(Fortune) -- Hedge funds have nowhere left to hide.
In November 2008 the top five U.S. hedge fund managers went to Washington to defend their business practices. With credit markets reeling, legislators demanded supervision of the notoriously secretive industry. Kenneth Griffin of Citadel Group called their bluff. "It breaks my heart when I go to Canary Wharf and I look at thousands and thousands of jobs in London in the derivatives market which belong in America," he said.
The implication was clear. Should Congress clamp down, U.S. hedge funds could always relocate.
The picture is now more complicated. Last week fund managers got their best glimpse yet of what a new regulatory regime might look like after the U.S. Senate and European finance ministers separately agreed on new rules to govern financial institutions. Here in the U.S., a tax loophole will probably be closed, leading to smaller after-tax salaries for hedge fund partners. And hedge funds will be forced to register with the SEC, an expensive process that will make the industry more transparent.
But defecting to London is no longer necessarily a better option. The proposed European regulations come down harder, making it more difficult and costlier for foreign funds to do business in Europe and placing limits on pay, risk taking, and borrowing.
So what now? Following Griffin's logic, might funds move to Singapore or Hong Kong, where tax rates are better and excessive regulation has been avoided? Asian growth is alluring, but hedge fund industry experts say a large-scale exodus from the U.S. is unlikely. That's because it's possible that some of the larger hedge funds might actually benefit from the financial overhaul bill, even if their employees gripe about higher taxes on income. Smaller funds, on the other hand, will face tougher decisions.
The new rules for hedge funds would not emerge in a vacuum. They would come alongside potentially major new restrictions on banks. Depending on the final version of the financial bill, hedge funds may prove to be among the winners. For starters, they could experience the benefits of a brain drain from banks if the government restricts proprietary trading. Funds might also pick up business that banks lose if they have to spin off their derivatives-trading businesses.
New rules are likely to govern the derivatives market, but according to Hedge Fund Alert, an industry trade publication, compliance shouldn't be a problem for the biggest shops, many of which have already modernized their derivatives-trading business. On March 1, some big market players, like D.E. Shaw and Citadel, wrote a letter to the New York Fed saying that the industry had made significant process clearing, warehousing, and reconciling derivatives trades.
Similarly, registration with the government won't be a big problem for the industry leaders. The SEC briefly required hedge funds to register in 2006, before a lawsuit ended the practice. But most large hedge funds didn't de-register. In fact, SEC registration proved to be a good marketing tool -- it reassured investors and helped attract significant pools of capital. Nor is it necessarily good corporate PR to relocate to another country -- such moves often prompt investors to wonder whether a fund has something to hide.
Enforced registration could hurt smaller funds, however, by increasing costs for startups (funds will probably be required to have a chief compliance officer and an independent auditor). Another regulatory change that could sharpen the dynamic is the push to raise the minimum level of assets an individual must own in order to become an accredited investor, clipping a source of capital for smaller funds.
Those pressures could force a wave of consolidation. The recent acquisition of GLG Partners by the London-based hedge fund Man Group seems to signal that funds on both sides of the Atlantic are preparing to deal with regulation -- and aren't necessarily looking to move anywhere.
The fact that many funds are now restructuring supports this thesis. European hedge funds are increasingly operating under a new regulated structure called UCITS (Undertakings of Collective Investments in Transferrable Securities), which enforces transparency and liquidity restrictions similar to those of mutual funds but allows for the trading flexibility and leverage of hedge funds. Industry insiders say U.S. funds may increasingly use this model in Europe.
In the long run, managers of new funds will certainly attempt to base themselves in cost-effective jurisdictions. U.S. policymakers have indicated that they might try to impose penalties on funds that move abroad to avoid excessive taxes but still want to conduct business on U.S. exchanges. The major scattering of funds will thus be in the market for startups -- a process that has already begun and may well continue as a result of new regulation.
But London and New York seem likely to remain financial hubs for the time being. The bigger issue at present, according to John Brunjes, director of the Connecticut Hedge Fund Association, is uniformity of regulation. If the U.S. and Europe aren't able to create a framework with consistent standards, funds will be able to arbitrage specific markets because of regulatory disconnects across borders.
The other part of the picture is that regulators on both sides of the Atlantic must understand how hedge funds work, says Sebastian Mallaby, author of More Money Than God, a forthcoming book on hedge funds. If bureaucrats don't have the skill and experience to identify Mickey Mouse accounting or understand what size hedge fund actually matters to the system, then additional regulation is an empty exercise.
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