T1038 Hedge Funds

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  Hedge funds and Dodd-Frank: Institutionalize, fly low or else! Thoughts  2  The Dodd-Frank Wall Street Reform and Consumer Protection Act will impose much stricter regulation on the hedge fund industry. The scope of that regulation, how the industry must respond to it, and whether firms will embrace the spirit of the regulation to gain competitive advantage are open questions. Government rulemaking will provide more answers in the months ahead. But the industry isn’t waiting to act. Despite continuing uncertainty, hedge funds, prime brokers, fund administrators and other service providers are starting to reposition themselves for a vastly different industry landscape and new opportunities, guided by what they do know. Some funds are looking to grow and consolidate so they can build the scale and infrastructure needed to meet increased compliance demands. Others are weighing whether to shrink their business below asset thresholds set by the act so they can avoid additional taxes and testing and reporting requirements. Some are simply exiting the business. Meanwhile, service providers are assessing whether they have the personnel, processes and technologies to meet the needs of customers facing intensified regulation at both the federal and state level.This white paper examines the implications of regulatory reform and changing market conditions for hedge funds. It discusses 10 requirements hedge funds will need to consider as they decide where they fit in the fund spectrum. And it describes some practical steps that funds and service providers can take to begin positioning themselves to capitalize on the dynamics of the new environment. 3 Hedge funds and Dodd-Frank: Institutionalize, fly low or else! By Alvi Abuaf, Edward Hawthorne and Sandeep Vishnu, Partners and Emmanuel Chesnais, Managing Principal Hedge fund regulation – how we got here The idea of increasing regulatory oversight of hedge funds did not srcinate with Dodd-Frank. In response to the explosive growth of hedge funds’ assets under management (AUM) and growing concern over their operations and transparency, the U.S. Securities and Exchange Commission (SEC) issued a rule in 2006 requiring funds to register as investment advisers. However, that same year, the U.S. Court of Appeals for the District of Columbia Circuit vacated the rule on the basis that it was not compatible with the Investment Advisers Act of 1940.In the wake of the financial crisis, hedge funds again became a target for increased regulation. With the industry becoming more institutionalized and negative investor sentiment growing, hedge funds embraced or in some cases acquiesced to inclusion in Dodd-Frank, which became law in July 2010. The act imposes new registration and reporting requirements, risk rules, and investment limits (Figure 1 on page 4),  as well as other safeguards (see “A look at Dodd-Frank hedge fund  provisions” on page 13).  Along with requiring hedge funds to register with the SEC, the act imposes new reporting requirements, significant oversight of nonbank financial firms, transformation of the over-the-counter (OTC) derivatives business and limitations on proprietary trading by banks. Over the next several years, regulatory bodies, including the SEC, the U.S. Commodity Futures Trading Commission (CFTC),  4 Systemic riskSEC regulationPrivate fund reporting Volker RuleMajor swap participantFuture regulatory changes Figure 1. Hedge funds face intersecting Dodd-Frank requirements ã Hedge and private equity funds with assets >$150 million will be forced to register with the SECã Registration subjects funds to periodic inspections by SEC examiners with multiple exemptionsã Funds must hire a chief compliance officer and set up policies to avoid conflicts of interestã GAO to complete a study on feasibility of forming a self-regulatory organization to oversee private funds and submit a report regarding the same to Congress within 1 year of the date of enactmentã Other SEC mandated studies (e.g. short selling, accredited investor status)ã If applicable, hedge funds will be subject to a high degree of regulatory oversight, including capital and margin requirements and business conduct standardsã Required to report information to the SEC about trades and portfolios that is “necessary for the purpose of assessing systemic risk posed by a private fund”ã Data will be shared with systemic risk regulator and SEC will report to Congress annually on how it uses this data to protect investors and market integrity ã Hedge funds can be placed under Fed supervision if determined to have grown too large or too risky (SSNF concept)ã Banks’ investments and sponsorship into private funds should not exceed:– 3% of total NAV of fund – 3% of Tier1 capital in the aggregate
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