Hossein Nabilou

Ignorance, Debt and Cryptocurrencies: The Old and the New in the Law and Economics of Concurrent Currencies

Cryptocurrencies are expected to have a significant impact on banking, finance, and monetary systems. Due to uncertainty as to the possible future trajectories of the evolving cryptocurrency ecosystem, governments have taken a relatively hands-off approach to regulating such currencies. This approach may be justified within the theoretical information-economics framework of this paper, which draws parallels between the information economics of money and quasi-money creation within the current central banking, commercial banking and shadow banking systems with that of the cryptocurrency ecosystem. In particular, drawing lessons from the literature on the role of information in creating ‘safe assets’, this paper finds that by building on symmetric (common) knowledge as to the inner workings of the Bitcoin Blockchain - though in a different way - bitcoin possesses a degree of endogenous information insensitivity typical of safe assets. This endogenous information insensitivity could support bitcoin’s promise of maturing into a viable store of value and a niche medium of exchange. This finding should not be overlooked in the policy discussions for potential future regulatory interventions in the cryptocurrency ecosystem.

The EU Framework for Bank Capital Regulation and Repo Collateral

This paper traces the roots of collateral flow and its potential vulnerabilities in the shadow banking system to their regulatory capital treatment in the banking sector. As part of assessing the interaction of banking regulation and the shadow banking sector, it investigates the impact of bank regulatory capital reforms on the repo markets, and specifically the regulatory treatment of certain types of collateral widely used to secure repo transactions in Europe. As sovereign bonds constitute 80% of the financial collateral used in the European repo transactions, this paper details the preferential regulatory capital treatment of such assets within the Basel framework as well as the EU regime for bank regulatory capital, i.e., the CRD IV package comprising the CRD IV & CRR. The paper argues that the effects of capital reforms percolate to collateral used in repo transactions, which constitute a large part of the shadow banking operations and is the major source of short-term funding for banks and other financial institutions. It highlights the favorable regulatory risk-weights assigned to sovereign debt the exposure to which requires lower levels of capital or bears no capital at all. In addition, the regulation-induced perceived riskless nature of sovereign bonds leads to lower collateral haircuts for government collateral in the repo markets, which again boosts the demand for such collateral. The main finding of the paper is that there is a positive correlation between the preferential regulatory treatment of certain exposures for regulatory capital purposes and the surge of interest in such exposures (collateral) to be used in repo transactions. The preferential treatments of certain repo collateral (domestic government bonds) in terms of capital requirements and repo haircuts can also partly explain the home bias and bank-sovereign loop in the European banking and financial markets. This paper concludes that the preferential regulatory capital treatment of sovereign bonds, which drives a wedge between their real or fundamental riskiness and perceived riskiness, should be removed, as they tend to increase the distortions in risk pricing and are likely to contribute to systemic risk, the consequences of which can by far offset the potential benefits of such a preferential regulatory treatment.

Shadow Banking in Europe: Idiosyncrasies and Their Implications for Financial Regulation

This paper studies the specificities of the regulation of shadow banking in the EU. It argues that the idiosyncratic features of the EU shadow banking sector call for a different (or indigenized) regulatory approach from that of the U.S. It highlights striking differences between the EU and the U.S. shadow banking sector based on both the market structure and the legal micro-infrastructure of the shadow banking sector in these two jurisdictions. These different institutional and legal infrastructures of the shadow banking activities, instruments, and entities, as well as the different trajectories of the evolution of development of the banking and the shadow banking sectors in terms of business models, size and composition of actors and transactions can be the driving force behind the differential regulatory treatment of shadow banking in the EU and the U.S. In highlighting the differences between shadow banking in the EU and the U.S., this paper focuses on the repo markets, securitization and derivatives markets as the main instruments and activities that play significant roles in credit intermediation (maturity and liquidity transformation) outside the regulatory perimeter of the traditional/regular banking system. It then discusses shadow banking entities, especially Money Market Funds (MMFs) as typical shadow banking entities and highlights the fundamental differences in the structure and functioning and existing regulatory treatment of the MMFs in the U.S. and the EU. In the end, the paper underscores the main structural and regulatory differences in the Alternative Investment Fund (AIF) industry across the Atlantic and argues that there is no homogeneous population of such funds and why they need to be treated differentially. The paper concludes that the market structure, business models, as well as legacy regulatory framework of shadow banking (as well as banking), display substantial differences in the U.S. and the EU. The findings in this paper rally against one-size-fits-all proposals to address the problems of the shadow banking system worldwide and require considerably differentiated regulatory approaches to regulating shadow banking across the Atlantic. Therefore, any adoption of the U.S. regulatory framework for the shadow banking sector by the authorities regulating the European shadow banking sector should be cautiously undertaken.

