Addressing the Regulatory Sine Curve

Warren’s and McCain’s proposal to reinstate the Glass-Steagall Act epitomizes bipartisan agreement that the Dodd-Frank Act falls short in several respects. Because crises are inevitable regulation should not merely follow crises but rather anticipate unknown future contingencies.

CLS Blue Sky Blog

A common denominator of regulatory responses to crises is the use of stable and presumptively optimal rules. The term “stable and presumptively optimal rules” refers to rules that, once in place, do not change other than through other rules and Acts of Congress. Congress, financial regulators, and the literature on financial regulation rely almost exclusively on such rules. However, the economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that different sets of rules could be optimal – in contrast with previous expectations. This has played out in the reaction to the financial crisis.  Congress made adjustments via stable rules. Later, these were followed by relaxation, revisions, and retractions. The resulting regulatory cycle has been costly and has produced suboptimal regulatory outcomes. Jack Coffee refers to this phenomenon as the “regulatory sine curve” (see here and here).    The regulatory sine curve results…

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The Hedge Fund Industry after the Lift of the Ban on General Solicitation

The SEC yesterday approved final rules implementing one of the most important changes to securities regulation and offering practices in decades, as mandated by Congress in the Jumpstart Our Business Startups (“JOBS”) Act: to lift the ban on general solicitation or advertising in offerings to accredited investors that are exempt from registration under Rule 506 of Regulation D under the Securities Act of 1933. The implications of this rule change for the private fund industry could be substantial. However, readers who are expecting to see Beyoncé laud XYZ fund’s risk-adjusted returns in TV-ads, on busses etc. are likely to be disappointed. Private funds are still bound by an existing ban on using celebrity endorsements and other gimmicks to sell financial products.

Although the SEC lifted the ban on general solicitation, it appears to desire a counterbalancing of possible effects in the private fund industry. The SEC approved for publication a series of proposed rules to enhance its ability to monitor offerings in the aftermath of these unprecedented rule changes. The proposed amendments to the private offering rules are designed to reduce the risk of fraud and would require issuers to notify the SEC fifteen days before any offering and provide information on the use of proceeds and the type of general solicitation used.

It will take some time until private fund advisers and their attorneys understand exactly how the combination of new rules works, and it will be interesting to see if the enhanced anti fraud requirements will indeed discourage private fund managers from using general solicitations. Given this significant discontinuity, it will be fun to evaluate the effects of the new sets of rules.

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Lifting the Ban on General Solicitation for Private Funds

I previously commented on the bright future for the hedge fund industry. More good news for the industry it seems: private funds could find the ban on general solicitation lifted very soon under SEC rules implementing the provisions of the JOBS Act. Europe’s pending new AIFM regime for alternative investments is stricter but still has lots of loopholes.
Long consigned to silence, hedge fund advisers are starting to practise their sales pitches. Private funds piggybacked on the JOBS Act reforms in the hope of widening the pool of investors they can pitch to. The SEC is busy writing the rules that would put the bill into practice. That process has been bedevilled by delays but it seems inevitable it will overturn the Depression-era ban on “general solicitation”.

The Effect of the Dodd-Frank Act on the Hedge Fund Industry

Presenting initial findings of this study on June 14th 

at the

 2013 Junior Scholars Workshop on Financial Services Law at the University of Connecticut School of Law 

Here is the tentative abstract:

Creating a paradigm shift for private fund regulation in the United States, Title IV of the Dodd-Frank Act mandates hedge fund adviser registration and increased disclosures. Anecdotal evidence suggests that Title IV disproportionally affects smaller hedge fund advisers, leading to barriers to entry for startups and consolidation of the hedge fund industry. To estimate the effect of Title IV, this study evaluates survey data collected after the registration effective date for hedge fund advisers under Title IV. The author finds that the size of hedge fund advisers as measured by assets under management is associated with the cost of Title IV compliance and other independent variables. These findings are inconsistent with the hypothesis that smaller hedge fund advisers are more affected by Title IV compliance than mid-sized and large hedge fund advisers. Adviser size may not matter as much for policy adjustments and SEC rule making as the hedge fund industry claimed. 

A Bright Future for the Hedge Fund Industry and its Impact on Policy Making

The Financial Times reports that hedge funds have transformed themselves and are increasingly influencing policy.

My own work provides some empirical support for these observations. My study “Hedge Fund Manager Registration under the Dodd Frank Act” shows that hedge fund managers are only mildly affected by unprecedented registration and disclosure obligations under the Dodd-Frank Act and will be able to grow their influence in future years.  This may have many significant policy implications.

Two additional empirical studies are forthcoming and should help narrow down the effects of Title IV on hedge fund managers. One study pertains to the effect of Title IV on hedge fund manager earnings (in a regression discontinuity design), the other study evaluates the effect of Title IV on smaller hedge fund advisers. Initial results are significant and have important policy implications.

Another study will evaluate the impact of the Alternative Investment Fund Managers (AIFM) Directive on the European Hedge Fund Industry.

Please see the executive summary and summary graphs for the first of these four studies (“Hedge Fund Manager Registration under the Dodd Frank Act”) below:

Executive Summary:  Most hedge fund managers are not altering the size of their funds to avoid Dodd-Frank Act requirements. Managers are also not altering their investing styles. Most of the new registration and disclosure requirements have not affected the returns for hedge fund investors. 

Only very few managers have changed their funds’ legal structure in response to Dodd-Frank Act requirements. Rather, hedge funds are adapting to the new requirements by outsourcing compliance work, hiring additional counsel, establishing new record-keeping policies, hiring additional staff, and changing marketing materials and investor communication.

