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Emergence of a New Regulation : Informational Disclosure

Modalities In The Hedge Fund Opacity World

Yamina Tadjeddine & Sandra Rigot

SASE 22nd meeting, PhiladelphiaMini-Conference Evolutionary Regulation: Rethinking

the Role of Regulation in Economy and SocietySaturday, 26th June 2010

Aim of this contributionThe 2007-2008 crisis has highlighted the tensions

related to lack of transparency in the hedge fund industry.

Yet no consensus has emerged about the implementation of disclosure (different reports, proposals)\

From economic theory, usually only two case are considered: opacity (private information) / transparency (public information)

3 modalities in Boot W. A. and. Thakor A. V (2001)By considering proposals, we characterize a

continuum of informational disclosure agreements (Talley E. (2001): from private arrangement to public law)

An economic view

This article classifies the proposals of informational disclosure agreements

It is based on a consequentialist approach: the expected effect of proposal (micro / macro allocation) and the modality of disclosure (to one, to some, to public authority, to all)

It describes the social emergency of the future hedge funds regulation (in US, EU, UK) as a political bargaining with private/public actors more than an evolutionary game

Why do Hedge Fund have to be regulated ?• Hedge Funds damages: £ Soros, more recently

shortselling Volkswagen share, 28th october 2008

• Fear of systemic crisis caused by one leveraged hedge funds (LTCM, 1998)

• Increasing assets under managementBut• Hedge Funds were the victims of the crisis, not

its cause

=> The reform is more structural: the norm of transparency, the arrival of institutional investors

Evolution of hedge funds capital 1997-2006 AuM- $ billions and share of AuM (%)

Source: Hennessee Group LLC; estimates; Mac Kinsey Global Institute Analysis.

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Plan

1. Market failures induced by hedge funds opacity

2. Data: hedge fund recommendations since LTCM 1998

3. Encoding proposals: two criteria the aim / the modality

4. Results: classification of proposals and reports

5. Conclusion

1. Opacity and Market failures

Secret versus Performance Hedge fund capital has historically come from high-net-

worth individuals. - Clients invest with full knowledge of these vehicles judged

as risky and so they accept the consequences in terms of losses. The financial risks are assumed to be known and accepted by experienced wealthy clients.

- Clients accept this trade off

Regulatory Authorities:- opacity permits innovation (creating new strategy, trading in

new OTC products ), to prompt a search for private information.

=> Improve liquidity and market efficiency. - Furthermore, given that only sophisticated clients invest in

hedge funds, regulatory authorities have no legitimacy to protect them. They assume that these investors are aware of specific hedge fund risks and that risks are sufficiently dispersed.

An International Consensus for a Slight Regulation

Supervisors’ consensus = a mix of indirect regulation and market discipline

- Indirect regulation (managers’ regulation)> via prime brokers (investment banks)> via regulated markets

- « Market discipline » or autoregulation> via information disclosure (voluntary)> via incentives

Lack of public information and private standardized information

Market failures induced by opacity:

HF: private information

Clients Prime Brokers

Regulatory Authority Market “everybody”

Agency Problem: Micro misallocation

-Prime Broker/ HF: Credit relation

-Clients (Institutional Investors) / HF: Commercial relation

Efficiency Problem: Macro misallocation

-Financial Instability

-Systemic Risk: Real Instability

2 misallocation, 4 market failuresMicro Misallocation

Macro Misallocation

Asymmetry ex ante

Asymmetry ex Post

Financial Instability

Real Instability (Systemic Risk)

Credit to worse (Financial stability review 2007, Mac Kinsey, 2007).

No optimal allocation of private savings (Baquero G., Verbeek M.

2010)

(King and Maier, 2008, Boyson & alii, 2006)

(Garbaravicius T., F. Dierick, 2005, De Vries et

alii., 2009).

2. Our datas: reports about HF regulation

Inventory of propositions edited to enhance hedge fund regulation since 1998 (=15 institutions & 22 reports)-AIMA (Alternative Investment Management Association),

-FED (US Federal Reserve)

-FSA (Financial Service Authority)

-FSF (Financial Forum Stability)

-HFWG (Hedge Fund Working Group)

-Socialist group of European Parliament

-SEC (Securities and Exchange Commission)

-IMF (International Monetary Fund)

-IOSCO (International Organization of Securities Commissions)

-US PWG (President Working Group (US))

2 hedge funds law drafts:

> UE directive proposition from European commission entitled Alternative Investment Funds Managers (AIFMs) (april 2009, November 2009)

> US Treasury financial regulation reform (june 2009) +Volker plan (january 2010)

Our data: 209 proposals 30 proposals not related to informational disclosure:

regulation on markets and capital requirements for prime brokers, measures to constrain leverage and to limit short selling.

Informational disclosure proposals are predominant, (86% of all proposals).

Our final data base = 179 proposals, 109 (before the crisis) and 70 after.

only 45 different original proposals, some of which are suggested in various different reports (“Initial Due Diligences” in 13 reports).

3. Typology of proposals: the modality and aim of informational disclosure

Who discloses to whom?

