Sunday, 6 February 2011

The danger of the EU hedge fund directive, is to enervate the hedge fund market itself.

The danger of regulation is that it can destroy the very market it is trying to regulate. Please indulge me in using a hypothetical. Imagine that you are a regulator who wishes to regulate haulage companies for the emissions of their vehicles. You use scientific data on pollution to construct an ideal quanta requirement. You then pass regulation to deal with this. You are not too bothered, sadly, that there will be some haulage companies that will go bust as they will not be able to afford the appropriate vehicles. What you are further, and in some ways more worryingly, blind to is that haulage companies have a specific range of vehicles for the needs of their customers. Further that maintenance of a specific range is directly related to their profitability, growth, and to meet rising costs such as fuel. This is only discovered years later, when it is only shown that unemployment (a more interesting thing for politicians to throw around) in the haulage industry is serious.

Now have a look at the arbitrary way the capital adequacy requirements in the hedge funds directive were formed. The very notion of regulation here is designed to militate against the products themselves. The difference between the hypothetical, above, and the hedge-fund market makes an even stronger case for non-regulation. This is that the hedge-fund market is itself a risk based market, thus profitability is entirely based on the allocation of risks itself. This must depend, as my hypothetical suggests, on the knowledge of the market agent, who is best able to assess it. Thus to regulate a base line of capital adequacy does not, in itself, obviate risk as the real risk is the choice of investment, not the absence of collateral. The regulation of the collateral may only slow down transactions, thus increasing their costs, but will not eviscerate risk itself. Further, these requirements may make transactions costs so high that viable investing may no longer be on the cards. This may harm certain sectors of the economy who depend on high risk investment, and play an important role in the economy such as the provision of infrastructure. Further this regulation may not be a solution. For some it was only the off-shore banks that were largely unregulated that kept better capital adequacy requirements. Perhaps it is time to reiterate that old adage that the market knows best.

Abhijit P.G. Pandya Copyright 2011

Abhijit P.G. Pandya Copyright Birkenhead Society

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