Grey matters

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Gjergji Cici, Alexander Kempf, & Alexander Puetz, Caught in the act: How hedge funds manipulate their equity positions

(24 August 2010) available at

Using 13F position valuations, we show that hedge fund advisors intentionally mismark their stock positions. We document manipulation even after eliminating issues inherent in the pricing of illiquid securities. Hedge fund advisors mark their positions up (down) following poor (good) performance of their equity holdings. Mismarking is more pronounced for advisors that are audited less frequently, are domiciled in offshore locations, self-report to a commercial database and report more frequently to investors.

Furthermore, equity mismarking is related to some of the reported return patterns documented in previous studies, such as a discontinuity in the distribution of returns around zero and smoothed returns.

CFR comment
In the new regulatory climate following the financial crisis, and with greater scrutiny being given to hedge funds in onshore jurisdictions, auditors, investors, offshore regulators and others in the hedge fund industry ought to give this paper a close read, since the authors’ results could be used by onshore opponents of hedge funds to justify restrictions on offshore funds. As the authors note, “Intentional manipulation of hedge fund assets could result in wealth transfers across current, new and redeeming hedge fund investors.

Furthermore, manipulation intended to smooth reported returns could distort a hedge fund’s risk-return profile, leading investors to make sub-optimal investment decisions. In this regard, against the backdrop of a public outcry for increased hedge fund disclosure, we show that hedge funds intentionally mismark even position valuations that they report to a regulatory agency.

Thus, mandated disclosure alone might not be enough to protect the interests of investors in deterring asset manipulation by hedge funds.”

If the authors are correct, this suggests a problem the industry and offshore regulators will want to address. If they are not, the industry and offshore regulators need to develop some convincing evidence that the paper’s conclusions are incorrect.

Samuel Barkin, Racing all over the place: A Tiebout model of international regulatory competition, American Political Science Association Annual Meeting Paper,

2010, available at

The literature on the effect of globalisation national regulatory standards tends to focus on one of two patterns, regulatory races to the bottom or upwards harmonisation of regulatory standards. Neither pattern is well supported by empirical findings, particularly with respect to industries that can easily move offshore in search of lower regulatory standards. Global patterns of regulation in these industries tend toward dispersion rather than conversion either upward or downward. There is as yet, however, little work in the international relations literature on global patterns of regulatory dispersion.

One of the most common models of regulatory dispersion in the economics literature was developed by Charles Tiebout in the context of the provision of municipal services, but several international relations scholars have noted that the assumptions of the model are not appropriate to international regulatory competition. This paper develops a modified Tiebout model that describes patterns of international regulatory dispersion in industries that engage in international regulatory arbitrage. It explains both specific patterns of dispersion and the tendency for average regulatory levels to drift upward over time.

CFR comment
Opponents of offshore financial centres, like US Senator Carl Levin, often invoke the spectre of a “race to the bottom” if jurisdictions like the United States are forced to compete with OFCs.

This paper suggests that the appropriate model is not a race but that levels of regulatory activity vary across jurisdictions and, as the author concludes, is the result of “choices made by the states that are the major markets for the industry, and are a trade-off between the costs and benefits of internationalising domestic regulatory levels.”

This may be no surprise to people in the industry, but it likely will come as a shock to Sen Levin.

Frederik Boulogne, Transfer pricing of intangibles: A comparison between the Netherlands and the United States, VU University Amsterdam Tax LL.M. Thesis

(Dec. 2008) available at

This thesis examines how to determine an arm’s length consideration for intercompany transactions involving intangibles, comparing Dutch and US law and experience under the OECD’s guidelines. (Although submitted in December 2008, it was only recently posted on SSRN).

The thesis argues for a three-step method for the determination of an arm’s length consideration. The first step involves determining the owner of an intangible, focusing on tax authorities’ use of economic ownership rather than formal legal ownership. The second step identifies the arrangements made between the parties. Key is that, although contractual terms agreed upon by parties should be taken into account, one should always adhere to the arm’s length principle; observing every aspect of the transaction from the perspective of what uncontrolled parties in comparable circumstances would have done. The third and final step, focuses on the choice of transfer pricing methods suitable for determining an arm’s length consideration, especially reliance on gross margins.

CFR comment
This is a long piece, and so the full thesis will be of interest only to those working on transfer pricing issues. It provides a thorough discussion of the evolution of the legal rules governing transfer pricing, offers a reasonable explanation for the differences between the US and Dutch approaches and identifies the points of friction. Those involved with structures utilising Dutch entities for intangible property may find this interesting.

Russell Poskitt & Bradley Waller, Do liquidity or credit effects explain the behaviour of the BKBM-LIBOR differential?

19 August 2010, Available at

In August 2007 the BKBM-LIBOR differential switched from positive to negative and then widened considerably following the collapse of Lehman brothers in September 2008, before narrowing gradually as the turmoil financial markets subsided. Our structural regression model and decomposition analyses show that changes in liquidity largely explain the changes in the BKBM-LIBOR differential and that credit risk factors only played a minor role.

However our analysis also shows that liquidity in the offshore market also prices information regarding counterparty credit risk, suggesting that our initial results could understate the role played by credit risk factors.

CFR comment
This technical paper on the changes in the relationship between New Zealand and LIBOR interest rates after the financial crisis raises some interesting questions about the impact of the crisis. Those interested in Eurocurrency markets will find the paper of interest even if the reader is not particularly interested in New Zealand interest rates.

Jeo Lee, The significance of reputational risk: New evidence in small island offshore financial centres

(2010) available at

This paper investigates whether the poor reputation of a small island offshore centre would affect the centre’s economic growth, foreign direct investment, broad money supply or international reserves. To estimate the potential reputational shock, we use the vector error correction model and the impulse response function within a framework of short-term dynamics and the impact of each variable on the system. The main findings suggest that favourably-listed offshore islands such as Cyprus, Malta, Mauritius and Singapore are less affected by reputational shock. For all sixteen sample islands, reputational shock was found to be long-lasting but not permanent, regardless of reputation (blacklisted or cooperative), with consequences for the stability of small island economies.

Further, the results for all the islands indicate that foreign direct investment becomes more variably co-integrated after the shock. The blacklisted islands adopted heterogeneous after-shock policies for money supply, while the opposite was found for favourably-listed islands. In summary, the key message from the study is that a favourable reputation would undoubtedly be essential for an island’s economic and financial stability.

CFR comment
The author, from the Isle of Man International Business School, does some statistics to test the impact of reputational shocks to small island economies, which emphasize the importance of overall reputation. Unfortunately only the abstract is available on SSRN at the moment. In a world where blacklisting threats are increasingly common, research into how smaller jurisdictions can react is becoming more important and this is a good first step into examining the impacts of reputation shocks.

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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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