HF

Customer Prime Brokers

Regulatory Authority

All

4 Disclosure modalities1) Discretionary disclosure: a liberal approach by mutual agreement. The co-contractors freely agree on the disclosed information content

2) Contractual disclosure: Private information is necessarily revealed to all contractors. The standardized contract (by law as UCITS mutual funds, by guidelines or best practices) .

3) Regulatory disclosure: hedge funds have to disclose information to the regulatory authority which is responsible for financial and banking stability. This type of public interventionism is similar to the prudential policy implemented for banks.

4) Public disclosure: It stipulates communication to all. Information is available for everyone, whether clients, participants in financial markets, prime brokers or plain citizens.

Informational disclosure agreements

Encoding Data, a sampleInstitution

Variable Information Disclosure

Aim

Intermediate Objective

Time

Origin

Status

Proposal

AIMA

AIMA20061 1 1 1 1 1 1 Reputation

AIMA

AIMA200611

2 1 2 1 1 1 Ongoing due diligences

AIMA

AIMA20065 2 1 1 1 1 1 Minimum standard of regular and complete disclosure

AIMA

AIMA20091 1 1 2 2 1 1 To appoint an independent third party

AIMA

AIMA200910

2 1 4 2 1 1 Reinforcement of international cooperation between regulatory authorities and Hedge Funds

AIMA

AIMA20092 1 1 2 2 1 1 An independent and competent Valuation Service Provider

AIMA

AIMA20093 1 1 2 2     Detailed Valuation Policy Document, approved by the Governing Body after consultation with other stakeholders

FED FED20061 1 1 2 1 2 2 To develop benchmarksFED FED20062 2 1 1 1 2 2 Ex ante due diligencesFMI FMI20074 2 1 1 1 3 4 Initial due diligencesFSA FSA20051 1 1 2 1 1 2 Best practicesFSA FSA20052 2 1 1 1 1 2 Obligation of registration of managers of hedge funds with

regulatorsFSA FSA20053 2 1 1 1 1 2 Ex ante due diligencesFSA FSA20055 2 1 1 1 1 2 To promote on shore hedge fundsFSF FSF20092 2 1 1 2 3 2 Using independent control procedures

4. Results- statistical results- classification using Kohonen Maps

Before/after crisis proposals:

Total before crisis after crisis Law Draft:

UE, US

after crisis except draft

law179 109 70 22 48

discretionary 9% 8% 11% 0% 17%contractual 44% 42% 46% 45% 46%

public authority 34% 36% 33% 55% 23%all 12% 14% 10% 0% 15%

ex ante asymmetry 23% 21% 27% 23% 29%ex post asymmetry 31% 28% 34% 23% 40%financial instability 23% 31% 11% 9% 13%

systemic risk 22% 19% 27% 45% 19%Micro 54% 50% 61% 45% 69%Macro 46% 50% 39% 55% 31%

Proposals of informational disclosure

#

informational disclosure

Intermediate Objectif

Finality

Emergency of a contractual agreementClients seem to be the favorite recipients of

information

Since the crisis, proposals mainly aimed at optimizing micro allocation and recommended more contractual relations between hedge funds and clients and prime brokers than between hedge funds and regulation authorities.

Hedge funds are not the main problem of the financial crisis.

=> Macro misaallocation is less important

Kohonen algorithm We ran the Kohonen algorithm on the proposal database

and on the report database.

An individual proposal or report is defined by a vector of dimension 6 (discretionary, contractual, regulatory, all, micro aim, macro aim).

We obtain two Kohonen 3*3 maps: one to classify proposals, and the other to classify reports.

discretionary

contractual autority all micro macro

           

Kohenen Map KACP on proposals1. Class 1 corresponds to a code

vector (1;0;0;0;1;0). It groups proposals of informational disclosure based on the discretionary modality with a micro allocation aim. Class 1 groups proposals with discretionary modality and micro aim;

2. The class 3 groups contractual modality and micro aim;

3. The class 5 contractual modality and macro aim;

4. The class 6 contractual/ all modalities mainly with micro aim;

5. The class 7 regulatory modality with macro aim

6. The lastly class 9 publicity with macro aim.

The others classes (2, 4, 8) do not exist in our sample of proposals

0

1

0

1

0

1

11 22 33

44 55 66

77 88 99

AIMA20066 FSF20071 HFWG20094 PWG19992AIMA200610 FSF20072 HFWG20093 PWG19991AIMA20064 FSF20096 IOSCO20062 PWG19993AIMA20063 FSF20095 IOSCO20063 PWG20081AIMA20065 FSF20091 IOSCO20097 SEC200610AIMA20097 FSF20093 IOSCO20094 SEC20064AIMA200910 FSF20094 IOSCO20096 SEC20061AIMA20098 FSF20092 IOSCO20099 UE 20092FED20062 G2020091 IOSCO20095 UE 20094FMI20077 G820073 IOSCO20092 UE 20091FMI20074 G820072 IOSCO20093 UE200910FSA20055 G820071 PSE20075 UE20102FSA20054 HFWG20072 PSE200719 UE20103FSA20053 HFWG20075 PSE20073 UE20101FSA20052 HFWG20071 PSE20072 UE20108FSF20073 HFWG20095 PSE20074 US treasury20091FSF20074 HFWG20092 PWG19994 US volcker20101