Please see the summary graphs below:

Figone.onePlan a Strategic Response to Dodd-Frank
: A minority of respondents in the survey has planned a strategic response to the Dodd-Frank Act requirements. This suggests that the requirements in Dodd-Frank and the SEC regulations implementing these requirements are not perceived as materially changing the existing business and compliance model.

FigOne.TwoConsider Current Regulations to Determine AUM Size: A majority of respondents did not plan to change their assets under management in response to the new regulatory environment even though lowering the AUM below a certain threshold could exempt hedge fund advisers from the Dodd-Frank Act requirements.


Fig.One.TreeMost Common Actions Taken
: Hedge fund managers’ most common strategic responses in reaction to the registration and disclosure requirements under the Dodd-Frank Act include new record-keeping policies, the outsourcing of compliance work and changes in marketing materials. Most respondents indicated that they are addressing the requirements through compliance measures.

Figure-1_4Least Common Actions Taken
: It is not common for hedge fund managers to change of the funds’ legal structure or to lower the AUM to escape the application of the Dodd-Frank Act.

Figure-1_5Take Regulatory Regime into Account for AUM: 25 per cent of respondents plan on decreasing the AUM size of their funds to avoid the regulatory hassle. Others will increase current AUM size to cover expenses.


Desired AUM After Dodd-Frank
 The ideal AUM size for most respondents is somewhere between$150 million and $1.5 billion. However, existing regulation does not appear to have influenced funds’ choice regarding the size of their AUM. Choosing a particular AUM size is based on a fund’s strategy and its existing size.


Factors Influencing AUM Preference
:  Title IV  does not appear to have influenced fund managers’ choice regarding the size of their AUM. Choosing a particular AUM size is based on fund managers’ strategy and its existing size.


Private fund profitability after the enactment of the Dodd-Frank Act: While the new requirements do not appear to have change the earnings of hedge funds themselves, the profitability of the management company appears to be affected.

Dodd-Frank Affect Fund’s Earnings?

Figure-2_1Dodd-Frank Affect Management Company Profits?


Figure-2_3Cost of Compliance with Title IV: The cost of compliance for the hedge fund industry is somewhat moderate. 48 per cent of respondents did not incur more than $100,000.00 in compliance costs per year after the enactment of the Dodd-Frank Act.





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The Return of CDOs – Do We Need Dynamic Elements in Financial Regulation?

Despite the role of collateralized debt obligations (CDOs) in the financial crisis of 2007-08, CDOs and other high risk investment products may soon be available again and are likely to proliferate.  The WSJ reports that  J.P. Morgan Chase and Morgan Stanley bankers are assembling synthetic CDOs to satisfy demand for structured products by investors who seek high returns amid low interest rates. This development is not a surprise.  Wall Street will continue to create new, increasingly complex, and riskier financial instruments to capitalize on market demand for such products.

Stable and presumptively optimal rules cannot keep pace with market developments and financial innovation. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal.  Despite the risk of future crises, anticipation of future developments and preemption of future crises do not play a significant role in the regulatory framework and academic literature.

Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises.

The concept of dynamic financial regulation describes the study of financial regulatory phenomena in relation to preceding and succeeding events.  Rulemaking is no longer a mere reactive process based only on preceding events and driven by the collective action problem of rulemaking. Rather, rulemaking in a dynamic framework increasingly utilizes institution specific and decentralized information reflecting preceding events and attempting to anticipate succeeding future contingencies.

Rulemaking with dynamic elements increases the adaptive capabilities of financial regulation through the increasing use of institution specific information. This may include information on the functioning of financial institutions and financial products. Information pertaining to how financial institutions, or decision makers in financial institutions, actually act and how they are expected to react to unforeseen contingencies can help incorporate dynamic elements into financial regulation.

Dynamic elements in financial regulation could help support regulators in their efforts to continually adapt to new market environments, financial innovation, and to the given regulatory environment. Dynamic elements in financial regulation may also support regulators in anticipating changes and adapt stable rules accordingly.

To improve quality and sustainability of legal rules, dynamic regulation may facilitate experimentation with different combinations of stable and dynamic elements in rulemaking. Experimentation with different combinations of regulatory approaches can be effective when several different approaches can be tried simultaneously. A mixture of market solutions, private ordering, and mandatory rules could help increase adaptive capabilities of rulemaking.  These dynamic changes in rulemaking could help create a governance mechanism that is constantly adapting to the given market environment, financial innovation, and the given regulatory environment.

Dynamic regulation is not just a theoretical concept. Several governance mechanisms with dynamic elements combined with existing stable and presumptively optimal rules could become part of a dynamic optimization and supplementation process for rulemaking.  Institution specific rules could be facilitated through the increasing use of institution specific information and private ordering. Contingent Capital Securities, Corporate Integrity Agreements, and Deferred Prosecution Agreements are among the governance mechanisms that can provide institutions specific information for financial rulemaking.

The return of the CDO market and the proliferation of high risk structured products could justify considering dynamic elements in financial regulation.

For more details see:

Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework – Festschrift in Honor of Christian Kirchner

Dynamic Regulation of the Financial Services Industry – Wake Forest Law Review 

Dynamic Regulation of the Financial Services Industry

Governance adjustments via stable rules in reaction to financial crises are inevitably followed by relaxation, revision, and retraction. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal. Despite the risk of future crises, anticipation of future developments and preemption of possible future crises do not play a significant role in the regulatory framework and academic literature. Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises. By including dynamic elements, the regulatory sine curve of financial regulation could be optimized in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises. Dynamic regulation could help dampen the degree of volatility of both the cosine curve and the regulatory sine curve by creating an anticipatory regulatory response to financial crises.

Full article available on SSRN at:

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