“Hedge funds tend to employ aggressive investment strategies, and they highly leverage their funds. While hedge funds infuse liquidity into the financial markets and enhance market efficiency, they also engage in complex financial transactions that leave open the possibility of systemic losses that are often borne by the financial markets they invest in.
In this context, the role of regulation of hedge funds in host-countries that receive their investment assumes importance. Regulation needs to balance healthy development of financial markets and the prevention of 'systemic loss' due to risky investment strategies. While a worldwide debate lingers on the need for governmental regulation to rein in hedge funds (as opposed to leaving it to market forces to determine their own regulation through market discipline), the Indian securities regulator, the Securities and Exchange Board of India (SEBI) has experienced a checkered history of regulating hedge funds while always adopting a somewhat cautious approach. It has employed different regulatory strategies to deal with hedge fund investments. These include the prohibition strategy, disclosure strategy, restriction strategy and the registration strategy.
This paper analyses SEBI's strategies for regulating offshore hedge funds investing into India. It finds that each time a regulatory strategy has been employed by SEBI, the hedge fund industry has reacted by displaying considerable malleability in being able to dilute the force of regulation. One such instance relates to the manner in which hedge funds reacted to the prohibition strategy by investing through offshore derivative instruments such as participatory notes so as to stay outside the purview of the Indian regulatory regime (although this route too has been significantly curtailed more recently). Using the example of SEBI's measures in the Indian context, the paper examines the dynamics involved in regulating the offshore hedge fund industry. Although this study is primarily focused on India, the results would apply at a conceptual level to other emerging economies that receive investments from offshore hedge funds.”
Regulating Hedge Funds
I have uploaded an abstract of a working paper titled Analysing India's Approach to Hedge Fund Regulation on SSRN, which is reproduced below: