimum amounts are even lower, often no more than ##5,000-10,000. The Monetary Authority of Singapore (MAS) has reduced the minimum investment to $10,000 for funds of hedge funds.21 Regulators' choice: to prohibit marketing or to develop the product? Many countries are currently considering whether to allow hedge funds to be marketed to the public. The basic question is, should authorities hinder the public from investing in some investment forms by prohibiting the marketing of those products? Alternatively, if marketing to the public is allowed, what conditions should be imposed? There are pros and cons in the matter. In addition to the difficulties listed above, if hedge funds were to become a mainstream investment form, many fund managers would face the problem of whether they were still able to invest all of their capital according to their investment strategies. Nonetheless, there is another side to the coin. Hedge fund managers promise that they can help investors to diversify their portfolios, because hedge funds have a relatively low correlation to mutual funds and market indices. They say that they can, therefore, offer investors more diversification and downside risk protection than mutual funds, in addition to providing absolute returns, even under difficult market conditions. While these promises must not be taken for granted, it should be noted that many of these funds have done very well in recent years. At the same time, there have been UCITS which have been very actively marketed to retail investors and which, after the bursting of the dot.com bubble, have lost up to 80-90 per cent of their capital. This loss has occurred despite them operating strictly under the diversification requirements of the UCITS Directive. It is, perhaps, beyond the capacity of regulations to prevent these kinds of crashes in mutual funds when the whole market goes down. In the end, one can only ask, is it really up to regulators to say what investments are good enough to be marketed to the public? Is it not more important to take care of transparency, to ensure that investors have the opportunity of getting hold of enough valid information on the investment targets so as to make up their own minds on where to invest? Of course, it is also the task of the authorities to prevent service providers that are not fit and proper from carrying on these kinds of

activities and to minimise chances of fraud. Nonetheless, fraud cannot be totally prevented, however careful the supervision.73 In today's world of internet and electronic banking, people can easily access information on different investment opportunities and invest wherever they want, irrespective of their physical location. This diminishes the meaningfulness of marketing prohibitions. Instead of prohibitions, therefore, one possible solution for the regulators would be to contribute to hedge funds being transferred to regulated onshore funds. Furthermore, if it is likely that, in the future, retail investors will also want to invest in hedge funds and will seek ways to do that, is it not better to allow the setting up of regulated and supervised funds that meet the demand? The following section will briefly describe one way of creating regulated hedge fund-type mutual funds, namely the Finnish system on special mutual funds. This is an example of one way to deal with the traditional problems regarding hedge funds, such as lack of supervision and transparency.74 Marketing of Hedge Funds to the Public: the Finnish Case Background to the regulation of special mutual funds Mutual funds are a fairly new form of securities investment in Finland. The first ones were created in 1987 when the Mutual Funds Act came into force. When Finland joined the European Economic Area in 1994 the legislation was amended to implement the UCITS Directive. The securities markets developed rapidly in the 1990s and market participants started asking for more developed forms of mutual funds which were not covered by the UCITS Directive. Because there was no agreement reached inside the European Union on how to develop the Directive in order to cover these new products, there was a need to have a new class of mutual funds. Since August 1, 1996 it has been possible to establish special mutual funds. This development of special mutual funds in Finland as well as their equivalent in many other countries in Europe means that these funds increasingly have the potential to carry on the same investment strategies as hedge funds. The Nordic countries, especially Sweden and Finland, have experienced this kind of development; the Swedish nationella fonder and the Finnish special mutual funds have many of the qualities of hedge funds. Other examples of national funds in
73

J.R. Oppold, The Changing Landscape of Hedge Fund Regulation: Current Concerns and a Principle-Based Approach, 10 University of Pennsylvania Journal of Business & Employment Law (2008) p. 833, at p. 874 74 A.C. Pritchard, London As Delaware? (Michigan Law School John M. Olin Law and Economics Working Paper No. 09-008, 2009), at pp. 29-30, available at: <http://ssrn.com/abstract=1407610>.

