Regulatory Arbitrage and Hedge Fund Regulation: A Need for a Transnational Response?

Hedge funds, as paragons of exploiting regulatory discrepancies, are heavily criticized for thwarting regulatory efforts to address systemic risk. This paper investigates arbitrage seeking behavior of hedge funds in the globally-fragmented financial regulatory framework. Regulatory arbitrage is viewed as an indispensible element of regulatory competition, which plays a significant role in delivering the benefits of regulatory competition by providing regulatory substitutes for regulated firms, thereby increasing the elasticity of demand for regulators and engendering regulatory accountability.
Despite its benefits, regulatory arbitrage involve costs. Market discipline can constrain the negative externalities of regulatory arbitrage, however, this paper argues that due to certain idiosyncratic features of the hedge fund industry, such as sophistication of investor base, higher attrition rate, and lack of transparency, market discipline by itself cannot fully address the potential externalities of regulatory arbitrage by hedge funds. These features weaken market signals and reduce the reputational advantages of being subject to high-quality regulation. The lower reputational costs in turn reduce the overall costs of regulatory arbitrage for hedge funds compared with mainstream financial institutions, which makes it more likely for hedge funds to engage in regulatory arbitrage than other mainstream financial institutions do.
In a departure from the mainstream research, which recommends regulatory coordination, cooperation, harmonization, and consolidation as legal remedies to address problems originating from regulatory arbitrage by hedge funds, this paper argues that such proposals are at best misguided and at worst systemic risk amplifier. Instead, this paper suggests that to reduce the likelihood of regulatory arbitrage, instead of regulating hedge funds directly, the strategies for regulating hedge funds should focus on indirect regulation of hedge funds through their counterparties, creditors and investors for which reputational costs of regulatory arbitrage tend to be significantly high.