on the decision to regulate hedge funds - University of Illinois Law ...

PAREDES.DOC
9/8/2006 9:12:27 AM
986 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
First Boston report cites a number of studies indicating that hedge funds
account for between 40 to 50% of trading activity in major stock markets,
such as the New York Stock Exchange and the London Stock Exchange,
and account for over 70% of daily activity in the convertibles market, the
U.S. distressed debt market, and the U.S. exchange-traded fund market. 44
It is also important to keep concerns about hedge fund malfeasance
in proper perspective. The abuses and illegal activities that have punctuated
the hedge fund industry are not representative of hedge fund behavior
generally. The reality is that the vast majority of hedge funds are not
engaged in any fraudulent or otherwise illegal behavior, and the vast majority
of hedge fund managers are not rogue traders rolling the dice in
undisciplined ways while betting other people’s money. Whether it is because
we are still in a post-Enron climate with heightened sensitivity to
financial corruption, or because attention rarely focuses on the banks
that were not robbed, the reality that hedge funds provide investors with
legitimate opportunities to earn superior returns is downplayed. Additionally,
whatever systemic risk is posed by the trading activities of highly
leveraged hedge funds, hedge fund trading spins off important systemic
benefits by leading to more efficient and more liquid capital markets that
are better able to withstand unanticipated shocks to financial markets. 45
More recently, some hedge funds have come out of the shadows to assume
the role of shareholder activist, particularly in proxy contests and
takeover battles. 46
Without question, hedge funds are secretive. The very nature of
hedge funds requires that they operate in secrecy because hedge funds
make money by exploiting market inefficiencies and by taking positions
44. EUROPEAN WHOLESALE BANKS, supra note 19, at 4–5.
45. Timothy F. Geithner, President and Chief Executive Officer of the Federal Reserve Bank of
New York, put it this way in a 2004 speech:
Hedge funds play a valuable arbitrage role in reducing or eliminating mispricing in financial
markets. They are an important source of liquidity, both in periods of calm and stress. They add
depth and breadth to our capital markets. By taking risks that would otherwise have remained on
the balance sheets of other financial institutions, they provide an important source of risk transfer
and diversification.
They don’t perform these functions out of a sense of noble purpose, of course, but they are
a critical part of what makes the U.S. financial markets work relatively well in absorbing shocks
and in allocating savings to their highest return. These benefits are less conspicuous than the
trauma that has been associated with hedge funds in periods of financial turmoil, but they are
substantial.
Timothy F. Geithner, President and Chief Executive Officer, Fed. Reserve Bank of New York, Hedge
Funds and Their Implications for the Financial System (Nov. 17, 2004), http://www.ny.frb.org/
newsevents/speeches/2004/ge1041114.html. For the SEC’s take on the benefits of hedge funds, see
HEDGE FUND STAFF REPORT, supra note 19, at 4–5.
For more technical discussions of the role of hedge funds in financial markets, see Suleyman Basak
& Benjamin Croitoru, On the Role of Arbitrageurs in Rational Markets, J. FIN. ECON. (forthcoming
2006), available at http://ssrn.com/abstract=475483.
The finance literature on hedge funds ultimately ties into the general literatures on the limits on arbitrage,
the efficient capital market hypothesis, behavioral finance, and heterogeneous investor expectations.
For an excellent, nontechnical overview of these literatures, see Lynn A. Stout, The Mechanisms
of Market Inefficiency: An Introduction to the New Finance, 28 J. CORP. L. 635 (2003).
46. See infra note 101.