From Systemic Risk to Financial Scandals: the Shortcomings of U.S. Regulation on Hedge Funds

In the recent past, hedge funds have demonstrated that they can pose and spread systemic risk across the financial markets, and that their managers can use them to commit fraud and misappropriation of fund assets. Even if the first issue now seems to be considered a serious one by the U.S. legislature, which in 2010, as a legislative response to the global financial crisis of 2007-2008, enacted the Dodd-Frank Act Wall Street Reform and Consumer Protection Act (Dodd-Frank), the current regulation still appears inconsistent and inappropriate to prevent and face it. By contrast, the second issue is not always considered as a real priority, since the only investors who are allowed to invest in hedge funds are sophisticated, wealthy, and/or institutional—namely, investors who do not need to be protected by regulation. However, this argument cannot be shared in light of the number of scandals that recently involved hedge funds damaging their investors, regardless of their level of sophistication and wealth. Although Dodd-Frank includes among its legislative purposes the protection of consumers from abusive financial services practices, its new provisions do not seem to be able to achieve this result. This Article argues that the current rules are not appropriate, or at least are not enough, to address the problems that hedge funds can cause to investors and markets. This Article therefore proposes to consider the possibility of introducing new rules that can help prevent and counteract these issues; namely, self-set limits on the use of leverage, the mandatory involvement of a depositary-custodian with the task of controlling the adviser’s activities, and the mandatory involvement of an external independent valuer with the task of evaluating the fund’s assets on a periodic basis. Even though the application of these rules could be costly for the industry, this cost is reasonably motivated by very important legislative aims, such as investor protection and systemic risk prevention and counteraction.