Hedge Funds as Shadow Banks? Liquidity Risk and the Case of Long Term Capital Management

Abstract

This short comment illustrates a relatively concealed aspect of the hedge fund industry which makes it part of the shadow banking system. It is partly inspired by Mehrling’s analysis of the collapse of Long Term Capital Management (LTCM) and his emphasis on the liquidity risks that brought the hedge fund to its knees. The comment argues that a better understanding of Mehrling’s ‘money view’ of the collapse of LTCM requires viewing hedge funds (at least those funds engaging in maturity and liquidity transformation) as part of the shadow banking system. Needless to say, depiction of hedge funds as part of the shadow banking system and hence systemically important financial institutions significantly contributes to the literature on hedge fund regulation.

Introduction

A ‘hedge fund’ is a privately organized[1] investment vehicle with a specific fee structure,[2] not widely available to the public,[3] aimed at generating absolute returns irrespective of the market movements (Alpha),[4] through active trading[5] and use of a variety of trading strategies at its disposal. Hedge funds provide several benefits to financial markets. They are additional sources of diversification[6] and liquidity.[7] Furthermore, by investing in ‘less liquid, more complex and hard-to-value’ markets such as convertible bonds, distressed debt, and credit default swaps, they complete and deepen financial markets.[8] More importantly, hedge funds’ focus on generating alpha is rooted in exploiting market imperfections and discrepancies[9] which facilitates the price discovery mechanism by eroding arbitrage opportunities.[10] In addition, hedge funds are considered as contrarian positions takers in financial markets.[11] The mechanisms used to lock-up capital in hedge funds (such as limited redemption rights and side-pocket arrangements) enable them to further sustain their contrarian positions.[12] Such sustained contrarian position can potentially smooth market volatilities and reduce the number and magnitude of asset price bubbles.[13] Hence, it is argued that since the emergence of hedge funds as major market participants, markets became more resilient in times of market distress.

Despite their benefits, hedge funds can potentially pose risks to financial systems and contribute to financial instability. Although their role in financial instability is highly contested,[14] hedge funds’ size, leverage, their interconnectedness with Large Complex Financial Institutions (LCFIs) and the likelihood of herding are among the features that can make hedge funds systemically important. The data on hedge funds’ size[15] and leverage[16] show that these features are far from being systemically important. Nevertheless, theoretical and empirical evidence on hedge fund interconnectedness and herding is mixed and it remains a major concern for regulators.[17] In addition to the above risks that the hedge fund industry might pose to financial systems, hedge funds can become systemically important if they undertake functions originally performed by banking industry, namely, maturity and liquidity transformation.

Mehrling and Edward’s view of the collapse of LTCM

According to Mehrling, since LTCM extensively undertook liquidity transformation function in international financial markets, it got caught by a sudden liquidity shock in the aftermath of the Russian government’s default on its debt. Dealing with the liquidity mismatch is typical to dealer’s business in financial markets and Central Banks do not hesitate to extend their emergency liquidity facilities to dealers whenever the illiquidity in the markets questions the solvency of the firms and threatens the well-functioning of the financial system. However, hedge funds getting caught by illiquidity shocks with systemic implications were unprecedented. Indeed, from Mehrling standpoint, the troubling aspect of hedge funds is that they can engage almost freely in almost all investment strategies. This freedom in employing investment strategies can enable hedge funds to employ financial instruments and strategies to engage in liquidity and maturity transformation which is traditionally performed by banking entities.

In Mehrling’s view, the liquidity transformation function of LTCM is the most compelling argument for the bailout of LTCM by a consortium of bankers and investment firms organized by the Federal Reserve Bank of New York.[18] Indeed, what Mehrling highlights in the operations of hedge fund industry is that they engage in liquidity transformation in the financial markets and that is exactly what makes them systemically important. Put differently, hedge funds’ engagement in the liquidity and maturity transformation pushes them from the periphery of the financial system to the apex of the hierarchy of finance.[19] The policy implications of Mehrling’s view is that if hedge funds operate as shadow banks they should be directly regulated because of systemic importance of their activities in credit markets.

In contrast to Mehrling’s view which is a ‘money view’, Edwards’ view on hedge funds tends to lean towards banking or finance view which mostly ignores or pays less attention to the role of liquidity in the potential systemic importance of the hedge fund industry. For Edwards, hedge fund regulation is unjustified. Instead the regulatory focus on hedge funds should be shifted to banking regulation. In other words, Edwards advocates indirect regulation of hedge funds[20] through the regulation of hedge funds’ investors, counterparties, and creditors such as banks, mutual funds, pension funds and other mainstream financial institutions.[21] He starts with the traditional investor protection argument for regulation of hedge funds and repudiates such concerns because of hedge fund investor sophistication and their high net worth which enables them to easily fend for themselves. In the end, he argues that the real concern about hedge funds is the systemic risks that they might pose. Nonetheless, even with systemic risk concerns, he does not see the locus of systemic risk in the hedge fund industry itself; instead he traces the risks (apparently stemming from hedge funds) down to the banking industry.

In this short comment, I will endeavor to put hedge fund industry in the ‘money view’ context, highlighting the hidden liquidity risks embedded in hedge fund industry which can pose systemic risks to the financial markets.

What is shadow banking and why can hedge funds be viewed as part of the shadow banking system?

From a money view, in order to understand systemic liquidity risk about hedge funds and their relationship with banks, it is important to view hedge funds as part of the shadow banking system. Shadow banking system is a system of credit intermediation involving activities and institutions outside the traditional banking system.[22] It mostly refers to the origination, acquisition and pooling of debt instruments into diversified pools of loans and financing the pools with short term external debt.[23] It is mostly because of this function that shadow banks are given the label of “non-banks performing bank-like functions”.[24] It is also due to its financial intermediation function that the shadow banking system is considered as an alternative term for market finance[25] because it “decomposes the process of credit intermediation into an articulated sequence or chain of discrete operations typically performed by separate specialist non-bank entities which interact across the wholesale financial market”.[26] In the recent global financial crisis, shadow banking system (also known as securitized banking) played a major role;[27] however, it attracted less attention in regulatory overhaul triggered by its repercussions.