The Law and Economics of Shadow Banking

This essay discusses the economic case for regulating shadow banking. Focusing on systemic risk, shadow banking is defined as leveraging on collateral to support liquidity promises. Regulating shadow banking is efficient because of the negative externality stemming from systemic risk. However, because uncertainty undermines the precise measurement of systemic risk, quantity regulation is preferable to a Pigovian tax to cope with this externality. This paper argues that regulation should limit the leverage of shadow banking mainly by imposing a minimum haircut regulation on the assets being used as collateral for funding.

The Conundrum of Hedge Fund Definition

This Article attempts to define hedge funds and to distinguish them from a variety of similar investment funds. After reviewing the hedge fund definition in the U. S. and the EU, this Article argues that the current regulatory framework, which defines hedge funds by reference to what they are not rather than to what they are, is prone to regulatory arbitrage. Even in the presence of a statutory definition, due to the ineluctable indeterminacy of language and regulatory arbitrage problems, borderline issues will persist, which makes statutory definitions of hedge funds neither possible nor desirable. Therefore, regulators should avoid the temptation of proposing such statutory definitions. Instead, they should rely on regulatory discretion within a broad principles-based regulatory framework to do so. For such a principles-based regulatory regime to work, regulators should rely on a functional definition of hedge funds. Accordingly, this Article defines hedge funds as privately organized investment vehicles with a specific fee structure, not widely available to the public, aimed at generating absolute returns irrespective of market movements (Alpha) through active trading and making use of a variety of trading strategies. This functional definition is likely to help address regulatory problems that might originate from statutory definitions of hedge funds.

Bank Proprietary Trading and Investment in Private Funds: Is the Volcker Rule a Panacea or Yet Another Maginot Line?

The Volcker Rule is part of the post-financial-crisis regulatory reforms that partly aim at addressing problems associated with proprietary trading by banking entities and the risks associated with the interconnectedness of private funds (e.g., hedge funds and private equity funds) with Large Complex Financial Institutions (LCFIs). This mission is pursued by introducing provisions that prohibit proprietary trading and banking entities’ investment in and sponsorship of private funds. These prohibitions have three specific objectives: addressing problems arising from the interconnectedness of private funds with LCFIs; preventing cross-subsidization of private funds by depository institutions having access to government explicit and implicit guarantees; and regulation of conflicts of interest in the relationship between banks, their customers, and private funds. Having studied the provisions of the Volcker Rule in light of its objectives, this article highlights the potential problems with the Rule and provides an early assessment as to how successful the Rule is in achieving its objectives.With respect to achieving these objectives, the Volcker Rule can only be partially successful for various reasons. The foremost reason is the numerous built-in exceptions (i.e., ‘permitted activities’) in the Rule included as a result of political compromises. Although the permitted activities under the Rule are backed by sound economic reasoning, there are serious practical problems with these exceptions. The main problem involves distinguishing prohibited activities from permitted activities. Such determinations require regulatory agencies to make subjective and case-by-case evaluations of activities. It is not known what the costs of such determinations would be in practice or how regulators would react if the costs of such determinations exceed their benefits.Regarding concerns about moral hazard, the Volcker Rule strikes a reasonable balance between preventing such an opportunistic behavior (i.e., taking advantage of government subsidies) while not stifling the investment by the banking industry in start-up private funds. However, with regard to mitigation of conflicts of interest, the Volcker Rule only marginally addresses such concerns. This limited regulatory intervention in mitigating conflicts of interest could be partially understood in light of the fact that market forces and private law have been successful in addressing conflict-of-interest concerns originating from the relationships between hedge funds and the banking industry.

