Speech by SEC Commissioner:
Remarks at the Symposium on “Hedge Fund Regulation and Current Developments”
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
The Center for Law, Economics & Finance (C-LEAF)
The George Washington University Law School
New York, New York
June 8, 2011
Thank you, Scott [Kieff], for that very generous introduction. As an academic myself, I always welcome the chance to participate in law school sponsored events such as this one. Given my many friends at The George Washington University Law School, I am especially pleased to join you at this “C-LEAF in New York” symposium on “Hedge Fund Regulation and Current Developments.” For all of those who are participating, this event promises to be an informative exploration of hedge funds and their role in financial markets.
Not only is the conversation sure to be intellectually interesting, but I expect that this gathering will prove to be consequential in more practical and concrete ways as well. We all stand to learn something when policymakers, academics, and practitioners are brought together to share their ideas and perspectives. I, for one, am better able to fulfill my responsibilities at the Commission when I have the opportunity to be part of an exchange at an event like this. By hearing the ideas and viewpoints of others, I am better able to appreciate the consequences of our policy choices when weighing the tradeoffs embedded in each decision we face as regulators. In other words, I am better equipped to make informed decisions as a result of the insights I hear when interested and knowledgeable parties engage.
I expect that you will hear many specifics from the distinguished panelists who will be speaking shortly, so I am going to speak more generally this afternoon. My goal is to outline the broad contours of key regulatory developments that will impact the hedge fund industry, leaving the details to another day, and to share some of my thoughts for the difficult task of fashioning and administering the federal securities laws.
All of my remarks are in service of one overarching point, which is this: We must avoid constructing a financial regulatory regime that unduly burdens and constricts the U.S. financial system at the expense of our country’s economic growth and the competitiveness and dynamism of our financial markets. If we overregulate our financial markets, we run the risk that companies will find it more costly to access the capital they need to grow and to hire new employees; that businesses and individuals will find it more difficult to manage their risks effectively; that consumers will find it more challenging to get the credit they rely on to buy the goods and services they need; that investors will enjoy fewer opportunities to accumulate wealth and earn income and to transact efficiently and at low cost; and that important new ideas and technologies will not be commercialized.
Before saying more, now would be a good time for me to pause to remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
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Not too long ago, the primary regulatory debate capturing the attention of the hedge fund industry was whether or not advisers to hedge funds should be required to register under the Investment Advisers Act. In late 2004, the SEC amended its rules implementing the Advisers Act so that hedge fund managers would have to register with the Commission as investment advisers.1 In particular, as a result of the new SEC rule, a hedge fund manager that advised a “private fund” could no longer rely on the so-called “private adviser exemption” of Section 203(b)(3) of the Advisers Act if the fund or funds the manager advised had 15 or more total investors. The requirement that hedge fund managers register was short-lived, however, as the D.C. Circuit overturned the Commission’s rulemaking in the court’s 2006 Goldstein decision.2
Fast forward to today. Today, investment adviser registration is just part — albeit an important part — of the mass of regulatory change that is set to impact the hedge fund industry. Less than three years ago, the peak of the financial crisis gripped us, and we were challenged in responding to — and persevering through — a period of financial and economic strain unlike anything since the Great Depression. Not only did the turmoil give rise to a great deal of hardship and misfortune, but the historic crisis also evoked a historic expansion of the federal government’s role in the economy as evidenced by the Dodd-Frank Wall Street Reform and Consumer Protection Act and the hundreds of rules and regulations that it demands of the SEC and other financial regulators.
Certain provisions of Dodd-Frank directly impact hedge funds. For example:
- Dodd-Frank repeals the private adviser exemption, as the SEC effectively attempted to do in 2004, thus extending the reach of Advisers Act registration to hedge fund managers that are unable to take advantage of the more limited exemption from registration that Dodd-Frank affords advisers to private funds with less than $150 million in assets under management;
- The Commission, in accordance with Dodd-Frank, has proposed rules to require investment advisers to hedge funds, as well as other private funds, to report a significant amount of information to the SEC on Form PF to assist the new Financial Stability Oversight Council (“FSOC”) in assessing systemic risk;3 and
- Dodd-Frank directs the SEC to adopt regulations or guidelines that prohibit any incentive-based compensation arrangement that “encourages inappropriate risks” by a financial institution, including an investment adviser with assets of $1 billion or more, by providing “excessive compensation” or that “could lead to material financial loss.”4
Other provisions of Dodd-Frank are not directed toward hedge funds per se, but nonetheless impact the hedge fund industry by influencing, in one way or another, the market activities and strategies of hedge funds. Title VII of Dodd-Frank is illustrative. Title VII confers upon the SEC far-reaching authority to regulate the over-the-counter derivatives market. This expansion of the SEC’s authority obligates the agency to engage in extensive rulemaking in order to craft the new regulatory regime — a regime that will shape the structure and determine the performance of the derivatives market.
The nature and degree of the regulatory engineering that Dodd-Frank calls for is best exemplified by reference to the numerous proposals that the SEC has already advanced for restructuring and overseeing the derivatives market, at least insofar as security-based swaps are concerned.5 To date, the Commission has proposed rules and regulations to, among other things, define what constitutes a “swap,” “security-based swap,” “security-based swap agreement,” and “mixed swap” to demarcate the SEC’s and the CFTC’s respective jurisdictions;6 define “security-based swap dealer” and “major security-based swap participant”;7 define “security-based swap execution facility” (“SB SEF”), establish a registration regime for security-based swap execution facilities, and implement 14 “Core Principles” to govern these trading venues;8 mitigate conflicts of interest for security-based swap clearing agencies and SB SEFs;9 institute standards for the operation and governance of clearing agencies;10 provide for security-based swap transaction reporting;11 prohibit fraud and manipulation in connection with security-based swaps;12 set forth the SEC’s process for reviewing products that a clearing agency plans to accept for clearing;13 and establish an end-user exception to mandatory clearing.14 The Commission has yet to propose other significant rules, such as those relating to capital and margin requirements and business conduct standards.
Because short selling was such a focal point during the peak of the financial crisis in 2008, I should also note that Dodd-Frank calls upon the Commission to conduct two studies of short sale disclosure that hedge funds undoubtedly have an interest in.15 First, Dodd-Frank requires the SEC to study the effects of requiring the reporting of short sale positions in real time, either publicly or confidentially to the SEC. Second, the statute requires the agency to study the prospect of a pilot program that would require that trades be marked as “long,” “short,” “market maker short,” “buy,” or “buy-to-cover” in real time on the Consolidated Tape. The Commission has issued a request for comment to receive input on these studies.16
In addition to taking stock of all of this and other regulatory mandates of Dodd-Frank that affect hedge funds, one also has to factor in Title I of Dodd-Frank, referred to as the Financial Stability Act of 2010. The Financial Stability Act not only creates the Financial Stability Oversight Council, but provides for expanded governmental oversight and regulation of nonbank financial companies that the FSOC deems to be “systemically important.” How the FSOC and the Federal Reserve Board will choose to exercise their considerable power under Title I — including which nonbank financial companies will be designated as “systemically important” (that is, as “SIFIs”) and thus subject to heightened prudential supervision and more intrusive government dictates — is still uncertain. Personally, I am concerned about the ability of even a conscientious and well-intentioned systemic risk regulator to accurately identify when a firm is “systemically important” and to properly calibrate the source of future danger to the financial system.17 And questions persist, at least to my mind, as to what the limits are on the government’s authority to regulate under the Financial Stability Act once SIFIs are designated.
Dodd-Frank has not been the only origin of regulatory change for the hedge fund industry. Separate from the agency’s Dodd-Frank responsibilities, the SEC in recent years has moved forward a number of regulatory initiatives of significance to hedge funds concerning matters such as short selling;18 the custody of advisory client assets;19 investment adviser disclosures;20 and political contributions by certain investment advisers or so-called “pay to play.”21
Furthermore, the structure and performance of the U.S. equity markets in which hedge funds transact has received a considerable amount of attention. The Commission has advanced proposals concerning flash orders22 and dark pools;23 and the SEC issued a concept release on equity market structure in 2010.24 The equity market structure concept release solicited input from commenters on high frequency trading, co-location, the price discovery process, order execution, undisplayed liquidity, the quality of our equity markets, as well as other topics.