Taking the above definitions of shadow banking into account, it seems that the key to identifying shadow banks is spotting maturity and liquidity transformation function in their activities. Maturity transformation entails a mechanism for intermediation through which the short-term deposits are transformed to long-term credits, i.e., borrowing short and lending long. In other words, it involves issuing short-term (liquid) liabilities to finance long-term (illiquid) assets.[28] Banks’ role in maturity transformation which involves holding longer term assets than liabilities delivers major economic and social value by enabling non-bank sectors of the economy to hold shorter term assets than liabilities, ultimately encouraging long-term capital investments.[29]

The maturity transformation though beneficial to the overall economy, involves major risks. These risks arise from the nature of maturity mismatch between assets (particularly long-term loans) and liabilities (particularly demand deposits) of banking entity which historically resulted in many bank runs and panics.[30] The banks have developed specific arrangements to address risks arising from maturity transformation which are mostly reflected in their liquidity policies. These policies often involve limiting the extent of the maturity transformation of banks, “the insurance via committed lines from other banks”,[31] and borrowing from interbank repo markets.

In addition to banks’ own risk mitigating strategies, to prevent the runs on banks, their deposits are insured by the government. The main benefit from deposit insurance is preventing bank runs and panics, thereby sustaining financial stability.[32] Further, banks are provided with access to the ‘discount window’ or the ‘lender of last resort’ (LOLR) facilities of central banks. The LOLR function of central banks is devised to prevent bank runs on illiquid but solvent banks when they have liquidity problems due to their inability to borrow from interbank market or other facilities of central banks.[33] All these protections are to ensure that a banking entity’s main function, i.e., maturity and liquidity transformation, and their role in payment system are not impaired because of sudden liquidity shocks.

However, unlike banks that are allowed to accept (government guaranteed) deposits, shadow banks mostly rely on credit markets for funding and are prohibited from accepting deposits.[34] In addition, shadow banks also are not provided with a similar mechanism to deposit insurance scheme to insure their short-term liabilities. Furthermore, shadow banks do not enjoy other explicit government guarantees such as access to liquidity back up (discount window). One of the markets that hedge funds use for their liquidity management purposes is the repo markets. However, these markets are also prone to runs[35] partly because of the bankruptcy proof nature of repurchase agreements[36] and partly because there is no government guarantee of those contracts. And here is where the risks lie in the shadow banking system.

Structured Investment Vehicles (SIVs), investment banks, and mutual funds created deposit like investment opportunities with the prospects of upside gain by attracting investment from investors by promising on-demand redemption rights and implicit or explicit guarantees to the investors that the capital invested in the fund will not fall below its initial investment value.[37] However, the risk in a system which heavily relies on short term liquid liabilities is that if a liquidity crisis hits, the financial institutions have to immediately sell long term illiquid assets to meet redemptions by investors. Needless to say, such a behavior contributes to the systemic liquidity crises.[38] Such maturity and liquidity mismatches in shadow banks causing deleveraging and resulting in fire sales and liquidity spirals are vastly evidenced in the recent financial crisis.[39]

Likewise, the maturity transformation in hedge fund industry can happen through hedge funds or hedge fund-like entities’ engagement in originating derivative instruments such as mortgage backed securities (MBSs)[40] and collateralized debt obligations (CDOs). Although most hedge funds may not engage in maturity transformation, they are certainly engaging in the liquidity transformation when they invest in securitized debt instruments especially mortgage backed securities.[41] Therefore, if not all, certainly some types of hedge funds can be considered as shadow banks. As mentioned above, absent government safety nets, because of the engagement of shadow banks in maturity, credit, and liquidity transformation, they can be as fragile as traditional banks.[42]

Conclusion

Due to hedge funds’ potential role in maturity and liquidity transformation, they can be viewed as part of the shadow banking system. Given hedge funds’ freedom in engaging in almost all types of investment strategies, they can combine financial instruments and strategies to engage in liquidity and maturity transformation and hence functionally become part of the shadow banking system. Combined with the fact that at least theoretically hedge funds can take unlimited amount of leverage, the risks embedded in liquidity transformation can be amplified by the excessive use of leverage. In this regard, the case of LTCM is a case in point.

Performing banking functions without enjoying the regulatory privileges of a banking entity, i.e., explicit and implicit government guarantees such as deposit insurance and access to LOLR facilities of central banks, can make shadow banks extremely fragile. Given the inherent risks in shadow banking system, public policy responses are needed to address the potential systemic aspects of hedge funds functioning as shadow banks.

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[1] Mostly in the form of a Limited Liability Partnership (LLP) or a Limited Liability Company (LLC)

[2] A typical hedge fund charges 2% of the net asset value under management as management fee and 20% of the profits as performance or incentive fee (certain high-water marks and hurdle rates may apply).

[3] In the US, the Jumpstart Our Business Startups (JOBS) Act directs the SEC to amend the rule 506 of regulation D to remove the ban on hedge fund general solicitation. However, the sale of hedge fund products is still restricted to the accredited investors. See: 15 USCA § 77d–1 (2012)

[4] William A. Roach Jr., "Hedge Fund  Regulation- “What Side of the Hedges are You on?" The University of Memphis Law Review 40 (2009-2010), 166. See also: Andreas Engert, "Transnational Hedge  Fund Regulation," European Business Organization Law Review 11, no. 03 (2010), pp. 333-335.      

[5] J. S. Aikman, When Prime Brokers Fail: The  Unheeded Risk to Hedge Funds, Banks, and the Financial Industry (Hoboken, New Jersey: Bloomberg Press, 2010), p. 60. In addition, investment in hedge funds is often illiquid and may only be redeemed intermittently. J. S. Aikman, When Prime Brokers Fail: The  Unheeded Risk to Hedge Funds, Banks, and the Financial Industry (Hoboken, New Jersey: Bloomberg Press, 2010), p. 60.      Prior to the introduction of the Post-crisis financial regulation, the absence of registration requirement and legal restraints on their investment strategies were among the defining features of hedge funds. See for example: United Stated Securities and Exchange Commission, Implications of the Growth of Hedge Funds,[2003]).; Houman B. Shadab, "The Law and Economics of Hedge Funds: Financial Innovation and  Investor Protection," Berkley Business Law Journal 6 (2009), p. 245.       

[6] Wouter Van Eechoud et al., "Future  Regulation of Hedge Funds—A Systemic Risk Perspective," Financial Markets, Institutions & Instruments 19, no. 4 (2010), pp. 275-278. Thomas Schneeweis, Vassilios N. Karavas and Georgi Georgiev, "Alternative Investments in the Institutional Portfolio," CISDM Working Paper Series (2002).     , See also: William F. Sharpe, "Asset Allocation: Management Style and Performance Measurement," Journal of Portfolio Management 18, no. 2 (Winter92, 1992), 7-19.      

