Regulating hedge funds

I have mixed feelings on the matter of regulating hedge funds. There are plenty of pros and plenty of cons. I think the question should be re-framed from whether to how, and whether regulation should be direct or indirect.

I was inspired to write these words after reading the article in The New York Times by Stephen Labaton entitled "Current Hedge Fund Rules Work, Regulators Say" which basically tells us that the Bush administration is not going to crack down on hedge funds, despite their clear excesses and potential risks.

Since big banks, insurance companies, and pension funds seem to be the primary investors in hedge funds, I strongly suspect we should  look at how those entities are financially regulated, which I would call indirect regulation of hedge funds.

For example, the Fed other other banking regulators can set rules as to how the big banks treat hedge fund investments in terms of risk and capital requirements. A direct requirement that banks report an accurate characterization of risk and refrain from investments with open-ended risk might either limit their investment in hedge funds or indirectly cause hedge funds to morph into a more transparent investment process.

One potential downside there is that venture capital is an inherently risky business and big banks, insurance companies, and hedge funds play an important role in investment into venture capital limited partnerships. We certainly do not want to throw out the venture capital baby with the hedge fund bath water. One difference is that with a venture capital investment, everybody knows that you could easily lose 100% of the investment, while with hedge funds, the assumption is that the fund will yield dazzling returns and only very rarely might the investment principal be at risk. So, there is reasonable clarity of risk with venture capital that simply isn't there with opaque hedge funds.

That brings us back to a core question of what risk of hedge funds are we most worried about? Granted, we do want to assure that all investors get clear and accurate characterizations of risks for all investments, whether they be individual stocks, bonds, mutual funds, commodities, venture capital, and even hedge funds, and hedge funds do need more clarity of risks, but the huge question plaguing policy makers is the issue of systemic risk, ala the LTCM meltdown. If there were only a relatively small number of hedge funds, each managing a relatively small amount of investments, there would be no issue at all. The problem is that there are a large number of large funds with large investments, not to mention that many of them are making the same large bets.

The essential problem is that we don't actually know what the systemic risks are today. The lack of transparency of hedge funds coupled with their number and size is an almost certain recipe for eventual disaster. Not a certainty, but a near certainty. My own belief is that LTCM was a true fluke and with just a few slight deviations in their trading patterns there would have been no disaster. To be sure, they were definitely skating on thin ice, but they still could have skated around the weak points. Alternatively, regulations requiring transparency of such funds would have reined in their excesses since a poorly hedged notional exposure or liability of a trillion dollars would frighten away even the largest bank, insurance company, or hedge fund.

One other area of regulatory concern that gets zero attention by the media is the degree to which speculative activity impacts consumer markets. Hedge funds have made huge speculative investments in commodities, thus driving up the price of oil, the retail price of gasoline, heating oil, natural gas, building materials, etc. I would not suggest that such speculation be prohibited, but that the regulators of those markets simply place limits on the total amount of speculation, so that, for example, speculative positions not be permitted to move the price of any commodity up (or down) by more than a few percent. Sure, by all means, let us still permit and encourage speculators to arbitrage small nickel and dime pricing discrepencies between markets, but outright market manipulation as has occurred with commodities over the past two years should be strictly banned.

The key here is not to regulate the hedge funds directly, but to prevent the hedge funds, or any other large investor, from causing harm to our economic and financial systems. After all, if you make hedge funds unattractive, managers (and their eager investors) will simply move on and form investment vehicles which skate around the technical and legal definitions of "hedge fund."

As the old saying goes, be careful what you ask for, because you might get it.

-- Jack Krupansky