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Give an overview of the different ways regulators try to limit hedge fund related risks.

FRM® Part II · Risk Management and Investment Management · Risk, Regulation and Organizational Structure · FRM2.IM.9.c

The idea

Regulators limit hedge fund risk in several ways. Direct regulation targets the manager and the fund. It covers registration, disclosure, and confidential reporting of positions, leverage and counterparty exposures so supervisors can monitor systemic risk. It also covers rules on valuation, custody and risk management. The EU Alternative Investment Fund Managers Directive is an example. It regulates the manager and requires a depositary and leverage reporting. Indirect regulation works through the fund's counterparties. It includes capital charges and exposure limits on banks, margin and clearing requirements for derivatives, and the Volcker rule, which restricts banks from sponsoring or investing in hedge funds. Investor protection rules limit who may invest, for example only accredited or qualified investors. Market-wide measures such as short-selling restrictions also apply. Exam point: separate measures aimed at protecting investors from those aimed at containing systemic risk. Most regulation reaches funds through their managers and the banks that serve them.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is an example of direct regulation of hedge fund related risk?

  1. Raising capital charges and exposure limits on the bank counterparties that lend to hedge funds.Why not: This is indirect regulation, working through the fund's counterparties.
  2. Restricting banks from sponsoring or investing in hedge funds through their trading subsidiaries.Why not: Also indirect: it regulates banks, not the funds or their managers.
  3. Requiring advisers to register and file confidential reports on positions and leverage. - correct
  4. Banning the sale of fund shares to investors in other countries, whatever their sophistication.Why not: Not a standard hedge fund regulatory tool, and not about systemic risk reporting.

Direct regulation applies to the manager or fund itself, for example registration, disclosure and reporting so supervisors can monitor leverage and exposures. Rules on bank capital and bank involvement are indirect.

A harder one

Which statement best describes the main thrust of the EU Alternative Investment Fund Managers Directive?

  1. It regulates the manager: authorization, risk management, valuation, custody and leverage reporting. - correct
  2. It bans the use of leverage by all alternative funds above a set size, whatever their strategy.Why not: The Directive requires leverage reporting and allows limits to be set, but it does not ban leverage.
  3. It regulates only the fund's prime brokers and sets their capital charges, not managers.Why not: The Directive is aimed at the manager, not at prime brokers.
  4. It limits investment in alternative funds to institutional investors only, closing retail access.Why not: Marketing and investor eligibility are addressed, but this is not a general ban on retail access.

The Directive's central feature is regulation of the manager: authorization, risk management, valuation, an independent depositary and disclosure and reporting of leverage. It is direct, transparency-based regulation, not a leverage ban.

The hardest tier

A policymaker says: 'The Volcker rule means hedge funds now face direct limits on their own leverage.' Which response is most accurate?

  1. It is accurate: the rule caps leverage at the fund level, so funds now face a set limit.Why not: The rule has no fund-level leverage cap.
  2. It is inaccurate: the rule only requires hedge funds to register as investment advisers, nothing more.Why not: Confuses it with adviser registration and reporting requirements.
  3. It is accurate: the rule requires funds to be cleared through central counterparties.Why not: Confuses it with derivatives clearing and margin rules.
  4. It is inaccurate: the rule works on banks' proprietary trading and fund ownership. - correct

The Volcker rule limits banking entities' proprietary trading and their ownership or sponsorship of covered funds, including hedge funds. It reduces connections between banks and funds and is indirect regulation, not a fund leverage limit.

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