[7] Robert J. Bianchi and Michael E. Drew, "Hedge  Fund Regulation and Systemic Risk," Griffith Law Review 19, no. 1 (2010), pp. 13-15  .                                                                                                                                                                                                                                 

[8] Eechoud et al., Future  Regulation of Hedge Funds—A Systemic Risk Perspective, Vol. 19, 2010), pp. 275-278.      & Bianchi and Drew, Hedge  Fund Regulation and Systemic Risk, Vol. 19, 2010), pp. 13-15  .    

[9] In fact, the lack of legal restrictions on the use of financial instruments, strategies, and investment concentration of hedge funds enables them to use a wide range of techniques to exploit market imperfections.

[10] Andrew Crockett, "The Evolution and Regulation of Hedge Funds," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), p. 22.        See also: Roach Jr., Hedge Fund  Regulation- “What Side of the Hedges are You on?, Vol. 40, 2009-2010), p. 173.      and  Crockett, The Evolution and Regulation of Hedge Funds, ed. Banque de France, 2007), pp. 22-23.      

[11] Andrew Ang, Sergiy Gorovyy and Gregory B. van Inwegen, "Hedge Fund Leverage," Journal of Financial Economics 102, no. 1 (2011), 102-126.      

[12] Crockett, The Evolution and Regulation of Hedge Funds, ed. Banque de France, 2007), p. 22.     

[13] Eechoud et al., Future  Regulation of Hedge Funds—A Systemic Risk Perspective, Vol. 19, 2010), pp. 275-278. 

Hence, it is argued that since the emergence of hedge funds as major market participants, markets became more resilient in times of market distress. See Roger T. Cole, Greg Feldberg and David Lynch, "Hedge Funds, Credit Risk Transfer and Financial  Stability," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), pp. 11-12.         Although, the severity of the recent financial crisis and the collapse of some hedge funds during the crisis shed substantial doubts on these claims, evidence suggests that many other hedge funds were launched to profit from price dislocations in securitized markets during the crisis. See for instance: Dixon Lloyd, Noreen Clancy and Krishna B. Kumar, Hedge Funds and Systemic Risk (Santa Monica, CA: RAND Corporation, 2012), pp. 47-49.                                                                                                                                                                                                                 Most commentators agree on the fact that hedge funds provide a significant stabilizing influence by providing liquidity and spreading risk across a broad range of investors. See: Jean-Pierre Mustier and Alain Dubois, "Risks and Return of Banking Activities Related to Hedge Funds," Banque De France, Financial Stability Review; Special Issue, Hedge Funds (April 2007), pp. 88-89.                                                                                                                                                                                

    

[14] Nicolas Papageorgiou and Florent Salmon, "The Role of Hedge Funds in the Banking Crisis: Victim Or Culprit," in The Banking Crisis Handbook, ed. Greg N. Gregoriou (Boca Raton, FL: CRC Press, Taylor & Francis Group, 2010), 183-201.      

[15] Data on hedge fund size demonstrates its relatively modest size compared with mainstream financial institutions. One of the most recent estimate of hedge fund industry size in March 2012 indicates that hedge fund industry’s assets under management (AUM) amounts to $2.55 trillion. See: Citi Prime Finance, Hedge Fund Industry  Snapshot, 2012).      Consistent with the industry's modest size, hedge fund liquidation had overall very limited impact on financial markets. See: Ben S. Bernanke, "Hedge Funds and Systemic Risk: Remarks Delivered at the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference—Hedge Funds: Creators of Risk." 2006).    

[16] Hedge fund leverage is significantly less than depository institutions, listed investment banks, and broker dealers. See: Anurag Gupta and Bing Liang, "Do Hedge Funds  have enough Capital? A Value-at-Risk Approach," Journal of Financial Economics 77, no. 1 (2005), 219-253.; Ang, Gorovyy and van Inwegen, Hedge Fund Leverage, Vol. 102, 2011), p. 121.    

[17] Nicole M. Boyson, Christof W. Stahel and René M. Stulz, "Hedge Fund Contagion and Liquidity Shocks," Journal of Finance 65, no. 5 (10, 2010), p. 1814.       . Fung and Hsieh find evidence of hedge fund herding in the European Exchange Rate Mechanism (ERM) crisis and evidence of herding in the Asian Crisis; however, they could find little evidence of systematically causal relationship of hedge funds behavior and deviation of market prices from economic fundamentals. See: William Fung and David A. Hsieh, "Measuring  the Market Impact of Hedge Funds," Journal of Empirical Finance 7, no. 1 (2000), 1-36.       

[18] Perry Mehrling, "Minsky and Modern Finance," The Journal of Portfolio Management 26, no. 2 (2000), pp. 85-87.     

[19] From the point of view of law and finance literature, it might be said that hedge funds will try to push themselves from the periphery to the core or the apex of the system to get a better regulatory treatment and also exert influence in the financial system. See: Katharina Pistor, "A Legal Theory of Finance," Journal of Comparative Economics 41 (2013), 315-330.    

[20] ‘indirect regulation’ is “market discipline-inspired regulatory measures targeting the creditors and counterparties of hedge funds (mainly, but not exclusively, their prime brokers and securities brokers).” See: Athanassiou, Hedge Fund Regulation in the European  Union: Current Trends and Future Prospects, , p. 227. He further adds that “The aim of such measures would be to enhance the counterparty risk management practices that financial institutions apply in their dealings with hedge funds and/or to impose disclosure duties on prime brokers and other crucial hedge fund counterparties in respect of their hedge fund exposures. An indirect approach could be complemented by the obligatory ‘registration’ of managers of hedge funds in conjunction with the (voluntary) improvement, by the hedge fund industry itself, of its transparency, risk management and asset valuations standards and practices.”

[21] F. R. Edwards, "Hedge Funds and the Collapse of  Long-Term Capital Management," Journal of Economic Perspectives 13, no. 2 (1999), pp. 204-208.   