Europe are the Austrian and German Spezialfonds, the Danishinnovationsforeninger and the Italian fondi speculativi. The scope of investment activities The new Mutual Funds Act (the Act), which came into force on February 1, 1999, was designed to give management companies more freedom in developing new products. Currently, special mutual funds' investments are not subject to detailed regulation. The Act sets the following criteria for them: investments must be mainly in securities and derivative instruments; the management company of a special mutual fund is responsible for ensuring that the fund's investment portfolio is diversified in terms of risks; the fund's rules are to be approved by the competent authorities unless available information indicates that the rules would be likely to jeopardise the stability or functionality of the financial markets. Rules of special mutual funds and amendments thereto are approved by the Ministry of Finance (the MoF), which first obtains an opinion fromRahoitustarkastus (the Financial Supervision Authority), Finland's supervisory authority for banking and capital market activities. In rendering an opinion on an application, the competent authorities provide interpretation to the abovementioned general requirements of the Act. Via administrative decisions, a regime is being developed regarding the scope of activities of special mutual funds and the provisions that apply to them. The Act does not permit the restriction of purchases of domestic funds to limited groups of investors. All Finnish funds are open to all investors, the only restriction being the fund's own minimum subscription. Subscription cannot be limited, for example, to sophisticated investors as in many countries. The Act also includes provisions on the marketing in Finland of foreign collective investment schemes that do not meet the criteria of the UCITS Directive. A foreign non-UCITS can market its units in Finland to the public only with the permission of the MoF. Such permission requires that unit-holders be afforded protection sufficiently similar to that prescribed in the Act for investors in Finnish funds. Permission is granted if the structure of the collective investment activity, the investment principles and the fund's home country legislation and supervision meet standards set out in the Act.

Control mechanisms The management companies are under the same kind of supervision irrespective of whether they manage UCITS or special mutual funds. When seeking a licence they are required to prove that the company's shareholders and persons responsible for its management are fit and proper, that the company has sufficient finances, and that it is likely that the company will be managed in a reliable and professional manner as well as in accordance with sound business principles. The MoF grants an authorisation to a management company on the basis of a written opinion from the Financial Supervision Authority, which is also responsible for supervision of the management companies and both UCITS and the special mutual funds managed by them. The continuous supervision of the Financial Supervision Authority includes, for example, review of monthly reports on the funds' portfolios and on-site inspections of the management companies. In addition to the Financial Supervision Authority's supervision there are several other control mechanisms in place to ensure that the special mutual funds are managed properly and according to the law and the fund rules. The unit-holders of the funds managed by a management company elect at least one third of the members of the board of directors of the company. A management company must have at least two certified auditors. One is elected by the shareholders of the company and the other by the unit-holders. At least one auditor must, at intervals of two months, check the calculation of the value of the fund. This is an essential mechanism to ensure correct valuation. The assets of the fund must be entrusted for safekeeping to a depositary. This must be a legally separate entity from the management company, a licensed credit institution or an investment firm. It has the same supervisory duties as required by the UCITS Directive of the harmonised funds' depositary to ensure, for instance, that legislation and the fund rules are complied with in the valuation, issue and redemption of the fund's units. More extensive transparency requirements for special mutual funds As a counterbalance to the special mutual funds' freedoms in investment policy, the Act requires a simplified prospectus, besides an ordinary full prospectus, that briefly describes the fund's risk profile and other key information in layman's language. The management company must also publish quarterly reports of the fund, in addition to the annual and half-yearly reports required by UCITS. In these reports, detailed information on the assets and liabilities of the fund must be disclosed.

This information must include an account of the fund's securities and derivatives investments and the distribution of these investments by sector, market location or other appropriate criteria that illustrate the application of the fund's investment principles as a percentage of the fund's investments. The report must include an account of the changes that have taken place in the profile of the investments during the survey period, and information relating to how extensively the fund has made use of various derivative instruments, borrowing, lending and repurchase agreements in its operations. Special mutual funds are also affected by other rules which are aimed at ensuring that investors are aware of the special nature of such funds. For instance, the name of the fund must make clear that the fund is a special mutual fund. The fund's rules and marketing material must clearly state the reasons why the fund is a special mutual fund.75 In approving a special mutual fund's rules, the MoF may set restrictions and conditions on the fund's activities. Special conditions may be placed on highrisk funds that engage, for instance, in short sales and securities borrowing. The prospectuses of such funds must clearly note the fund's higher risk profile when compared to normal mutual funds.76 Current situation and future prospects Product development in the area of special mutual funds has been very rapid. The funds have increasingly taken on the characteristics of hedge funds. These funds--as compared to UCITS--are marked by less risk diversification, active use of negative/positive derivative leverage, OTC derivative instruments, short sales and borrowing of securities, and longer intervals between subscriptions and redemptions. The use of performance fees has become common practice. Unsurprisingly, the managers of these funds have also labelled them as hedge funds in their marketing. Legislation on special mutual funds has worked well. There have not been any significant regulatory problems with these funds until now. The problem with the ever-accelerating product development towards hedge funds is that a large majority of Finnish investors are still in the phase of learning to grasp the basic features of mutual funds in general. It is clear that a majority of
75 76