The May 6 “flash crash,” when the markets fell precipitously before rebounding rapidly, accentuated interest in the regulatory infrastructure that governs the U.S. equity markets. In the aftermath of May 6, single-stock circuit breakers were instituted on a pilot basis;25 changes were made to clarify the process for breaking “clearly erroneous” trades;26 and market maker “stub quotes” were effectively prohibited.27 Earlier this year, a proposal to implement a “limit-up/limit-down” mechanism to curb market volatility was filed with the Commission.28 Still other suggestions have been offered for safeguarding against another “flash crash.” The Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues that was asked to examine the causes and effects of May 6, for example, has offered its own set of 14 separate recommendations in response to the events of that day.29
To appreciate the contours and consequences of the regulatory regime, it is necessary, in my view, to move beyond an understanding of the wave of substantive regulatory change that is being ushered in. One also must appreciate how the law is enforced. Dodd-Frank, then, proves to be additionally impactful in that it includes a number of important statutory provisions that will shape the government’s future enforcement of the federal securities laws. Dodd-Frank includes enforcement-related provisions regarding, among other things, the SEC’s authority to bring aiding and abetting charges under the Securities Act and the Investment Company Act;30 the imposition of penalties for aiding and abetting liability under the Investment Advisers Act;31 recklessness as satisfying the knowledge requirement for aiding and abetting under the Exchange Act;32 the authority of the Commission to impose monetary penalties in any cease-and-desist proceeding;33 the extraterritorial reach of SEC enforcement actions;34 bounties for whistleblowers;35 the Commission’s authority to seek collateral bars;36 and the disqualification of “bad actors” from certain private placements.37
Now is not the time or place to delve into the details of all that I have catalogued. Rather, my purpose in highlighting what I did — which, I should note, is far from an exhaustive treatment of the ongoing regulatory developments that are likely to affect the hedge fund industry domestically, and I did not even mention any regulatory change that is underway in other jurisdictions — is to bring into sharper relief the magnitude of the regulatory realignment that hedge funds, along with other market participants, must now account for in structuring their operations and in determining their investment strategies and trading activities.
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Regulators, including the SEC, still have many choices to make as we continue determining the scope and nature of financial regulation, whether it is pursuant to our rulemaking obligations under Dodd-Frank or otherwise. As I mentioned, not everything on the Commission’s regulatory agenda flows from Dodd-Frank. Let me, then, articulate three guideposts that I believe must inform how we exercise our discretion when crafting and administering the securities law regime.
First, and most specifically to the hedge fund industry, is that we must recognize the positive effects that stem from the active participation of hedge funds in our financial markets. Part and parcel of their diverse investment strategies and trading activities across a range of asset classes, hedge funds provide liquidity to our markets; contribute to price discovery and the efficient allocation of resources throughout our economy; are important to capital formation; enable other investors and commercial enterprises to more effectively manage their own risks; discipline management teams and boards to run their businesses profitably; and offer valuable opportunities for investors to diversify their portfolios and to enjoy higher returns.
When regulating, we need to account for the risk that these economy-wide benefits could be sacrificed if the regulatory regime unduly burdens and constricts the activities of hedge funds. It would be concerning, for example, if hedge funds were required to make public disclosures that compromise their proprietary investment strategies or if the regulation of our equity markets changed so that it became more costly to provide liquidity.
This introduces the second guidepost — namely, we need to use our regulatory power cautiously, carefully evaluating the intended benefits of our actions while giving due regard to the potential undesirable effects of our regulatory choices. In short, the Commission must engage in rigorous cost-benefit analysis when shaping the securities law regime.38 A demanding cost-benefit analysis that permits us to make informed tradeoffs across a range of potential outcomes is the best way of achieving the common good, of ensuring that the benefits of regulation outweigh the costs. 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. We cannot simply focus on the costs and benefits of a single rule change on a stand-alone basis. It is the totality of the regulatory infrastructure that impacts the private sector.