[22] Financial Stability Board, Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Finance Ministers and Central   Bank Governors,[2011]).                                                                           

[23] Nicola Gennaioli, Andrei Shleifer and Robert W. Vishny, "A Model of  Shadow Banking," NBER Working Paper no. 1711 (2011).                                                                           

[24] “non-banks credit intermediation” is the term used by the FSB, See: Financial Stability Board, Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability: Report of the Financial Stability Board to G20 Finance Ministers and Central   Bank Governors, 2011).                                                                           

[25] European Repo Council, Shadow Banking and  Repo,[2012]).                                                                            

[26] European Repo Council, Shadow Banking and  Repo,[2012]). See also: European Commission, Green Paper: Shadow Banking, 2012).                                                                           

[27] Gary Gorton and Andrew Metrick, "Securitized Banking and the  Run on Repo," Journal of Financial Economics 104, no. 3 (2012), 425-451. The role of shadow banks in the recent financial crisis is well illustrated in detail in: Gary B. Gorton, Slapped by the Invisible  Hand: The Panic of 2007 (New York: Oxford University Press, 2010a).                                                                            

[28] Alessio M. Pacces and Heremans Dirk, "Regulation of Banking and Financial Markets”," in Forthcoming in ‘Regulation and Economics’  in Encyclopedia of Law and Economics, ed. Pacces, Alessio, M. & Van den Bergh, RJ, 2nd ed. (Cheltenham: Elgar, 2011).                                                     More often than not, the maturity transformation in banking is accompanied by liquidity transformation; however, there might be instances that banks engage in liquidity transformation without engaging in maturity transformation.                       

[29] Financial Services Authority (FSA), The Turner Review: A Regulatory Response to the Global Banking Crisis, March 2009), p. 21.                                                                            

[30] Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. (Hoboken, New Jersey: John Wiley & Sons, Inc., 2005).                          

[31] Financial Services Authority (FSA), The Turner Review: A Regulatory Response to the Global Banking Crisis, March 2009), p. 21.                                                                          

[32] Alan S. Blinder and Robert F. Wescott, Reform of Deposit Insurance: A Report to the FDIC,[March 20, 2001]).                                   protection of small depositors is indeed an incidental benefit of the deposit insurance schemes.

[33] For more information on the Lender of Last Resort (LOLR) function of central banks, see: Xavier Freixas et al., "Lender of Last Resort: What have we Learned since Bagehot?" Journal of Financial Services Research 18, no. 1 (2000), 63-84. See also: Xavier Freixas and Bruno M. Parigi, "The Lender of Last Resort of the 21st Century," in The First Global Financial Crisis of the 21st Century: Part Ll June-December 2008, eds. Andrew Felton and Carmen M. ReinhartVoxEU.org Publication, 2009), 163-167. Historically, the LOLR function in the market was played by private financial institutions. A bold example of taking up of such a role in the crisis of 1907 was J. P. Morgan’s provision of liquidity to markets and institutions in those years. See: Robert F. Bruner and Sean D. Carr, The Panic of 1907: Lessons Learned from the Market's Perfect Storm (Hoboken, New Jersey: John Wiley & Sons, Inc., 2007). However, after the 1913, the year in which the Federal Reserve came into being, it took up such a function.

[34] Even with all those prohibitions, money market mutual funds developed products that were similar to demand deposits.

[35] Gary B. Gorton, Slapped by the Invisible  Hand: The Panic of 2007 (New York: Oxford University Press, 2010b). 

[36] Nathan Goralnik, "Bankruptcy-Proof Finance and the Supply of Liquidity," Yale Law Journal 122 (2012), 460-506.  

[37] These were sometimes called Negotiable Order of Withdrawal accounts or (NOW accounts).

[38] Financial Services Authority (FSA), The Turner Review: A Regulatory Response to the Global Banking Crisis, March 2009), p. 21.                                                                         

[39] Markus K. Brunnermeier, "Deciphering the 2007–2008 Liquidity and Credit Crunch," Journal of Economic Perspectives 23, no. 1 (2009), 77-100.  See also: Markus K. Brunnermeier and Lasse Heje Pedersen, "Market Liquidity and Funding Liquidity," The Review of Financial Studies 22, no. 6 (Jun., 2009), 2201-2238.                      

[40] To see how investment in MBS can be considered as shadow banking, see: Admati and Hellwig, The Bankers' New Clothes: What's Wrong with Banking and what to do about It (Princeton, New Jersey: Princeton University Press, 2013).

[41] For the distinction between maturity transformation and liquidity transformation, see: Anat R. Admati and Martin Hellwig, The Bankers' New Clothes: What's Wrong with Banking and what to do about It (Princeton, New Jersey: Princeton University Press, 2013).

[42] Zoltan Pozsar et al., Shadow Banking (New York: ,[2010]).                                                

The grass is always greener on the other side of the fence

Having visited northern Italy and southern Switzerland, I realized that in some parts of northern Italy, most traffic signs and boards are in German, while in southern Switzerland most of them are in Italian. I have no idea about its underlying reasons, but it seems to me that the people in southern Switzerland have a tendency to associate themselves with Italian culture of the other side of the border, while northern Italians want themselves to be associated with German culture (and not the Italian culture that their southern Swiss counterparts in their proximity want to be associated with). By and large, no matter where you are and how your economic and financial situation is, the grass is always greener on the other side of the fence.
(Photo Courtesy: Wiktionary.org)

Philanthropic Capitalism vs. Banal Pseudo-capitalism

Simply put, the diminishing marginal utility of money means that the utility derived from an additional dollar decreases when the amount of money you already have gets larger. For example, if you have one dollar, an additional dollar can buy you a not-so-decent sandwich which can in some extreme cases save your life. However, when you are a billionaire, an additional dollar almost makes no difference to you.

Based on this belief, some people argue that capitalism culminates in philanthropy, because as you get richer and richer, you derive less utility from earning additional amounts of money. In the meantime, you realize that if you donate that money to other people, you will increase their welfare by a large margin. This asymmetric welfare increase motivates you to donate more and more. Moreover, the utility you derive from donating money to the poor far outweighs the utility of the money you lose in philanthropic causes.

Although I have not come across any empirical evidence supporting or falsifying this argument, my personal observation supports this idea. So, let’s say a few words in terms of anecdote. [Warning: Anecdotes can be extremely misleading].

In welfare state/socialist Europe, I have seen people particularly in Italy, Switzerland, and France (and to a lesser degree in Germany, the Netherlands and Belgium) dressed in fashionable robes strolling around on the streets with obsessive use of chemicals and cosmetics. They enjoy long vacations in European resorts and etc… (Let’s not get into details of something about which I know the least.) This is all brought by the wealth created by embracing markets and opening up their economies and having a welfare state in place distributing that wealth. On the other hand, my limited observations on the streets show that they are also less inclined to help the poor. (This way of life I call banal pseudo-capitalism).

One explanation is that maybe in Europe government social welfare program crowds out the charitable activities of the individuals. One idea from Dennis Mueller’s class in Public Choice about the donations to the universities in the US and in Austria always resonates with me  I remember him saying that the amount of the donations by professors and alumni to the US universities is just incomprehensible for his Austrian colleagues.

