Monday, June 13, 2011

Commissioner Paredes Cautions on Hedge Fund Regulation

When crafting regulations affecting hedge funds, said SEC Commissioner Troy Paredes, the Commission should be mindful of the risk that economy-wide benefits could be sacrificed if the regulatory regime unduly burdens and constricts the activities of hedge funds. In remarks at a recent symposium, he noted that hedge funds provide market liquidity, contribute to price discovery, enable other investors and commercial enterprises to more effectively manage their own risks, discipline management teams to run their businesses profitably, and offer valuable opportunities for investors to diversify their portfolios and enjoy higher returns.

The Commissioner would be concerned if hedge funds were required to make public disclosures that compromise their proprietary investment strategies or if the regulation of the equity markets changed so that it became more costly to provide liquidity.

More broadly, the Commissioner noted that the SEC should use its regulatory power cautiously and carefully evaluate the intended benefits of its actions while giving due regard to the potential undesirable effects of regulatory choices. The Commission must engage in rigorous cost-benefit analysis when shaping the securities law regime, he emphasized, since a demanding cost-benefit analysis allowing for informed tradeoffs across a range of potential outcomes is the best way of ensuring that the benefits of regulation outweigh the costs.

In his view, this should include assessing the cumulative impact of the entire package of regulatory demands to anticipate the overall effect of the regulatory regime when viewed in its entirety. He Commission cannot simply focus on the costs and benefits of a single rule change on a stand-alone basis, he cautioned, adding that it is the totality of the regulatory infrastructure that impacts the private sector. As part of this analysis, the SEC must be mindful of compliance costs. It is costly for firms to comply with the regulatory obligations they confront both in terms of out-of-pocket expenditures, he observed, as well as the opportunity cost of the time and effort of personnel that could have been directed toward other productive endeavors.

Proposals that have been advanced pursuant to Dodd-Frank, including proposed disclosures that investment advisers to private funds would have to make on new Form PF and proposed amendments that would expand the disclosures required under Part 1 of Form ADV, would add additional regulatory burdens. Dodd-Frank brings about a more fundamental change in the compliance burden for investment advisers that had been exempt from registration but that will now have to register under the Advisers Act because Dodd-Frank repealed the private adviser exemption.

But, he continued, assessing the cost-benefit tradeoffs of a particular regulatory course is not just about factoring in compliance costs. It is about accounting for a broader range of potential counterproductive effects and unintended outcomes that offset the anticipated benefits of the regulatory change, even if the out-of-pocket compliance costs are low. In fact, he emphasized, even transparency is not costless. Citing the goal of transparency or noting the disclosure philosophy that animates the federal securities laws to justify regulation should not distract from a rigorous analysis of the competing pros and cons. Indeed, he believes that, all things considered, some transparency may be unwarranted when its full effects are understood. He cited as an example the proposed regulations on security-based swap execution facilities.

Dodd-Frank contemplates a new type of trading venue for security-based swap execution facilities where parties will be able to transact in security-based swaps as an alternative to transacting in the OTC derivatives market or on a national securities exchange. In offering an interpretation of what constitutes a security-based swap execution facility, the Commission underscored the value of investor choice and gave regard to the cost of pre-trade transparency, namely, the risk of front running.

The Commission proposed to allow a party, when transacting on a security-based swap execution facility to select its counterparty by sending its request for quote to one dealer without having to expose the request to other liquidity providers so long as the party had the ability to send its request for quote to multiple liquidity providers on the swap execution facility if it preferred to. The proposed approach would accommodate concerns about front running, that pre-trade transparency about a trade may enable other market participants to exploit information about the upcoming trade to the ultimate disadvantage of the investor initiating the transaction, in striking a balance between the costs and benefits of transparency in this context.