Recently, various hedge funds have incurred significant financial difficulty. The most widely publicized being the difficulties encountered by Long Term Capital Management, L.P., operating Long Term Capital Portfolio, L.P. (“LTCM”). The LTCM fund employed various trading strategies, with the majority of its trading positions in government bonds of the G-7 countries. In summer 1998, conditions caused by financial problems in Russia and other emerging markets caused LTCM to incur substantial losses. The enormous size of the LTCM hedge fund placed its trading counterparties and creditors in a position to lose substantial amounts because they had extended excessive credit to LTCM, either through trading counterparty or lending relationships. Since LTCM's creditors and counterparties had allowed LTCM to build up dangerous levels of leverage, they faced the real possibility that LTCM would default on the credit obligations it owed them. To protect themselves from an LTCM default, some of the fund's creditors and counterparties created a consortium, which injected $3.6 billion in equity into LTCM in return for receiving ninety-percent equity stake in the fund. Banking regulators assisted LTCM creditors and counterparties in creating the consortium because they feared that LTCM's losses could cause financial shock to the markets if LTCM's seventy-five counterparties sought to liquidate their positions simultaneously in response to an LTCM default.
The financial collapse of LTCM has led federal legislators and financial regulators to question whether additional regulatory constraints on a hedge fund's use of leverage are necessary to protect against financial market disruption. This Article discusses whether additional regulation is needed to protect against the possibility of systemic loss triggered by a hedge fund's excessive use of leverage. After reviewing the existing federal regulations to which hedge funds are potentially subject, this Article concludes that private market regulation, through the exercise of more diligent market discipline by both hedge funds and those entities that extend credit to hedge funds, is needed to protect against systemic loss. Further, the Article concludes that public regulation requiring hedge funds to disclose comprehensive information about their trading positions to financial regulators is also needed. Without such disclosures, hedge funds can assume dangerous levels of leverage that could disrupt financial markets without the foreknowledge of financial regulators, as illustrated by LTCM's recent predicament. Part I of this Article provides an overview of the hedge fund industry, while Part II reviews existing federal securities and commodities laws that potentially apply to hedge funds. Part III discusses the major public policy concerns surrounding hedge fund trading and argues that these policy concerns can be addressed through limited public regulation and private market regulation.
- hege fund regulations