However, in the US, the social equilibrium leans towards philanthropic capitalism. You do not have to go far to find anecdotal evidence for such a claim. I can remember professors in top US Universities dressing almost the same clothes during one semester. On the contrary, I used to see professoresse in Italy, changing their dress on a daily basis, as if they are models whose aim is to impress the people by their clothes rather than their intellects; the epitome of platitude! So much for the anecdotes!

Not surprisingly, the data supports me in drawing such a distinction.

PS: Of course, there are lots of charitable people in Europe and by no means, this post is meant to undermine their great deeds.

Lenin’s Swiss Comrades

Based on my limited observations, I am very much surprised by the number of socialists (leaning towards communism) in Switzerland. Still words like ‘bourgeois’ and ‘petit bourgeois’, referring to the rich supposedly in a degrading manner, abound in their talks.

I always enjoy talking to them mostly because they challenge my arguments which are totally different from theirs, but I am least interested in their habit to stereotype people. I would say not only are they interested in stereotyping others, but also it seems they take pride in categorizing and labelling themselves. Unfortunately, rushing to fit the people into their ideologically-built categorizations, sometimes they totally ignore your arguments aimed at showing the flaws in theirs. 

Although Lenin faced cold shoulders in Switzerland in the 1910s, he would have found himself much happier surrounded by his comrades a hundred years later. 

PS: Of course, the failure of 1:12 executive compensation cap initiative a few days ago shows that he could not feel so much at home.

On Thanksgiving & National Day of Prayer

I stumbled upon this Act while wandering about in the West Law. The Act establishes a National Day of Prayer. To my surprise, it is enacted in 1998 in the US. See its fate as well.

36 U.S.C.A. § 119: National Day of Prayer
Effective: August 12, 1998

"The President shall issue each year a proclamation designating the first Thursday in May as a National Day of Prayer on which the people of the United States may turn to God in prayer and meditation at churches, in groups, and as individuals."

"Constitutionality
Statute creating the National Day of Prayer, whose sole purpose is to encourage all citizens to engage in prayer, an inherently religious exercise that serves no secular function in such context, violates the establishment clause; the statute goes beyond mere “acknowledgment” of religion and conveys message of government endorsement of prayer, purpose of the National Day of Prayer is to encourage all citizens to engage in prayer, in particular the Judeo-Christian view of prayer, statute does not “accommodate” religion, and government has taken sides on a matter that must be left to individual conscience. Freedom From Religion Foundation, Inc. v. Obama, W.D.Wis.2010, 705 F.Supp.2d 1039, vacated and remanded 641 F.3d 803."

By Courtesy of the West Law

Decentralized Knowledge, Charter Cities and Economic Development

Poverty, misery, economic disparity and inequality are the salient characteristic of the modern world. These problems are one of the main concerns of the almost everybody and I was no exception to the rule. Though poverty sometimes seems to have a geographic pattern, in my view the problem of poverty is not directly related to geography, but it is closely related to the human capital of the people living within a "politically defined" territories which have been evolved through the ages of ebbs and flows of war and peace.

A quick look at the geopolitics and economics of poverty and development shows that the poverty and misery usually is confined in these political entities. In some instances, it can be seen that two states roughly within the same geography have two absolutely different standards of living. The bottom-line is that the poverty is not a natural or geographic phenomenon, but it is a human problem caused by humanity itself and could be dealt with human intervention. It seems that it is the cooperation and coordination failure which creates such problems or at least cannot prevent them from happening. Why is it so? And what can be done about it? What role legal and economic theory can play in dealing with these grave human problems?

In this short note, I see the status quo in international law and generally acknowledged theory of the state as the first culprit for having such a situation in place. The current system of international law is the debris of tumultuous history of wars. The suboptimal Nash equilibriua generated by the failure of cooperation and coordination along with innumerable prisoners' dilemma the humanity has been trapped into, in Westphalia in 1648, caused states to adopt the principle of sovereignty which normatively fortified states, isolated them and used the international law as a tool to reinforce their territorial sovereignty.

In this new geopolitical order states are defined firstly by their territories and secondly by the people. This is the territory which determined what laws should be applicable to the individuals. The policies and institutions of non-intervention and absolute sovereignty and territorial integrity are clear evidences for this claim. The peace treaty of Westphalia gave birth to the territorial integrity which afterwards made its way into the Charter of the United Nations. Within these territories each country has an absolute sovereignty, of which the governments tend to present a quite generous interpretation.

This abusive construction of the principle of territorial integrity has its roots in the double-degree agency problems the statesmen have in their international missions. The diplomatic mission participating in an international convention or meeting thinks of his own interest how to perpetuate his position and job in the career and forgets about the interest of the government he or she is representing and on the other hand, the government who chooses the agent/diplomat to send to the international conferences, thinks of its own interest how to perpetuate the government and his party in power; the forgotten man is the nation.

Though the states wanted to territorially define themselves and isolate themselves, the point is that many of the human problems cannot confine and accord themselves to the political borders, and they increasingly become global. On the other hand, Decentralized knowledge and the impossibility of central planning are among the biggest concerns of the economists from almost the outset of the modern economic thinking. In this paper, I want to analyze the implications of dispersed and decentralized knowledge for the size and structure of the state to see how the policy makers can take advantage of this local and decentralized knowledge to make a difference in the development studies.

The line of reasoning will be as follows: Economic misery has its roots in human mismanagement and misadministration. The optimal way of dealing with this problem is establishing knowledge-based economies. Since the human knowledge is dispersed, mechanisms that can involve everybody (free entry and exit) to voluntarily contribute to the public policy are the optimal ways of dealing with those problems. This model is a model which should be based on the free market for ideas. I will argue that one of the mechanisms to give the opportunity to citizens to engage and share his knowledge in the public policy is localism and creating strong networks among people. Given the flaws (coercion/involuntariness) and the problems of localism, one might take the idea of charter cities as an alternative way toward development; it might be considered as an alternative or a complementary way of the existing model toward development, as a constant and steady growth over a considerable period of time. The problem with this alternative idea is that it challenges the exiting conservative structure of international law.

