Hedge Fund Compliance Chapter 2: How Hedge Fund Regulation Actually Works
Chapter 2 of Scharfman’s book is all about regulation. Who makes the rules for hedge funds? Who enforces them? And what happens when the regulators actually show up at your door? Let’s break it down.
What Is Financial Regulation?
At a basic level, financial regulation is just the rulebook. Every country (or group of countries, like in Europe) has laws and guidelines telling financial institutions how to behave. If a hedge fund follows these rules, it’s “in compliance.” If it doesn’t, it’s “out of compliance.” Pretty simple concept.
But here’s the thing. Not every rule applies to every type of financial company. A hedge fund does different stuff than a bank or an insurance company. So the rules are different too.
Scharfman gives a good example with prime brokers. These are firms (usually connected to big banks) that help hedge funds with trading. When a hedge fund places assets with a prime broker, that broker can actually lend those assets out to other people. This is called rehypothecation. Think of it like a bank lending out money that other people deposited. In the US, there’s a rule (Rule 15c-3) that limits how much a prime broker can rehypothecate. In the UK, historically there was no such limit.
The point is: different entities, different rules. But if you work at a hedge fund, you still need to know the rules that apply to the companies you deal with.
Does Regulation Even Work? The Debate
Not everyone agrees that hedge fund regulation is a good thing. Scharfman lays out both sides honestly.
Arguments against regulation:
- Government is too involved in finance
- Hedge fund investors are sophisticated people who don’t need protection
- The industry can police itself
- Compliance costs too much money
And there’s a real criticism about regulators themselves. Some people say regulators don’t have the knowledge or resources to do their job properly. The biggest example? The SEC completely missed Bernie Madoff’s Ponzi scheme for years. Billions of dollars stolen, and the regulators didn’t catch it. Same story with Raj Rajaratnam at the Galleon Group, who ran an insider trading operation for a long time before anyone noticed.
There’s also this thing called the “captured regulator” problem. People who work at the SEC or other agencies for a few years then leave to work at hedge funds or become compliance consultants. They basically use their inside knowledge to help funds navigate around the rules. Madoff himself pointed this out, saying SEC staffers work there for five years and then become compliance managers at hedge funds.
Arguments for regulation:
- Someone needs to protect the financial system
- Investors need minimum protections
- Hedge funds now manage money for pension funds and charities, so there’s a public interest
- Regulation forces better record keeping and transparency
- The threat of oversight keeps bad behavior in check
The reality? After the 2008 financial crisis and scandals like Madoff, regulation became nonnegotiable. Love it or hate it, hedge fund regulation is here to stay worldwide.
Who Makes the Rules?
Compliance rules come from legislation. In the US, Congress passes the laws. In the UK, it’s Parliament. Once laws are passed, regulators refine them and handle enforcement.
And here’s something interesting: one country can have multiple regulators. In the US, the main ones for hedge funds are:
- SEC (Securities and Exchange Commission) - the big one
- CFTC (Commodity Futures Trading Commission) - for futures and commodities
- NFA (National Futures Association) - another layer for futures
- FINRA (Financial Industry Regulatory Authority) - this one is actually a self-regulatory organization, meaning it’s run by the industry itself but overseen by the SEC
In the UK, there’s just one main regulator: the FCA (Financial Conduct Authority).
Other important regulators around the world include ESMA in Europe, FINMA in Switzerland, the SFC in Hong Kong, the FSA in Japan, and the MAS in Singapore. Even the Cayman Islands has CIMA, because a lot of hedge funds are set up there.
The Global Problem
Hedge funds don’t stay in one country. A fund might be based in New York but also operate in London. For a long time, the SEC could only regulate what happened in the US. They wouldn’t even know what the fund was doing overseas.
To fix this, regulators started signing cooperation agreements called memorandums of understanding. Now the SEC and the FCA share information. Same with the SEC, CFTC, and Asian regulators like the Hong Kong SFC. It’s not perfect, but it’s better than everyone working in isolation.
How are regulators funded? This matters more than you’d think. The UK’s FCA gets its money from fees paid by the firms it regulates. FINRA works the same way. Some people say this creates a conflict of interest, because why would you punish the companies that pay your bills? The SEC, on the other hand, is funded by the US government. There’s even a third idea floating around: fund regulators entirely from fines collected from rule-breakers, and use some of that money to pay back victims.
What Regulators Actually Do With Hedge Funds
When regulators interact with hedge funds, they’re usually doing one of three things:
- Collecting information - this starts when a fund launches and continues throughout its life
- Ongoing monitoring - checking that funds stay in compliance over time
- Market risk assessments - studying hedge fund data to understand bigger trends in the market
How Examinations Work
This is where it gets real. Regulators examine hedge funds in three main ways:
Routine Examinations
These are regular checkups. A regulator sends people to the hedge fund’s office and reviews everything. But here’s the catch: there’s no set schedule. The regulator decides when to show up, and they don’t tell you in advance. Some funds go three or more years between routine exams. Others get checked more often.
Why the difference? Bigger funds that could affect the overall market get more attention. Funds that launch new products get more scrutiny. And geography matters too. Funds in the New York area get examined more often simply because the SEC has more staff there.
This uncertainty creates what Scharfman calls the chilling effect. Because you never know when the regulator will knock, you’re motivated to stay compliant all the time. The threat of an exam is sometimes more powerful than the exam itself.
But there’s a counter-argument: the bad actor principle. If someone is going to break the law, they’ll do it regardless of when the next exam might be. And if there are years between exams, a bad actor has plenty of time to cover their tracks.
Targeted Examinations and Sweep Inquiries
Sometimes regulators focus on one specific area across multiple funds. For example, cybersecurity has been a recent target. Instead of checking everything, they zero in on one topic. They might not even visit your office. Sometimes they just send a written request asking for specific information. You answer, and that might be the end of it.
Regulatory Reporting
This is the stuff hedge funds have to submit on their own, without being asked. Things like periodic filings that give regulators information about the fund’s activities and assets. The Chief Compliance Officer usually handles this process, which we’ll cover in the next chapter.
Key Takeaways
Chapter 2 gives you the big picture of how hedge fund regulation works. The rules come from legislation, get enforced by regulators, and hedge funds have to deal with examinations and reporting requirements. The system isn’t perfect. Regulators have missed huge frauds. There’s a revolving door between regulators and the industry. But after 2008 and scandals like Madoff, nobody seriously argues that hedge funds should be left unregulated anymore.
The most practical thing to remember: regulators can show up for a routine exam at any time, they can target specific issues across the industry, and funds have to report information regularly even when nobody asks. If you run a hedge fund, compliance isn’t optional. It’s just how business works now.
Next chapter, we’ll look at the person responsible for all of this at a hedge fund: the Chief Compliance Officer.
This is part of a series retelling “Hedge Fund Compliance: Risks, Regulation, and Management” by Jason A. Scharfman (Wiley, 2017, ISBN: 978-1-119-24023-5). I’m breaking down each chapter into plain language so anyone can understand how hedge fund compliance works.