As part of this analysis, we need to 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, as well as the opportunity cost of the time and effort of personnel that could have been directed toward other productive endeavors. Indeed, the compliance burden on investment advisers has increased of late due to, for example, the need to comply with the new “pay-to-play” rule restricting political contributions;39 the recent amendments to Part 2 of Form ADV concerning the preparation and delivery of a “brochure” and “brochure supplements” to advisory clients;40 and the recent amendments to the custody rule.41
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 PF42 and proposed amendments that would expand the disclosures required under Part 1 of Form ADV43 — 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.
Assessing the cost-benefit tradeoffs of a particular regulatory course is not just about factoring in compliance costs, however. 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, 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. All things considered, some transparency may be unwarranted when its full effects are understood. The Commission’s recently-proposed Regulation SB SEF offers an example.
Dodd-Frank contemplates a new type of trading venue — security-based swap execution facilities — where parties will be able to transact in security-based swaps as an alternative to transacting in the over-the-counter derivatives market or on a national securities exchange. In offering an interpretation of what constitutes an SB SEF, the Commission underscored the value of investor choice and gave regard to the cost of pre-trade transparency — namely, the risk of “front running.”44 The Commission proposed to allow a party, when transacting on an SB SEF, to select its counterparty by sending its request for quote (“RFQ”) to one dealer without having to expose the RFQ to other liquidity providers so long as the party had the ability to send its RFQ to multiple liquidity providers on the SB SEF 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. I look forward to considering commenters’ views on the Commission’s Regulation SB SEF rule proposal.
The third guidepost is this: Regulatory decision making should be supported by data, to the extent available, and economic analysis. This is particularly important to stress insofar as the SEC is concerned, because the SEC is an agency that traditionally has overwhelmingly been comprised of lawyers. Empirical analysis must be much more central to decision making at the SEC than has been the case.
A consideration of the structure of the U.S. equity markets shows this guidepost in operation. The data we have today — as reflected, for example, in the extensive comment the Commission received in response to our market structure concept release — substantiate that the U.S. presently enjoys high quality markets that have performed extremely well, including during the financial crisis. The data consistently show, among other things, that bid-ask spreads are narrow; that execution speeds have fallen; that liquidity has increased; and that commissions for retail investors have decreased. Concerning the turmoil of 2008, although price declines and volatility led to investor losses and unease, U.S. equity markets opened and closed in an orderly fashion and transactions cleared.
Given that, on the whole, U.S. equity markets already perform very effectively according to a host of measures, one has to question whether additional regulatory steps that would further engineer our equity markets are worth the risk that the new regulatory demands might blunt innovation, inhibit productive trading activities, and constrict investor choice.
This is not to say that there is no room for improvement, and some have identified various equity market features and dynamics that concern them, such as the level of undisplayed liquidity and the impact of high frequency trading. I welcome the active discussion of these and other important topics. But in rendering policy judgments, it is important to allow the data to channel the regulatory agenda in the directions that are most productive.
Indeed, the report prepared by the SEC and CFTC staffs on the May 6 “flash crash” exemplifies how the careful study of data can — and should — guide us as regulators.45 More to the point, I would underscore that the circuit breakers instituted after May 6 were done so on a pilot basis precisely because a pilot affords regulators the opportunity to learn from the actual effects of a rule change so that the permanent decision can be grounded in empirical analysis. Pilots, in other words, provide regulators a mechanism for proceeding incrementally so that we can more readily adjust the regulatory framework if needed to strike a better balance among competing regulatory considerations.
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As I suggested at the outset, the SEC is better equipped to make informed decisions when we receive input from those who are subject to our rules and impacted by our choices. With input from you and others, we can evaluate more critically the practical impacts and tradeoffs of choosing one regulatory option over another.
I appreciate that the pace and volume of rulemakings right now is a challenge for commenters looking to weigh in on the Commission’s proposals. That is why I want to conclude by encouraging your active engagement in the process by stressing how key it is. In particular, I want to encourage you to tell us how our rules will impact the operation and administration of hedge funds.
I also want to emphasize my view that, in advancing the numerous Dodd-Frank rulemakings that the SEC is charged with, the agency cannot rush. The scope and complexity of the rulemaking is daunting and unprecedented. Trying to adopt too many rules and regulations too quickly is fraught with risk. Nor should we rush the implementation of the new rules and regulations, whatever their substance may be when enacted. Market participants, including hedge funds, will need to evaluate their business and investment options in light of the new regulation; structure their operations and activities accordingly; and develop and implement the systems, procedures, policies, and controls they will need to comply with the new regulatory regime. This will take time. Thus, we need to be realistic about how quickly after being adopted the new rules and regulations should become effective in order to ensure that the transition to the new regulatory environment is orderly and workable in practice.