Localism as a Mechanism of Exploitation of the Dispersed Knowledge
Let me start with the history to see how the dispersed knowledge in administering the territory caused even the greatest empires and states to abide by the special governance rules and structures. By a quick overview of history, we can see that even the most potent of empires of the world were restricted by the geographic and economic realities which played a very delicate role in their size and structure. Indeed, local governments have their roots in the long history of civilization and the rules of governance in large scale empires. As historians demonstrate; Cyrus, the Emperor of Persia, appointed the local officials for governing every region within the Empire. According to Herodotus, after conquering Lydia, Cyrus decided to appoint the ex-king of Lydia, Croesus, who was defeated by Cyrus as the governor of Lydia within the Persian Empire. Thereafter, Darius, the Persian king, did the same and appointed the local officials for the administration of the then Persian territories which at that time were constituted of about 20 provinces called “satrapies”. Though there might be a host of reasons behind these appointments, ex-post, it seems that one of the reasons was the difficulty of getting involved in the management of those vast and diverse territories without having a proper local knowledge.

As the above example shows, many of the empires who conquered a vast territory appointed the local governors for the administration of those occupied territories. This became a tradition in governance at least in the Middle East and the Minor Asia in ancient times. For instance, when Alexander conquered Persia, he made use of such a policy as well. The conquerors like Teymour Khan and Chingis Khan followed suit (again ex-post) partly because of the expertise problem and partly the common sense and intuitively known idea of the diseconomies of scale arising from such a big territory under administration, decentralized nature of the knowledge which made central planning impossible for them and would have frustrating effects on their territories and their strength of traditional sovereignty.

This continued tradition had its special advantages and economic justifications for those emperors. Although many of the ancient empires officially claimed that they had a universal sovereignty, save King Canute, they were well aware of the limits of their power. Van Creveled puts it this way, [because of] “the problems of time and distance as well as the limits of the information at their disposal, many emperors preferred to deal with entire communities – tribes, chiefdoms, villages, cities, even client-kings – rather than with individuals”. This insightful phrase is the gist of what I am going to say and almost perfectly shows how the case for local governments was established. This comment also shows that almost from the advent of urban life and civilization, how great empires with vast territories severely suffered from the transaction costs, agency problems and diseconomies of scale. Add to the scope of the country the problems arising from the lack of means of communication that the industrial revolution partly solved for their modern counterparts. These limits imposed multilevel or multilayer system of governance even to those ancient empires. The insightful lesson that we can take from history is that decentralized knowledge breeds decentralized government, unless you live in a body politic in which "La République n'a pas besoin de savants" (the Republic does not need the erudite).

Theoretically speaking, localism can promote the use of local and dispersed knowledge and contribute to the socio-economic development. Many of the adherents of localism argue that smaller governments provide a better context in which the citizens can have a better sense of community. Some of these proponents go farther and argue that the constitutional and legal rights should be context sensitive. These advocates of localism believe in a broader decentralized constitutionalism. They argue that the courts should respect the “geographical variations of constitutional requirements in the aid of community”. In addition, the existence of large number of local governments who are much more familiar with the needs of the special communities and certain localities, with the amount of services and consumption which is usually limited to their own jurisdiction increases the economic efficiency in the provision of public goods and certain utilities.

Localism can promote economic efficiency by taking account of the differences in preferences and cost differentials in the locally needed public goods. Therefore, it appears that the efficient level of output in local public goods seems to be variable in the local jurisdictions and likewise governments provide the better allocation of local services in a decentralized structure. Other economic adherents of localism argue that the very existence of the localities brings about plurality of localities and extend the opportunities of the citizens to move into better localities which provide the better allocation of services and taxes and eventually serves the economic efficiency. Tiebout was the first theorist who elaborated the idea of the “voting with the feet”. However, it seems that he overlooked some costs affiliated with his idea such as tremendous migration costs, externalities and asymmetric information, which adversely affect the outcome of the theory. All in all, these local governments play an extremely important role as a channel through which local knowledge channels into the federal level and makes planning in a central level a bit less onerous.

Unfortunately there were inefficiencies in the localism as well which could not bring about the desired result we might have expected to reach. But why do we see inefficiencies even with having local governments in place for centuries? The answer is in the inefficiencies embedded in the localism. Inefficiencies resulting from the diseconomies of scale, high costs of communications among many local governments, duplication of efforts and the forgone opportunities of network economic effect in a sub-optimally organized networks of local governments, existence of the commons in the regions, free riding problem, and problems arising from the taxation, transactions costs and hold-out problems hindered the local governments from flourishing and the long fought battle between home rule and Dillon's rule was resolved in favor of the latter.

Let's have a quick look at the history to see why this form of government could not be efficient enough. With the gradual evolution of urban life, consciously or unconsciously, some other problems and thereafter concepts came into existence; the concepts similar to annexation and incorporation in the history of urban life. The rising of these phenomena signaled that the network economic effects (having bigger entities with lots of individual components) prevailed over the benefits of the having small local governments.

First let's see why would people like to migrate and live in prosperous places rather than the isolated underdeveloped places? The answer lies in a concept known as network externality. Network externalities appear when greater numbers of users join to a network. This theory assumes that “the utility that a given user derives from a good depends upon the number of other users who are in the same “network” as is he or she.” This network can appear for example when the municipalities join together in a unified network to share their resources. Although this fact may generate some unintended consequences like diseconomies of scale, but it seems that taking the size and number into a serious consideration and not letting them grow more than necessary, this will increase the positive externalities of networking.
One of the best historical examples of network effects which caused some cities to grow immensely, is the city of Baghdad at the time of Abbasid Caliphate (Rome might be a good approximate to a western mind). At that time, the city of Baghdad had a position in the world comparable to world cities of today. Ibn-e-Khaldun describes the City of Baghdad as follows:

“[T]he town will extend farther and farther. Eventually, the layout of the town will cover a wide area, and the town will extend so far and wide as to be almost beyond measurement. This happened in Baghdad and similar cities. Baghdad included over forty of the adjacent neighboring towns and cities. It was not just one town surrounded by one wall. Its population was much too large for that, the same was the case with al-Qayrawan, Cordoba, and al-Mahdiyah in Islamic times. It is the case with . . . Cairo at this time, so we are told.” (Badi, 1988, p. 86)

This discussion of the growth of large cities such as Baghdad is similar in essence to what is referred today as the process of suburbanization, a phenomenon that in turn causes sprawl. With the growing number of districts within a country or a city, other problems come into being as well, i.e., coordination problem embedded in the decentralized and (more recently) separated power structure of the state. So from the above examples and economic history indications, one can see that neither large nor small sizes are optimal for the states/cities.

The further complication is that the size of the population of societies does not remain constant and increasingly changes with the fluctuations in the labor, capital and technologies, while the supply of the land almost remains constant. Furthermore, there exists an optimal size for the states. But who knows what that optimal size is? Therefore, the restructuring of the state will not mitigate the problems and if it does, further problems will arise (coordination problem & the like). As above examples show, many of the problems could not be dealt with either by centralization or decentralization. There must be a way out.

