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Abstract

This Article studies regulatory strategies to address the potential systemic risk of hedge fund 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. This Article defines the distinction between direct and indirect regulation, maps this distinction’s implications in terms of regulatory techniques and instruments, and analyzes the arguments for and against direct and indirect regulation of hedge funds. This Article argues that the indirect regulation of hedge funds through their counterparties and creditors is not only less costly but also can better address regulatory arbitrage by hedge funds and their potential contribution to systemic risk. The economic and organizational structure of hedge funds and their particular features in terms of the number and composition of their counterparties and creditors support this policy recommendation.

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