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Abstract

Regulatory arbitrage is an indispensable element of regulatory competition as it provides regulatory substitutes for firms, and allows those firms to optimally benefit from such competition. This also increases the elasticity of demand for regulators and engenders accountability among them. Hedge funds, as paragons of exploiting regulatory discrepancies, are heavily criticized for thwarting efforts to address systemic risk. This Article investigates the arbitrage-seeking behavior of hedge funds in a globally-fragmented financial regulatory framework.

Despite its benefits, regulatory arbitrage involves certain costs. Although market discipline can constrain these negative externalities, due to certain idiosyncratic features of the hedge fund industry, such as the sophistication of investor base, operational mobility, higher attrition rate, and lack of transparency, market discipline by itself cannot fully limit the potential externalities of regulatory arbitrage by hedge funds. These features weaken market signals and reduce the reputational benefits of being subject to greater regulatory oversight. The lower reputational costs and broad private investor exemptions in turn reduce the overall costs of regulatory arbitrage for hedge funds in comparison to other financial services providers and mainstream financial institutions, and make it more likely for hedge funds to engage in regulatory arbitrage.

In a departure from mainstream research, which recommends regulatory coordination, cooperation, harmonization, and consolidation as legal remedies to address problems originating from regulatory arbitrage by hedge funds, this Article argues that such proposals are at best misguided and at worst systemic risk amplifiers. Instead, this Article suggests that to reduce the likelihood of regulatory arbitrage, instead of regulating hedge funds directly, the strategies for regulation should focus on indirect regulation of the funds through their counterparties, creditors, and investors for whom reputational costs of regulatory arbitrage tend to be significantly high.

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