International Law and the Exchange of Authority: Towards Creation of Charter Cities
The idea of comparative advantage based on the division of labor and ensuing expertise simply states that each country can be good in producing or providing some special goods or services, and they can enter into a contract to exchange goods and services that can create new economic value for both sides of a transaction. Based on this theory and upon the demise of the zero-sum fallacy, rise of the marginalism, and new theory of economic value, we almost see the end to the beggar thy neighbor policies that the states pursued in the pre-modern era by waging extremely costly wars against their neighbors or rivals. These theoretical transformations gave birth to the new theory of international law, i.e., the economic theory of international law, the goal of which is to let the states to achieve their preferences with better and greater efficiency through exchanges of authority and transactions in Jurisdiction. This is a very good point to set the stages to establish our argument for charter cities. This approach to international law can explain how a metamorphosis in international law; i.e., from sovereignty based international law to market based international law can contribute to the economic prosperity and development of the nations.

Although, the economic approach to international law states that the states can do more efficiently by exchanges of authority and transactions in jurisdictions, we can push the argument one step further in the sense that nation-states exchange their sovereignty over the defined pieces of territory. This model proposes that to enhance efficiency, nations should bargain on their territories and hence this model supports the creation of a market for the national territories (specially barren and undeveloped national territories) so that the territories will go to their most valued use. This is roughly what the idea of "charter city" proposed by Paul Romer is.

First let's see what a charter city essentially is. The concept of charter city, as formulated by Paul Romer, is a city which is composed of three elements: host state, source state and the guarantor. The host country provides undeveloped lands, the source country or countries provide the residents and guarantor ensures that the charter of the city (which is essentially the constitution of the city) is enforced. The host country is supposed to ensure that it will not apply his internal rules and regulations on that specified undeveloped land and the charter will ensure that the basic requirements of rule of law will be in place. Notice that each of these countries has comparative advantage in goods, capital and services they provide for the Charter city.

Successful historical examples of charter cities are Lübeck in twelfth century, Pennsylvania/Philadelphia in the 17th century, and Hong Kong in the 20th Century, each with different stories which in this paper, for the sake of brevity is forgone. The argument is that if these models of the charter city achieve success, other countries will follow suit as other states and countries did in case of Pennsylvania and Hong Kong.

The difference between localism and the charter city mechanism is that localism is an attempt to involve everybody by creating incentives and increasing differential value of voting to increase the marginal value of voting to make it attractive for voter to become involved in the elections. Charter city is an attempt to provide an alternative pattern to the existing patterns of democracy and development to make the environment and context more dynamic. Charter city is an attempt to involve those who see it in their interest to involve and those who will.

Unfortunately, the principle of territorial integrity in international law was abusively construed by national authorities not to let nations to enter into a bargain on their territories while history documented several transactions transferring national lands such as Louisiana and Alaska purchase. The biggest problem in the way of such an idea is the double-degree agency problem in international law. As stated above, the government or the diplomats who are negotiating such a deal might have conflict of interest with the nation they are representing. Though the mechanism of checks and balances can mitigate this problem to a considerable extent, it can never eliminate it. And maybe this is the reason why many countries in their constitutions do not allow any negotiations on their territories.

The requirements of the modern complicated world with its extreme problems imposed on the isolated fortified states, requires more cooperation, coordination of the efforts and contribution of the capacities in which every individual state might have comparative advantage, to solve the problems of global magnitude.
The status quo is that there are many underdeveloped countries with vast territories under their rule and simultaneously there exists geographically small countries with almost fully-developed lands and in need of more lands. A salient example of an inefficiency caused by the "sacred", fortified boundaries is the example of Japan and Russia. Large population of Japan living on a bunch of small vulnerable islands while vast pieces of lands remains underdeveloped in Russia. It might be said that those lands are not inhabitable, but evidence shows that people even can make use of the swamps to live in if they do not have any better choice.

There is certainly tremendous amount of deadweight loss negatively affecting the lives of millions just because we drew some lines around us and made a lot of taboos around it, murdered and were murdered because of those usually fictive lines.
I know that the history of international law was a very sad one. And this history of wars which gave rise to the present extremely conservative international legal system, but the increasing realities may not wait for that conservatism of international law to vanish gradually. The population growth and the interconnectedness of this population will impose greater challenges on the international law than the immigration and other present environmental challenges. This time the target will be the very principles of international law.

As the last point, It should be noted that though the idea of charter city seems unrealistic and utopian, given the growing rate of obsolescence of ideas due to the accumulation of dispersed knowledge of the people through the virtual networks which connect the individuals from all over the globe, it will not be too far that everybody will see the flourishing of ideas which were considered too unlikely and unfamiliar. What seems à la mode today, will be obsolete tomorrow, special thanks and tribute to fiber optics, microchips/processors, satellite and internet.

International Trade and Race to the Bottom

"Should other states be concerned about your environmental protection choice?" This is a fundamental question in trade policy and regulation which is asked almost everywhere to set the stage for starting the debate about international trade regulation and our class in Economics of International Law was no exception. Most of the answers offered to justify the governments' intervention in the international trade policy are based on the externalities (jobs displacement, protection of the infant industries), strategic trade theory and race to the bottom argument. What I will be talking about is the last argument offered for having restrictions on international trade.

What constitutes the core idea in the race to the bottom argument for restricting the international trade and perceived to be the strongest argument for a hidden protectionism is the race to the bottom. It is argued that the free international trade will be in favor of the countries with less restrictive labor, environmental and human rights measures and will be detrimental to the countries with higher standards with regard to the above mentioned standards, so trading with those countries not only puts the countries with higher standards in comparative disadvantage, but also makes the acute problems of the environment and human rights worse, so there should be either no trade with countries with low standards or there should be some restriction on trading with them.

I my view there are problems with this argument.
1. In terms of economics, since the advent of the marginalist revolution based on the modern theory of economic value, no sound economist could be found to be thinking that there should be no trade at all. One of the fundamental methods of thinking like an economist is thinking marginally. It means that most of the times, we are not dealing with the problems involving either/or, but problems of different degrees or levels taking account of other available alternatives at disposal. Marginalism should be understood as part of the fundamentals of the theory of the microeconomics dealing with the optimal allocation of the limited resources to the unlimited wants and desires. It implies that most of the choices we are making in our life is not about whether we want something or not, but how much of something we want in combination of how much of some other things. So, when the question is not about all or none, but about how much, the answer should be about how much trade with those countries and how much restrictions should be put on those trades.

