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What is a Hedge Fund? Hedge Funds, the Glass-Steagall Act, and the Volcker Rule Explained

Oct. 5, 2012
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by Susan Lyon

Since the financial meltdown, there has been a lot of chatter in the news about financial regulation.  With the passage of the Dodd-Frank Act of 2010, the Obama Administration has made the regulation of hedge funds a key part of their effort to reform the financial system.

This begs the question: what exactly is a hedge fund?  The answer to this question reveals why so many government officials and analysts believe that tightening regulation of hedge funds is important for the stability of the financial system.  We explore what hedge fund protections are in place, and whether they are working as intended.

What Are Hedge Funds, and How Does a Hedge Fund Investment Work?

Put most simply, a hedge fund is an investment agreement made between a group of investors and a fund manager.  The investors can be private or institutional, and they entrust the hedge fund manager with a large amount of money that the manager invests as he or she sees fit.  If the investments make a profit, then the manager earns a percentage of the profit, as stipulated by the agreement signed by the investors.

So why do investors choose to place their money in the hands of a hedge fund manger instead of, say, a mutual fund or investment bank?  The answer is simple – the potential for profit is extremely high.  As opposed to investment banks, hedge funds are subject to less regulation by the SEC and hedge fund managers are empowered to make quick, highly leveraged decisions in response to market fluctuations.

Here is a quick snapshot:

  • The total amount of assets held by hedge funds in the 2nd quarter of 2012 was roughly $1.7 trillion.
  • One of the world’s top hedge fund managers, Ray Dalio, walked home with $3 billion in manager fees in 2011.

Despite a recent slump in hedge fund profits, people continue to invest large sums of money in them.

A Quick History of the Glass-Steagall and the Volcker Rule: How Well Are We Regulating Hedge Funds Today?

Check out our detailed explanation of the Glass-Steagall Act here, and check out our detailed explanation of the Volcker Rule here.

Created in 1933, the Glass-Steagall act effectively created an invisible ball between commercial banking and investment banking, to prevent banks from taking people’s deposits then investing them away into thin air.  The Glass-Steagall Act of 1933, passed during the Great Depression, prevented commercial banks from trading securities with their clients’ deposits and created the FDIC as a guard against bank runs. Passed in 1933 as the Banking Act, Glass-Steagall was chipped away over the years and eventually repealed during the Clinton Administration with the Gramm-Leach-Billey Act of 1999. Some experts believe that the act’s repeal contributed to the 2008 financial crisis, and the law served as a basis for the Volcker Rule of the 2009 Dodd-Frank reform bill.

Elizabeth Warren explains best how the act separated out hedge funds and related investing from consumer banking:

“Glass-Steagall said in effect that hedge funds should be separated from commercial banking. If a big institution wants to go out and play in the market, that’s fine. But it doesn’t get the backup of the federal government.”

An effort to restore the power of the Glass-Steagall Act, the Volcker Rule says commercial banks should not be speculating and placing speculative bets.  It prohibits commercial and FDIC-backed banks from:

  • Owning, partnering with or investing in hedge or private equity funds. 
  • Engaging in proprietary trading: speculation using the firm’s own funds with the intention of making a profit rather than mitigating risk. 

However, many argue that this is not enough, particularly since it is ambiguous what exactly constitutes “speculating” as opposed to just “hedging.”

Why Should Hedge Funds Matter to You?

Recently, the public has become alarmed by seemingly widespread misconduct among hedge fund managers.  The Justice Department has been cracking down on cases of insider trading committed by hedge fund managers.  In September, for instance, a former Intel executive testified against the high-profile hedge fund manager Raj Rajaratnam.  Rajaratnam was convicted and sentenced to 11 years in person for what some call the “biggest insider trading scandal in a generation.”

Despite concerns that hedge funds may have played a role in the financial collapse of 2008, there is uncertainty about how hedge funds should best be regulated.  The SEC is still working to fully enforce the new safeguards sanctioned by the Dodd-Frank bill, recently extending a deadline for hedge funds that make more than $150 million to register with the SEC.

Hedge funds control a significant amount of investment capital, and their highly leveraged bets can have sweeping consequences for the financial system, making the debate about how to regulate them efficiently to avoid rampant insider trading a pivotal issue for both the U.S. and the world financial system.

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