FED20067FMI200716FSF200713PSE200716SEC20065

AIMA20069 FSA20091 IOSCO20067 PWG19995AIMA20068 FSA20092 IOSCO20066 SEC20062AIMA20067 FSF200714 IOSCO20065 SEC20068FED20066 FSF20077 IOSCO200915 SEC20067FED20063 FSF200717IOSCO200914 SEC20066FMI20079 FSF20075 IOSCO200910 UE 20099FMI200713 FSF20076 IOSCO200913 UE 20097FMI20078 FSF20099 IOSCO200912 UE 20098FMI20076 FSF20098 PSE20079 UE20105FMI20075 FSF200911 PSE200717 UE20106FSA20058 FSF200910 PSE200721 US treasury20092FSA20057 G2020092 PSE20077 US volcker20104FSA20059 G2020093 PSE200720 US volcker20102FSA20056 G820075 PSE20076 US treasury20093FSA200510 G820074 PWG19998 US treasury20094FSA20093 HFWG20073 PWG19996

FMI20071FMI20073FSA20051FSA200514FSF200711

AIMA20062AIMA20061AIMA20092AIMA20096AIMA20095

PSE20071

AIMA20093AIMA20099AIMA20094AIMA20091FED20065FED20061

PWG20085SEC200611UE 20095UE20107

G820077IOSCO200911

PSE200713PSE200718PSE200715

FSF200715FSF200710FSF20097G820076

FMI200710FMI200714

FSF200712PSE200712PSE200714PWG20083PWG20082FED20064

FSA200512FSA20095

HFWG20076HFWG20091IOSCO20061IOSCO20064IOSCO20091

1

2

3

4 5 6

7

8

9

We find four significant sets of proposals: class 1: discretionary modality and micro aim, class 3: contractual modality and micro aimclass 7: regulatory modality and macro aimclass 9: publicity and macro aim .

Classes 5 and 6 are a kind of garbage. In class 5 we find proposals with contractual modality and macro aim, and in class 6 publicity modality and micro aim.

Agreements about informational disclosure

liberal type (class 1): the aim of informational disclosure is only to reduce the agency problem, no legal constrain

contractual type (class 3): a standardized public contract is enforced to reduce informational asymmetry

Regulatory type (class 7): the informational is disclosed to regulatory authority to reduce macro misallocation

Publicity (class 9): the information is public

discretionary

contractual autority all micro macro

           

1. Class 1 corresponds to regulatory disclosure and macro allocation,

2. class 2 mixed disclosures and macro allocation,

3. class 3 publicity modality with mixed aims,

4. class 4 contractual and regulatory disclosure and a macro aim,

5. class 5 mixed disclosures (discretionary and regulatory modalities) and a macro aim,

6. class 7 predominantly contractual and secondly regulatory disclosure with macro/micro aims,

7. class 8 a mix with predominantly contractual modality with mixed aims and

8. class 9 discretionary and contractual modalities with a micro aim.

9. The class 6 does not exist in our sample

Kohenen Map on reports

11 22 33

44 55 66

77 88 99

Classification of reports

5 sets:1) Hayekian type (class 3)

2) the liberal type (class 9)

3) the collective contractual type: reduce information asymmetry and prevent systemic risk mainly via a mix of contractual and regulatory disclosure modalities (class 8 and 5).

4) the consensual type: to optimize both private and public allocations, via a wide combination of contractual regulatory and public disclosure modalities (classes 2 and 7).

5) The regulatory type: to prevent systemic risk via the regulatory disclosure modality (class 1)

G20 2009 PSE 2007 PWG 2008

Volcker 2010 G8 2007  

US Treasury 2009 FSF 2007  

FSA 2009 FMI 2007  

SEC 2006 IOSCO 2006  

  FSA 2005  

  FED 2006  

IOSCO 2009 HFWG 2007 HFWG 2009

PWG 1998 AIMA 2007 AIMA 2009

UE 2010    

FSF 2007    

UE 2009    

11 22 33

44 55

77 88 99

Conclusion (1): the complexity of transparence

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We give an original perspective to understand the emergence of hedge funds regulation thanks to information economics tools.

• We emphasize the complexity of the application of transparency principle and the continuum of agreements

• The norm of informational disclosure is polymorphic We consider only two main aspects: the expected consequences and the modality to disclose.

The divergence between the public view of regulation (consensual type, regulatory type, collective contractual type) and the private view (liberal type)

The divergence between US and EU: US (macro aim and regulatory disclosure), EU ( micro & macro aim and mix contractual & regulatory disclosure).

The difficulty to build an international financial regulation: even if it exists a consensus about market failures induced by opacity

Conclusion (2): the difficult convergence

- We assume than information preexists. But the disclosed information results of social and political construction (risk model, innovation product evaluation…)

- We consider the informational disclosure, but it exists other forms of hedge funds regulation: indirect regulation via institutional investors (Pension Funds, Insurance)

- Subjective Encoding: algorithm like Prospero

Limits and work in progress :