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Dodd–Frank at 5

The role of alternative investments in today’s capital markets

Executive summary

This report provides an examination of the regulatory framework that has been implemented in the US since the global financial crisis. It also discusses the important role alternative investments like hedge funds play in this new, tightly regulated, postcrisis economy.

While special attention will be given to the Dodd-Frank Act, it is important to note that other jurisdictions have similarly adopted robust regulatory regimes for alternative investment and private fund managers, including the European Union’s adoption of revisions to the Markets in Financial Instruments Directive (MiFID), the Alternative Investment Fund Managers Directive (AIFMD) and the European Market Infrastructure Regulation (EMIR).

Combined, these new laws and regulations reach every corner of our global economy. Large banks now face new risk retention rules for securitization, capital rules and new mortgage requirements. This has, in many cases, contracted bank lending. Alternative investments have started to fill that vacuum in the US, EU, and most recently, in Asia.

The emergence of alternatives in capital markets highlights the important and expanding role private funds play in the global economy. This paper explores how funds operate in this new role, focusing on the tools used by fund managers to manage risk, provide reliable returns over time and offer portfolio diversification. Importantly, the paper also explains how funds do this without posing systemic risk to the broader financial system or investors.

With approximately $3 trillion dollars in global assets under management, the hedge fund industry is relatively small in size when compared to the size and scale of the overall financial system. The industry is also significantly less concentrated than other parts of the financial services industry and its transparency is at an all-time high.

Hedge funds have become part of the financially regulated mainstream. In the US, Europe and beyond, regulators now have extensive oversight of hedge fund managers and an array of information about their activities. In the US, large managers must register with the Securities and Exchange Commission and the Commodity Futures Trading Commission. They also file extensive reports about their portfolios and counterparty exposures with those agencies. Small fund managers are subject to state registration, examination and reporting requirements.

The market activities of every US-based hedge fund are subject to US securities and commodities laws. In addition, hedge funds execute trades and obtain other services from prime brokers (banks), which are also subject to extensive regulation that indirectly affects hedge fund activities.

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