Yamina Tadjeddine & Sandra Rigot SASE 22 nd meeting, Philadelphia

1. Emergence of a New Regulation : Informational Disclosure Modalities In The Hedge Fund Opacity World Yamina Tadjeddine & Sandra Rigot SASE 22nd meeting, Philadelphia Mini-Conference Evolutionary Regulation: Rethinking the Role of Regulation in Economy and Society Saturday, 26th June 2010 1

2. Aim of this contribution • The 2007-2008 crisis has highlighted the tensions related to lack of transparency in the hedge fund industry. • Yet no consensus has emerged about the implementation of disclosure (different reports, proposals)\ From economic theory, usually only two case are considered: opacity (private information) / transparency (public information) 3 modalities in Boot W. A. and. Thakor A. V (2001) By considering proposals, we characterize a continuum of informational disclosure agreements (Talley E. (2001): from private arrangement to public law)

3. An economic view This article classifies the proposals of informational disclosure agreements It is based on a consequentialist approach: the expected effect of proposal (micro / macro allocation) and the modality of disclosure (to one, to some, to public authority, to all) It describes the social emergency of the future hedge funds regulation (in US, EU, UK) as a political bargaining with private/public actors more than an evolutionary game

4. Why do Hedge Fund have to be regulated ? Hedge Funds damages: £ Soros, more recently shortselling Volkswagen share, 28th october 2008 Fear of systemic crisis caused by one leveraged hedge funds (LTCM, 1998) Increasing assets under management But Hedge Funds were the victims of the crisis, not its cause => The reform is more structural: the norm of transparency, the arrival of institutional investors

5. Evolution of hedge funds capital 1997-2006 AuM- $ billions and share of AuM (%) Source: Hennessee Group LLC; estimates; Mac Kinsey Global Institute Analysis.

6. Plan Market failures induced by hedge funds opacity Data: hedge fund recommendations since LTCM 1998 Encoding proposals: two criteria the aim / the modality Results: classification of proposals and reports Conclusion 6

7. 1. Opacity and Market failures

8. Secret versus Performance • Hedge fund capital has historically come from high-net-worth individuals. • Clients invest with full knowledge of these vehicles judged as risky and so they accept the consequences in terms of losses. The financial risks are assumed to be known and accepted by experienced wealthy clients. • Clients accept this trade off • Regulatory Authorities: • opacity permits innovation (creating new strategy, trading in new OTC products ), to prompt a search for private information. => Improve liquidity and market efficiency. • Furthermore, given that only sophisticated clients invest in hedge funds, regulatory authorities have no legitimacy to protect them. They assume that these investors are aware of specific hedge fund risks and that risks are sufficiently dispersed.

9. An International Consensus for a Slight Regulation • Supervisors’ consensus = a mix of indirect regulation and market discipline - Indirect regulation (managers’ regulation) > via prime brokers (investment banks) > via regulated markets - « Market discipline » or autoregulation > via information disclosure (voluntary) > via incentives • Lack of public information and private standardized information

10. Prime Brokers Clients Market “everybody” Regulatory Authority Market failures induced by opacity: • Agency Problem: Micro misallocation • Prime Broker/ HF: Credit relation • Clients (Institutional Investors) / HF: Commercial relation HF: private information • Efficiency Problem: Macro misallocation • Financial Instability • Systemic Risk: Real Instability

11. Financial Instability Asymmetry ex ante Real Instability (Systemic Risk) Asymmetry ex Post 2 misallocation, 4 market failures Micro Misallocation Macro Misallocation (Garbaravicius T., F. Dierick, 2005, De Vries et alii., 2009). (King and Maier, 2008, Boyson & alii, 2006) No optimal allocation of private savings (Baquero G., Verbeek M. 2010) Credit to worse (Financial stability review 2007, Mac Kinsey, 2007).

12. 2. Our datas: reports about HF regulation

13. Inventory of propositions edited to enhance hedge fund regulation since 1998 (=15 institutions & 22 reports) -AIMA (Alternative Investment Management Association), -FED (US Federal Reserve) -FSA (Financial Service Authority) -FSF (Financial Forum Stability) -HFWG (Hedge Fund Working Group) -Socialist group of European Parliament -SEC (Securities and Exchange Commission) -IMF (International Monetary Fund) -IOSCO (International Organization of Securities Commissions) -US PWG (President Working Group (US)) • 2 hedge funds law drafts: > UE directive proposition from European commission entitled Alternative Investment Funds Managers (AIFMs) (april 2009, November 2009) > US Treasury financial regulation reform (june 2009) +Volker plan (january 2010)

14. Our data: • 209 proposals • 30 proposals not related to informational disclosure: regulation on markets and capital requirements for prime brokers, measures to constrain leverage and to limit short selling. • Informational disclosure proposals are predominant, (86% of all proposals). • Our final data base = 179 proposals, 109 (before the crisis) and 70 after. • only 45 different original proposals, some of which are suggested in various different reports (“Initial Due Diligences” in 13 reports).