1 See http://www.sec.gov/rules/final/ia-2333.htm.
2 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
3 See http://www.sec.gov/rules/proposed/2011/ia-3145.pdf.
4 See http://www.sec.gov/rules/proposed/2011/34-64140.pdf.
5 I look forward to continuing to consider the comments we receive on these and related proposals.
6 See http://www.sec.gov/rules/proposed/2011/33-9204.pdf.
7 See http://www.sec.gov/rules/proposed/2010/34-63452.pdf.
8 See http://www.sec.gov/rules/proposed/2011/34-63825.pdf.
9 See http://www.sec.gov/news/press/2010/2010-190.htm.
10 See http://www.sec.gov/rules/proposed/2011/34-64017.pdf.
11 See http://www.sec.gov/news/press/2010/2010-230.htm; http://www.sec.gov/rules/proposed/2010/34-63347.pdf.
12 See http://www.sec.gov/rules/proposed/2010/34-63236.pdf.
13 See http://www.sec.gov/rules/proposed/2010/34-63557.pdf.
14 See http://www.sec.gov/rules/proposed/2010/34-63556.pdf.
15 Dodd-Frank § 417.
16 See http://www.sec.gov/rules/other/2011/34-64383.pdf.
17 Troy A. Paredes, Commissioner, U.S. Securities & Exchange Commission, Remarks at Midwest SIFMA & St. Louis Regional Chamber and Growth Association (Mar. 24, 2010), available at http://www.sec.gov/news/speech/2010/spch032410tap.htm (analyzing the role of a systemic risk regulator).
18 See http://www.sec.gov/rules/final/2010/34-61595.pdf.
19 See http://www.sec.gov/rules/final/2009/ia-2968.pdf.
20 See http://www.sec.gov/rules/final/2010/ia-3060.pdf.
21 See http://www.sec.gov/rules/final/2010/ia-3043.pdf.
22 See http://www.sec.gov/rules/proposed/2009/34-60684.pdf.
23 See http://www.sec.gov/rules/proposed/2009/34-60997.pdf.
24 See http://www.sec.gov/rules/concept/2010/34-61358.pdf.
25 See http://www.sec.gov/news/press/2010/2010-98.htm; http://www.sec.gov/news/press/2010/2010-167.htm.
26 See http://www.sec.gov/news/press/2010/2010-167.htm.
27 See http://www.sec.gov/news/press/2010/2010-216.htm.
28 See http://www.sec.gov/news/press/2011/2011-84.htm.
29 See http://www.sec.gov/spotlight/sec-cftcjointcommittee/021811-report.pdf.
30 Dodd-Frank § 929M.
31 Id. § 929N.
32 Id. § 929O.
33 Id. § 929P(a).
34 Id. § 929P(b).
35 Id. § 922. See also http://www.sec.gov/news/press/2011/2011-116.htm.
36 Id. § 925.
37 Id. § 926. See also http://www.sec.gov/news/press/2011/2011-115.htm.
38 See also Troy A. Paredes, Commissioner, U.S. Securities & Exchange Commission, Remarks at “The SEC Speaks in 2009” (Feb. 6, 2009), available at http://www.sec.gov/news/speech/2009/spch020609tap.htm (discussing the role of cost-benefit analysis in regulatory decision making).
39 See http://www.sec.gov/rules/final/2010/ia-3043.pdf.
40 See http://www.sec.gov/rules/final/2010/ia-3060.pdf.
41 See http://www.sec.gov/rules/final/2009/ia-2968.pdf.
42 See http://www.sec.gov/rules/proposed/2011/ia-3145.pdf.
43 See http://www.sec.gov/rules/proposed/2010/ia-3110.pdf.
44 See http://www.sec.gov/rules/proposed/2011/34-63825.pdf.
45 See http://www.sec.gov/news/studies/2010/marketevents-report.pdf.