Hedge funds and Private Equity - PES

3. Hedge funds
We have seen from Part I and Part II that there are important concrete arguments for transparency
and adequate regulations:
1. It is important to enhance the transparency of the hedge funds because of overall financial
stability in the EU. This is important because it allows the monetary authorities to have a fair
picture of the collective hedge funds investments and commitments, which in turn would allow
the monetary authorities to assess the consequences to the financial markets of the hedge
funds transactions and future transactions.
2. Transparency should be introduced in the hedge funds in order to protect investors.
3. Many of the hedge funds are in practice functioning more or less like traditional investment
funds.
4. Many hedge funds are based in offshore jurisdictions, including hedge funds active in the EU.
The problems relating to tax control, when investors based in EU Member States invest in
hedge funds based in offshore centres, are crucial. The offshore centres often do not have tax
control, nor are they obliged to provide information to the tax authorities concerning these
investments.
5. Companies are not protected from short-term thinking of hedge funds and LBOs. This is
creating problems for public companies competing globally as a part of our general promotion
of New Social Europe.
3.1 The fallacy of indirect regulation
Indirect regulation assumes that HFs counterparties are adequately regulated and supervised
in their business with hedge funds. It assumes also that they have an incentive to comply.
HF counterparties are prime brokers who are big multinational banking groups, either American
investment banks or investment arms of gigantic American financial conglomerates like City
Group or Bank of America and European universal banks. For effective indirect regulation, bank
supervisors must have a proper understanding of the risk exposure taken by banks on hedge
funds, so that they can check if the risk is adequately accounted for in Basel II capital provision.
One may say that this is a very partial view of hedge funds’ potential nuisance value. It is not only
systemic risk from HF leverage that is of concern. That is, admittedly, the main concern of the
Basel Committee of central bank governors. But it does not answer worries over consumer
protection and market integrity related to HF trading.
Even the narrower view of indirect regulation is questionable. Banks do not simply lend money
to hedge funds. This plain type of leverage is properly accounted for in computing bank leverage,
at least in principle. But it is superseded by financial leverage through securities lending and
derivatives that is less so. Financial leverage is due to exposures created by off-balance sheet
positions ahead of the cost of derivative contracts. Prime brokers provide high leverage through
reverse repos, using assets as collateral in non-tractable transactions that are not reported by the
banks. At best, regulators can only know the total net exposure of a bank to all hedge funds. But
they do not know the exposure of any hedge fund provided by all counterparties. Therefore the
nature and the ever-changing size of HFs liabilities to their lenders make illusory the knowledge
of the relevant indicator of leverage risk due to hedge funds, which is potential future credit
exposure.
Part III – Lessons to be drawn for future regulation
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