Hedge Funds, Liquidity and Prime Brokers

Article excerpt

INTRODUCTION

Over the past decade, the hedge fund industry has enjoyed remarkable growth. The media enthusiastically described the success of the top-performing funds and the lavish riches they bestowed on their employees.1 At the same time, however, there were remarkable stories of failure in the industry.2 Both politicians and economists warned of the potential dangers hedge funds present to the national and global economies.3 These warnings and concerns created a debate regarding the level of regulation needed, if any, over what is currently a largely unregulated industry.4 This Note argues that while increased regulation of the hedge fund industry is necessary, the government's recent and ongoing attempts to increase regulation are misguided. A self-regulating body comprised of the brokers that serve the hedge fund industry is the most efficient and effective instrument to limit the most critical risks hedge funds present, while still maintaining the numerous benefits hedge funds bring to economies. Part I provides a general background of the hedge fund industry, the current regulatory environment in which hedge funds operate, and the risks and shortcomings associated with the current regulatory scheme. Part I also presents the failure of the hedge fund Long-Term Capital Management as an example of the risks inherent in the present regulatory scheme. Part II discusses recent efforts to increase regulation and offers an alternative solution. Part III examines the potential benefits and limitations of the alternative solution.

I. THE BENEFITS AND THE RISKS OF HEDGE FUNDS

The term "hedge fund" generally refers "to an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company under the Investment Company Act [of 19405]."6 A hedge fund's goal is to provide an absolute return to its investors regardless of the overall condition of the securities market.7 Hedge funds trade a variety of securities, such as equities, "fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments."8

Hedge funds offer many advantages, both to their investors and to the securities market as a whole.9 Hedge funds aim to achieve positive investment returns without the volatility of traditional investments such as stocks and bonds.10 Hedge fund advisers are able to use more sophisticated and flexible investment strategies than advisers at entities such as mutual funds.11 Hedge funds offer investors the opportunity to diversify their portfolios by providing alternative investment vehicles that offer positive returns, while historically showing a low correlation to traditional investments in the fixed-income and equity markets.12

In addition to profiting its own investors, hedge funds also benefit the general securities market. Hedge funds help improve efficiency in pricing securities in the marketplace.13 Funds may take speculative trading positions based on extensive research about the true value or future value of a security, and then execute a "short-term trading strategy to exploit perceived mispricing of securities."14 This behavior tends to cause the market price of the security to move toward its true value.15

Hedge funds also help the overall dispersion of risk in the marketplace.16 For example, they often serve as counterparties to entities that wish to hedge risk.17 The result is that risk is more properly allocated to participants in the financial markets.18 In the case of mortgaged-backed securities, for example, the reallocation of risks made possible by hedge funds allows for lower mortgage interest rates throughout the economy.19 Without hedge funds, the economy would experience a higher overall cost of capital.20

Despite its many advantages, hedge funds can also have negative effects on the economy. …