highwaymen or heroes should hedge strongfundsstrong be regulated.pdf

Highwaymen or Heroes: Should Hedge Funds be Regulated?∗ J´on Dan´ıelsson, Ashley Taylor and Jean–Pierre Zigrand London School of Economics and FMG September 2005 First version September 2004 Abstract There are increasing calls for the regulation of hedge funds, both for consumer protection and systemic reasons. We argue that the con- sumer protection arguments for direct regulation are not convincing, but find that the systemic concerns are sufficiently serious to warrant some forms of regulation. Existing regulatory methods, disclosure and activity restrictions, are unsuitable for hedge funds. Any future regu- lation must reduce the likelihood and potential costs of the failure of systemically important hedge funds whilst at the same time preserving the wider market benefits of hedge funds’ ongoing activities. ∗The authors would like to thank Phelim Boyle, Howard Davies, Charles Goodhart, Paola Robotti, and an anonymous referee. The views in this paper are ours alone. Our papers can be downloaded from www.RiskR. Our email addresses are j.danielsson@lse.ac.uk, a.d.taylor@lse.ac.ukand j.p.zigrand@lse.ac.ukrespec- tively. 1 1 Introduction When hedge funds remained niche players, their special regulatory status raised few concerns. However, in recent years assets under management by hedge funds have grown exponentially and so have worries about their impact on the financial system. This has been prompted by the role of hedge funds in the major financial crisis episodes of the 1990s such as the ERM, Asian, and Long Term Capital Management (LTCM) crises. The recent expansion of the client base has added further micro–prudentia