I. Ayres and S. Choi, Internalizing Outsider Trading, 101 Michigan Law Review (2002) p. 313, at pp. 328-336. G8 Summit Heiligendamm, Growth and Responsibility in the World Economy (2007), at p. 3, available at:

<http://www.g-8.de/Webs/G8/EN/G8Summit/SummitDocuments/summit-documents. html> (we reaffirm the need to be vigilant).

investors now would have problems in understanding the features of the new hedge fund-type of funds with their complex strategies.

CONCLUSION Transnational regulation is different. What distinguishes it from regulation in a purely national setting is, primarily, the mismatch between the single regulator's authority and the scope of the market failure. The causes and effects of systemic events cut across the territorial boundaries of jurisdictions. As national regulation corresponds less and less well to the regulated risks and activities, it turns into patchwork. Therefore, transnational regulation takes a natural interest in the full array of private substitutes and complements to government oversight. This broader perspective aligns itself with certain elements in the theory and practice of regulation within the nation state, ranging from self-regulatory organisations, notions of responsive or principles-based regulation, to the high-flying new governance theme. Yet as regards the specific aim of controlling systemic risk from hedge funds, the analysis has led to the somewhat sobering conclusion that industry self-regulation depends critically on support from the government. A need for more robust backing emerges at two different levels: without the threat of cumbersome government intervention, the hedge fund industry as a whole lacks incentives to establish a stringent self-regulatory regime. Even where the industry creates its own standards, it likely fails to enforce them sufficiently if it relies only on reputational sanctions, that is, without resort to government powers. Governments thus remain indispensable for regulating hedge funds (if such regulation is considered desirable). Therefore, the specific constraints of multiple government regulators in dealing with transnational hedge fund activities gain importance. Analogously to the limits of selfregulation, regulatory competition among national jurisdictions cannot be trusted to provide for adequate regulation; it implies a slant towards laissez-faire even where stricter systemic risk regulation is called for. As argued above, governments have to coordinate their policies to reassert their power to regulate. A question not considered so far is how harmonised government regulation plays out for selfregulation. There are benefits to letting the industry write the rules and to giving individual firms responsibility for accomplishing regulatory objectives, even if securing these benefits requires a

benign big gun regulator as a backup. It is less clear, however, if multiple governments - some of them actively competing for hedge fund business - can be as effective in policing and sustaining self-regulation. As regulatory harmonisation cannot produce very detailed standards, it inevitably leaves a lot of discretion to individual governments. National regulators can still differentiate themselves and compete through their expertise and flexibility in handling the rules. Accordingly, regulatory harmonisation will tend to concede room for self-regulation to flourish under the oversight of national regulators. Yet there remains an inherent tension between regulatory competition and entrusting individual jurisdictions with monitoring self-regulation. The great advantage of responsive or principlesbased regulation lies in the regulators' ability to condition the use of their benign big gun on nonverifiable information, such as the perceived trustworthiness of regulated firms and insights from an ongoing dialogue with the industry. It follows that how regulators employ their big gun must be equally non-verifiable and discretionary. Predictably, captured states will be tempted to use their discretion to compete for hedge fund business, succumbing to excessively lax self-regulatory standards and practices by individual firms. To prevent principles-based regulation from deteriorating into underregulation, government regulators can try to cultivate a relational network among themselves. Unless they succeed in enforcing informal standards, regulatory harmonisation might have to forgo some of the benefits of self-regulation in order to be effective.