European Hedge Fund Regulation - An introduction to and a discussion of the mitigation of the risks associated with the hedge fund industry

Abstract: The hedge fund industry has become one of the most creative and innovative areas within banking and finance during the past ten years. Its rapid growth and constant development has made it hard for regulators to mitigate the potential risks posed to investors and the financial system. The aim of this thesis is to discuss the potential need for further regulation of hedge funds, mainly based on the concern for financial stability but also investor protection. I have given a brief description of what the hedge funds are, how they function, their legal status and the risks associated with the hedge fund industry. I have also described and analysed how the identified risks are mitigated through legislation, both on national and international levels. The thesis aims to identify and briefly describe and analyse the rules affecting the hedge fund industry in the EU in general and in the UK in particular as the UK is the centre for hedge funds in the EU. It has also been my intention to discuss the regulatory regime's functionality and appropriateness in the global economy the funds exists and functions in and also the present and future developments regarding hedge fund risk mitigation. In the thesis the reader will find a comparative chapter where I provide the reader with an overview of how different and diverse the hedge fund regulation throughout Europe is. In the chapter, comparative research material provided by IOSCO, PricewaterhouseCoopers and the European Fund and Asset Management is presented. I do not go in to details when describing the laws found in the different countries in the EU. The intention is to give the reader an idea of how diverse and dissimilar the different legislators' approaches can be, not to present a detailed description. I draw three conclusions in this thesis. The first conclusion is that risks can never be truly mitigated as long as the funds can use regulatory arbitrage. The funds main concerns are low taxes and no disclosures. The funds have the possibilities to choose the most favourable jurisdiction and if one country changes its rules, taxes, disclosure requirements etc&semic the fund, its managers and administrators can easily move. The hedge fund industry is a source of income for countries and no country wishes the industry to change jurisdiction which would even further reduce the effects of the authorities' attempts to mitigate risks. The second conclusion is that even though it is easy to find risks associated with hedge funds, we must not forget why the funds exist to begin with: there is a demand for them. If it were not for the investors' demand for the funds, there would not be a hedge fund industry. I argue that the legislator should not impose too many rules, especially not on fund of hedge funds. Investors must have the ability to make informed decisions regarding their investment activities and the states should not stop individuals trying to diversify their portfolios. My third conclusion is that it is in the interest of everyone if the financial markets were regulated by those who fully understands them. Parliaments and politicians do not decide which advanced pharmaceuticals should be allowed to be sold to the public, a special authority does. It is my view that it is in the best interest of the consumer and the society if the financial authorities across the globe could all use an ad-hoc approach which would allow them to quickly react to potential threats to consumers and the financial system. While writing this thesis, I have realised that it is not possible to limit the discussion to include only legal issues. To mitigate any risks through regulation demands a full understanding of the potential effects of that regulation so that any unnecessary loss to the economy can be avoided. In order to efficiently discuss any regulation in the complex world of the global economy&semic one must not only have a profound knowledge in the discipline of law, but also in the disciplines of finance and economics.