The Hedge Fund Regulation Dilemma: Direct vs. Indirect Regulation

Abstract

This article studies the regulatory strategies to address the potential systemic risk of hedge funds operation in financial markets. Due to the implications of the choice of regulatory strategies and instruments in terms of mitigating systemic risk, the article focuses on one critical aspect of hedge fund regulation, namely the choice between direct regulation and indirect regulation. Having defined the distinction between direct and indirect regulation, also mapping its implications in terms of regulatory techniques and instruments, the arguments for and against direct and indirect regulation of hedge funds are analyzed. This article argues that the indirect regulation of hedge funds through their counterparties and creditors, while being less costly, can better address regulatory arbitrage by hedge funds and their potential contribution to systemic risk. This policy recommendation is further supported by the economic and organizational structure of hedge funds and their particular features in terms of the number and composition of their counterparties and creditors.