15. 3. Typology of proposals: the modality and aim of informational disclosure

16. Who discloses to whom?

17. 4 Disclosure modalities 1) Discretionary disclosure: a liberal approach by mutual agreement. The co-contractors freely agree on the disclosed information content 2) Contractual disclosure: Private information is necessarily revealed to all contractors. The standardized contract (by law as UCITS mutual funds, by guidelines or best practices) . 3) Regulatory disclosure: hedge funds have to disclose information to the regulatory authority which is responsible for financial and banking stability. This type of public interventionism is similar to the prudential policy implemented for banks. 4) Public disclosure: It stipulates communication to all. Information is available for everyone, whether clients, participants in financial markets, prime brokers or plain citizens.

18. Informational disclosure agreements

19. Encoding Data, a sample

20. 4. Results- statistical results- classification using Kohonen Maps

21. Before/after crisis proposals:

22. Emergency of a contractual agreement • Clients seem to be the favorite recipients of information • Since the crisis, proposals mainly aimed at optimizing micro allocation and recommended more contractual relations between hedge funds and clients and prime brokers than between hedge funds and regulation authorities. Hedge funds are not the main problem of the financial crisis. => Macro misaallocation is less important

23. Kohonen algorithm • We ran the Kohonen algorithm on the proposal database and on the report database. • An individual proposal or report is defined by a vector of dimension 6 (discretionary, contractual, regulatory, all, micro aim, macro aim). • We obtain two Kohonen 3*3 maps: one to classify proposals, and the other to classify reports.

24. 1 1 2 3 0 1 5 6 4 0 1 7 9 8 0 Kohenen Map KACP on proposals • Class 1 corresponds to a code vector (1;0;0;0;1;0). It groups proposals of informational disclosure based on the discretionary modality with a micro allocation aim. Class 1 groups proposals with discretionary modality and micro aim; • The class 3 groups contractual modality and micro aim; • The class 5 contractual modality and macro aim; • The class 6 contractual/ all modalities mainly with micro aim; • The class 7 regulatory modality with macro aim • The lastly class 9 publicity with macro aim. The others classes (2, 4, 8) do not exist in our sample of proposals

25. We find four significant sets of proposals: • class 1: discretionary modality and micro aim, • class 3: contractual modality and micro aim • class 7: regulatory modality and macro aim • class 9: publicity and macro aim . Classes 5 and 6 are a kind of garbage. In class 5 we find proposals with contractual modality and macro aim, and in class 6 publicity modality and micro aim.

26. Agreements about informational disclosure • liberal type (class 1): the aim of informational disclosure is only to reduce the agency problem, no legal constrain • contractual type (class 3): a standardized public contract is enforced to reduce informational asymmetry • Regulatory type (class 7): the informational is disclosed to regulatory authority to reduce macro misallocation • Publicity (class 9): the information is public

27. 3 1 2 5 6 4 7 9 8 Kohenen Map on reports Class 1 corresponds to regulatory disclosure and macro allocation, class 2 mixed disclosures and macro allocation, class 3 publicity modality with mixed aims, class 4 contractual and regulatory disclosure and a macro aim, class 5 mixed disclosures (discretionary and regulatory modalities) and a macro aim, class 7 predominantly contractual and secondly regulatory disclosure with macro/micro aims, class 8 a mix with predominantly contractual modality with mixed aims and class 9 discretionary and contractual modalities with a micro aim. The class 6 does not exist in our sample

28. 1 2 3 4 5 7 9 8 Classification of reports 5 sets: 1) Hayekian type (class 3) 2) the liberal type (class 9) 3) the collective contractual type: reduce information asymmetry and prevent systemic risk mainly via a mix of contractual and regulatory disclosure modalities (class 8 and 5). 4) the consensual type: to optimize both private and public allocations, via a wide combination of contractual regulatory and public disclosure modalities (classes 2 and 7). 5) The regulatory type: to prevent systemic risk via the regulatory disclosure modality (class 1)

29. Conclusion (1): the complexity of transparence • We give an original perspective to understand the emergence of hedge funds regulation thanks to information economics tools. • We emphasize the complexity of the application of transparency principle and the continuum of agreements • The norm of informational disclosure is polymorphic We consider only two main aspects: the expected consequences and the modality to disclose. 29

30. The divergence between the public view of regulation (consensual type, regulatory type, collective contractual type) and the private view (liberal type) The divergence between US and EU: US (macro aim and regulatory disclosure), EU ( micro & macro aim and mix contractual & regulatory disclosure). The difficulty to build an international financial regulation: even if it exists a consensus about market failures induced by opacity Conclusion (2): the difficult convergence

31. Limits and work in progress : • We assume than information preexists. But the disclosed information results of social and political construction (risk model, innovation product evaluation…) • We consider the informational disclosure, but it exists other forms of hedge funds regulation: indirect regulation via institutional investors (Pension Funds, Insurance) • Subjective Encoding: algorithm like Prospero