The Hedge Fund Regulation Dilemma: Direct vs. Indirect Regulation

This article studies the regulatory strategies to address the potential systemic risk of hedge funds operation in financial markets. Due to the implications of the choice of regulatory strategies and instruments in terms of mitigating systemic risk, the article focuses on one critical aspect of hedge fund regulation, namely the choice between direct regulation and indirect regulation. Having defined the distinction between direct and indirect regulation, also mapping its implications in terms of regulatory techniques and instruments, the arguments for and against direct and indirect regulation of hedge funds are analyzed. This article argues that the indirect regulation of hedge funds through their counterparties and creditors, while being less costly, can better address regulatory arbitrage by hedge funds and their potential contribution to systemic risk. This policy recommendation is further supported by the economic and organizational structure of hedge funds and their particular features in terms of the number and composition of their counterparties and creditors.

The Alternative Investment Fund Managers Directive and Hedge Funds’ Systemic Risk Regulation in the EU

In the aftermath of the financial crisis, hedge fund regulation was put at the top of the European regulators’ agenda for their alleged contribution to financial instability. This paper studies the recently enacted Alternative Investment Fund Managers Directive (AIFMD) in the EU and its attempt to address potential systemic externalities of hedge funds. To include all relevant pan-European regulations addressing the sources of potential systemic risks of hedge funds, a systematic review of the recently enacted laws, regulations and implementing measures has been conducted. The analysis is predicated upon the methodology of law and economics with a consequentialist approach according to which the merits of the AIFMD and relevant regulations will be evaluated in terms of the achievement of the intended goals. The legislative process of the AIFMD suggests that hedge fund regulation in the EU was a politically motivated overreaction to their perceived contribution to financial instability. The aim of the AIFMD is mostly achieving the single market objectives, rather than addressing systemic risks. The EU regulators’ emphasis on investor protection can also be understood in light of the aim of creating a single European market for financial services. However, since the investors in hedge funds are professional investors, the AIFMD’s focus on investor protection in hedge fund regulation seems to be a misallocation of limited regulatory resources. Despite the fact that the impetus for the enactment of the AIFMD mostly involved the concerns about their systemic aspects and their contribution to the financial instability, hedge fund regulation in the EU only marginally addresses systemic risks that hedge funds can potentially pose to the financial system. In addition, the AIFMDs focus on capital requirements, leverage limits, and remuneration policies and practices, and requirements for AIFMs depositaries does not address the real concerns about hedge funds which are their interconnectedness with Large Complex Financial Institutions (LCFIs), and their potential herd behavior. Rather, imposing such limits is likely to undermine the benefits of hedge funds to European financial markets. Moreover, since the business model of a hedge fund can substantially differ from that of private equity, real estate funds, infrastructure funds or commodity funds, the one-size-fits-all regulatory approach adopted in the AIFMD will likely have adverse effects on hedge funds and undermine their benefits to the financial markets. Furthermore, hedge fund regulation is likely to put EU hedge funds in competitive disadvantage compared with their global competitors by overburdening EU hedge funds. Overall, it is primarily estimated that such direct and heavy-handed regulation of hedge funds imposing substantial costs to the industry can encourage regulatory arbitrage resulting in the ineffectiveness of the EU hedge fund regulation in the long run. This paper also sheds light on potential future regulations supplementing the AIFMD and possible future amendments thereto. It suggests that the EU’s regulatory policy towards hedge funds particularly in areas involving direct regulation of hedge funds arising from investor protection concerns should be revised. Instead, the regulatory focus should be shifted towards indirect regulation of hedge funds targeting their interconnectedness with LCFIs and their potential herd behavior. Otherwise, it is suggested that with the level of protection offered to investors of the AIFs, the AIFMD or the competent authorities of the Member States can loosen the statutory limits for investing in hedge funds.