Financial Reform Legislation and Transparency in Hedge Fund Management

With the economy sputtering, seeking to recover from the Great Recession that followed the financial meltdown of 2008, Congress worked for more than a year to develop comprehensive financial reform legislation. The result was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed on July 21.

Dodd-Frank contains many features intended to require more transparency in financial transactions so that elaborately packaged products do not create and disguise excessive risk that can harm unwary investors and consumers.

The concerns that led to the legislation reared their head during the 2008 crisis, but they had been building for years. Credit had been too easy to obtain for too many people. Subprime real estate loans, even for people with problematic credit histories or insufficient income, were the most obvious and egregious example. But the problems went beyond subprime loans. Investment banks and financial services firms package such loans and other forms of debt into numerous complex financial instruments that often were devoid of any transparency. And these same financial institutions took on more and more risk through credit default swaps and the use or ever-increasing leverage that placed the future existence of the institutions at great risk. Such risk is what led to the demise of investment banks like Lehman Brothers.

These financial problems infected the economy. Main Street, Wall Street and Washington spent much of 2008 and 2009 performing on-the-fly improvisation, trying to get credit flowing again in the midst of loan defaults, bankruptcies (including Lehman Brothers), rising foreclosures, high unemployment, and a huge government bailout of "too-big-to-fail" financial firms like AIG.

Trust but Verify

Against this backdrop, the Dodd-Frank Act seeks to restore trust and establish a sound regulatory framework for the financial services marketplace. It contains numerous components aimed at more transparency through the disclosure of relevant information and awareness of risk. To borrow and repurpose a line from Ronald Reagan (who was referring to arms-control negotiations with the Soviet Union), this means to trust, but also to verify.

The Dodd-Frank Act aims to verify trust through provisions.

  • Derivatives - Derivatives trading is to be shifted to organized exchanges and clearinghouses, rather than being done over the counter. In addition, banks - with some exclusions - are supposed to spin off their derivatives trading activities into separate subsidiaries. But large firms, such as Goldman Sachs, may still be able to keep trading in many different types of derivatives instruments, including credit default swaps.
  • Hedge Funds - The so-called "Volcker Rule," named after former Federal Reserve Chairman Paul Volcker, is intended to limit banks' involvement in private equity and hedge funds. The goal is to prevent banks that have accepted federal deposit insurance from essentially betting against themselves by engaging in proprietary trading on their own accounts. In addition, private equity and hedge funds will have to register with federal regulators and make financial disclosures. (Venture capital funds are exempt from this requirement.)
  • Consumer Protection - A new agency, to be called the Consumer Financial Protection Bureau, is designed to be a consumer watchdog, looking out for and preventing predatory lending and other types of unfair business practices.

There are also numerous other aspects of the lengthy (2,300 pages) legislation. One of these has been dubbed the "Wall Street Death Panel," a colorful way of referring to a process intended to avoid massive bailouts by allowing government authorities to seize and liquidate financial firms that are on the brink of collapse.

Did Dodd-Frank Go Far Enough?

Does the Dodd-Frank Act go far enough to promote the transparency the economy needs? Much like the health care reform debate, which morphed into the health insurance reform debate, the financial services law was sweeping but perhaps not utterly transformative in scope.

  • Derivatives - Large firms like Goldman Sachs may still be able to keep trading in many different types of derivatives investments, such as credit default swaps.
  • Hedge Funds - The version of the "Volcker Rule" that was passed was much weaker than the original proposal and made significant exceptions to the limits on proprietary trading.
  • Consumer Protection - Though a strong initial director may be able to put an activist stamp on the new office, legislative opposition to the office's creation resulted in it being set up within the Federal Reserve, rather than as a stand-alone agency.

Much will depend, of course, on how authorities implement and enforce the legislation. The debate over who should be the first director of the new Consumer Financial Protection Bureau is attracting wide attention across the political spectrum, akin to the nomination of a Supreme Court justice. And, on a more mundane level, hundreds of administrative rules will be written in order to flesh out the new law.

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