The costs and benefits of hedge fund disclosure

Larry Ribstein —  3 February 2011

The WSJ reports on proposed rules forcing hedge funds to disclose confidential proprietary information:

Under current rules, many managers are required each quarter to publicly disclose their long equity positions in public securities. The proposed rules would require a much greater level of disclosure to regulators about trading positions, counterparties, liquidity, leverage and performance. * * *

“WikiLeaks has more or less proven that anything you give to the government you have to assume could one day be public,” said Nathan Greene, a lawyer with Shearman & Sterling LLP who represents hedge funds, referring to the leaks of thousands of diplomatic cables in recent months.

“It is impossible, after seeing State Department cables, to say to yourself, ‘I’m going to package my most sensitive business information and give it to the U.S. government,’ and do it without a pit in your stomach,” he said. * * *

Systemic-risk monitoring has long been under consideration for the hedge-fund industry.

Onerous disclosure regulation of hedge fund trading positions is costly and unnecessary, as I’ve discussed:

Hedge funds are not part of the systemic risk problem.  It’s more likely they’re part of the solution in the sense that they use proprietary and business methods to bet against the accepted wisdom, rather than following all the other lemmings off of financial cliffs.  For a good statement of this argument, see Jon Macey, Promises Kept, Promises Broken, 275-82 (2008). Increased disclosure may reduce the funds’ incentives to invest in developing these strategies, which could actually increase systemic risk.

More generally, as I’ve said, hedge funds, through short selling and takeovers, have been an important source of market discipline.

And then there are also the risks that (1) the SEC won’t effectively guard the information; and (2) won’t effectively use the data it gets.  Here’s more bearing on those issues.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

5 responses to The costs and benefits of hedge fund disclosure

  1. 

    “WikiLeaks has more or less proven that anything you give to the government you have to assume could one day be public.”

    Wrong lesson. Government is no more prone to leaks than private enterprise, indeed, is probably less prone to such leaks. The tobacco industry was taken down more or less single handedly from a high profile leak from one of their law firms by a junior employee there. Customers of Swiss banks have been repeatedly burned by leaks about tax fraud to government agencies and Wikileaks itself. Government agencies are generally more systemic in their measures to maintain secrecy and privacy than private enterprises like insurance companies and credit rating firms entrusted with similar information.

    Indeed, the SEC, because it is a relatively small entity independent of other large federal government departments, might be in a better position to protect private information than many other agencies. There are certainly plenty of examples of the federal government being successful in keeping secrets. For example, the IRS has had considerable success in keeping tax information from other agencies, and the Department of Commerce has successfully kept census information segregated from immigration enforcement agencies. The Secretary of State’s office which was exposed in the Wikileaks scandal, has less stringent confidentiality rules in part because most of the information it gathers does not come through covert channels that have to be protected the way that the information gathered by the CIA agents in their midst do must, and in part because few non-employees of the agency voluntarily entrust sensitive information to the agency – so the need to show that the trust is justified is absent.

  2. 
    Douglas B. Levene 3 February 2011 at 10:04 pm

    The concerns expressed by Mr. Clearfield may or may not be valid but they do not have anything to do with the financial crisis. I have yet to read any evidence that hedge funds in any way were responsible for the crisis. Why burden hedge funds with expensive disclosure obligations that will not do anything at all to prevent the next meltdown?

    The heart of the problem, which Dodd Frank and the Commission report go out of their way to ignore, is moral hazard. How do you solve the problem of moral hazard in a financial system that seemingly requires a lender of last resort? That’s the question. The notion that wise regulators can compensate for moral hazard seems far fetched in the light of past experience and what we know about the failures of regulation generally. Until and unless the Government can credibly signal to the market that there will not be any bailouts for distressed institutions we can just sit and wait for the next disaster.

    • 

      Douglas Levene: “I have yet to read any evidence that hedge funds in any way were responsible for the crisis.”

      Nor have I. I don’t think they did. In fact, a few of the hedge funds were about the only players in the market trying to prick the bubble; if attention had been paid to them sooner, things wouldn’t have gotten as far out of hand.

      I agree with you about moral hazard, and that should be addressed, although I’m increasingly discouraged by the lawmakers’ response thus far in this regard. But not all derivative positions were held by hedge funds, and some of these represented risks so large they came to constitute a moral hazard in and of themselves. And as hedge funds continue to play an ever-more important part in the capital markets, and they are playing more and more with Other People’s Money, this will create the potential for larger and larger moral hazards in the hedge fund sector as well.

      There will still be enormous fortunes to be made in hedge funds. It is competition that kills margins in fund management, not regulation—even if that sometimes imposes an onerous burden. There’s a lot of room in 2 and 20 for the additional costs.

      Generals are often accused of preparing for the last war. It would be better if regulators don’t make the same mistake.

  3. 

    Dear Larry,

    I agree that requiring still further additional disclosures can give one a queasy feeling in the pit of one’s stomach, or I suppose give one “a pit in one’s stomach,” as our colleague at Shearman & Sterling would have it. However, there are a couple of problems with not having to disclose large (I think we’re only talking about large) derivative positions.
    (1) An activist investor could be trying to influence a company to pursue one course of action, while actually being net short, and therefore having an interest that the company act contrary to its best and other shareholders’ best interests. We’ve already had this sort of situation come out publicly: Perry Partners and the Mylan Laboratories/King Pharmaceutical deal.
    (2) Concealed takeovers. Although this wasn’t in the U.S., it indicates the danger: a controlling position in Volkswagen was built up by Porsche, without either the company or other shareholders having any idea that this was going on. Control was transferred to a small, family-controlled company which almost sank in the process, threatening to bring VW down with it, and the other shareholders never got any premium for their shares.

    While the machinations of hackers like Julian Assange and his abettors endanger the confidentiality of anything and everything, one must admit that revelations about hedge fund positions that are more than a couple of months old are normally useless as guides to arbitrage one’s competitors; anyone who acts on such information risks getting blind-sided as the position will often have changed in the interim. I know that many fund managers like to think that their strategies are as vulnerable as the technical secrets of new weapons or the identities of intelligence operatives, but they really aren’t sensitive for more than a short time before everything is priced into the market and positions change. If the boys want to play spy for real, they should join the CIA instead.

    To protect against the hacking of truly time-sensitive information, disclosure could be lagged by a month or a quarter. This wouldn’t provide the same direct protection against sneak takeovers as more timely disclosure might, but it would allow for serious retroactive enforcement actions which should deter all but the most criminally-minded. By the time such disclosures could leak, there would be little or no arbitrage value in the information.

    Derivatives can be a good way to control or modify risk. Hedge funds are tremendously important and useful parts of the investment spectrum. But if the tail wags the dog, there is the potential for a problem. It’s only going to get worse as human inventiveness comes up with more and more synthetic ways to create a position.

  4. 
    north fork investor 3 February 2011 at 6:54 am

    You are just so busy today!