Locusts, predators, highwaymen ... as the financial markets' favourite bogeyman, hedge funds have become used to name-calling. But the $6 billion losses at Greenwich-based hedge fund Amaranth Advisors in September might just lead to sticks and stones replacing the verbal attacks. With the US Securities and Exchange Commission (SEC) looking at how it can tweak its rules requiring the registration of hedge funds - thrown out by the US Court of Appeal in June - the latest failure has given renewed impetus to those campaigning for tighter regulation of the sector.
There appears to be no shortage of critics. In the past month, politicians on both sides of the Atlantic have queued up to attack hedge funds for their lack of transparency, the danger they pose to investors, and the potential systemic risk they create in the financial markets, with some calling for even tighter regulation than the rules originally proposed by the SEC.
Let's just pause a minute. Yes, the losses at Amaranth were staggering, and there seems to be some basis for those that argue the fund manager should never have been allowed to take on such large-scale, concentrated exposure. And yes, regulators in both the UK and US have drawn attention to the potential systemic dangers posed by the growth of the hedge fund industry - that investors could simultaneously pull cash out of hedge fund investments during a market stress event, and that this could have a severe effect on liquidity.
But most of the doomsday scenarios outlined in the popular press are alarmist and naive. Hedge funds perform a vital role in the financial markets - they absorb risk, they provide much needed liquidity and they iron out anomalies, arguably leading to more efficient markets. Just how many crises have been averted because hedge funds were on hand to provide liquidity during times of stress?
Forcing disclosure of hedge funds' outstanding positions, as some have suggested, would mean they would not be able to perform that role in the same way.
Setting stringent requirements for back-office controls or forcing funds to put aside capital reserves would mean smaller boutique funds - which may be extremely successful generators of alpha - would be unlikely to survive.
There may well be a valid argument for forcing funds to disclose their risk management, compliance and control procedures. But it's important to have a rational debate, away from the scaremongering of politicians and the media.
- Nick Sawyer, Editor.
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