2. Second and more logically based argument against the race to the bottom is about the fallacy/problem of equivocation lying in the context of the debates on the international trade. The repeated use of the race to the bottom argument makes economists to take it as granted. I think the question we should ask should concern with the meaning and implications of the word "bottom". We should come up with an idea of what this bottom means and after setting the reference/anchor points in the definition of the bottom, proceed to make use of this argument against international trade. Someone sitting in the developed country may see a situation as bottom while the other one in an underdeveloped / undeveloped / emerging market sees it as top. This fallacious argument arising from the improper use of the language and ambiguity in the meaning of the words is called equivocation. If we want to resolve this problem, the parties to an argument should first agree about the meaning of the concept or the conception of the particular concept they have in their minds in that particular context.

The other days, I was watching an interview with an ex-Chinese teacher who was working in a factory at that moment, he was telling to the interviewer that when he was a teacher he earned one hundred Yuan per month (I am not sure about the currency and the period, but sure about the numbers), while working in the factory he could earn 3.000 and despite being in a very modest situation he was very happy. What developed world sees a bottom, to him it was top.

There is a nice and almost untranslatable verse in Persian which best describes this problem with a very palpable analogy. It goes as follows:
حوران بهشتی را دوزخ بود اعراف
از دوزخیان پرس که اعراف بهشت است
A'raf is a place located in between the heaven and hell. The verse says that for the angels of heaven, A'raf is a hell, while for the residents of hell, it is a heaven. So two categories of people with two different socio-economic! standings, see one thing differently and consequently if these two with the above specifications argue about the a'raf, they have two distinct conceptions in their minds and cannot come to a proper conclusion on that.

It appears that in the race to the bottom argument convergence on the word "bottom" has yet to be achieved. Though this "bottom" concept could be roughly taken as granted when we are talking about one domestic legal system, we should not hastily and unthinkingly borrow the concepts from the domestic legal or economic system and apply it to a different legal structure.

Another important argument against restricting the trade with countries with looser standards is that it will prevent the evolutionary process of divergence of the conception of the concept of the "bottom" which trade with those countries can bring about. As the basic principles of economics imply, no trade/ voluntary exchange can occur unless it is beneficial to both parties, when we see that one enters into a voluntary exchange of goods or services, it is appropriate to assume it is in the interest of both parties to engage in that particular trade. Having this in mind, it will become clear that imposing restrictions on the trade with these countries will wipe out both producer and consumer surpluses and will be detrimental to both parties, especially it will make barriers for developing countries to reap the profits of the trade and will leave them in their regrettable status quo, i.e., poverty and starvation, while having trade can fill the gap between those countries and more developed ones to a considerable degree and pushes the "bottom" up.

3. I personally believe that the main reason behind this kind of argument is nothing more than a hidden filthy protectionism formulated and propagated by the more organized producers to the detriment of the non-organized consumers and society trapped in the collective action problem unable to further their interests.

The last point I want to make is that we cannot judge and evaluate the arguments in vacuum, when we want to assess the implications of particular policies we are supposed to look at the alternatives we have at hand. There seems to be two alternatives for having trade with countries with looser standards, first having no trade with them and sanctioning their products, second having limited trade imposing higher tariffs and quotas on their product. I think both of these arguments are doomed to fail. Why? The first one is quite obvious, it will end up in huge losses in the forgone gains of trade and both parties to the trade will lose. The second one will result in a huge deadweight loss arising from the restrictions on the trade. Though less detrimental than the first one, it will bring more restrictive measures to the trade in favor of the organized interest groups which will endure even after the change in circumstances. After an institution is established, it will be very hard to unravel it. On the other hand, this institution will generate public officials and bureaucrats seeking their interest to the detriment of the society as a whole.
So it seems appropriate to ask whether a free trade with emerging markets even with looser human rights, environmental or labor standards will result in the race to the bottom or race to efficiency.

Hawkin's Round Trip Fallacy

Mr. Hawkin knows very well how to play (maybe he does not really play). Once he wrote there is a God and Millions of copies of his book were sold, now he claims on the contrary but confusing no evidence of Heavens/God with evidence of no heavens again. A big round trip fallacy which seems to be very delightful for many, and once again will turn him into another bestseller. Once I have read this quotation somewhere: "Without education we are in a horrible and deadly danger of taking educated people seriously" and as time passes, I realize it is the most plausible justification for getting educated.

Regulatory Paternalism and its Unanticipated Consequences

One of the ironies of the modern word is the unwanted and unanticipated (who knows?) consequences of the regulatory intervention in economic activities. One of these consequences is in the securities regulation in which regulators had hard times regulating recently. Regulators are supposed to protect investors and one of the mechanisms of investor protection is the disclosure requirements in public offerings. They think that the disclosure of information will protect the investors while many unsophisticated individual investors cannot make heads or tails of the disclosed information. I do not like to focus on this issue, what I would like to discuss is the problems arising from the paternalistic approach of the regulators. As I said, this disclosure requirement is limited to public offering while laws and Regulations made some exceptions to this general requirement and one of those exceptions is the private placement.

As defined in the famous case of 1953 SEC v. Ralston Purina Co. "a transaction not involving a public offering" is "an offering to those who are shown to be able to fend for themselves." Who is able to fend for himself, SEC Rule 501 (a) defines such a person as an "accredited investor". Accredited investor is any "natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000”; any “natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year”; plus executive officers and directors of the issuers.

There are some other details into which there is no need to enter. The hedge funds and private equity funds are among those issuers of securities taking advantage of the above mentioned provisions who can sell securities to accredited investors. Having a quick look at the hedge funds returns and a quick comparison of their overall returns to S&P 500 and other indices returns reveal that hedge funds either in times of economic prosperity or in times of turmoil earns much more and lose much less than other indices. It means that both in upturns and downturns they outperform the market. Thanks to the SEC/securities regulation which does not restrict the hedge funds and some other private equity funds' strategies while doing so for other financial institutions. Taking advantage of this laxity in regulation for hedge funds and more stringent regulation for other financial institutions, hedge funds are able to have better risk management strategies because a wide variety of the financial strategies, especially short selling mechanism, at their disposal, .

Anyhow, the hedge funds outperform the market with having a helping hand from regulators who create an economic rent for them. The irony is that only the so called "accredited investors" can invest in these funds and general public are banned from investing in them. It means that if you are poor, you cannot invest in them and have higher return on your equity, but if you are rich enough, you can do so and get increasingly richer than the poor in market upturns and in the market downturns lose lot less than the poor does.