Shining a harsh light on hedge funds

The Obama administration's proposals for hedge fund regulation are exactly what is needed to ward off systemic risk

By Andrew Leonard
Published July 17, 2009 2:56AM (UTC)
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On Wednesday, the U.S. Treasury sent proposed legislation to Congress outlining new rules for hedge fund regulation.

From Bloomberg:

The legislation would require firms for the first time to report their assets, leverage, off-balance sheet holdings and investments to regulators on a confidential basis, the department said today in a statement. The law would apply to hedge funds, private-equity firms and venture capital managers with more than $30 million in assets.

Simply requiring large hedge funds to report what they're doing, confidentially, might seem like weak beer to those looking for Obama to smack Wall Street around with a heavier stick. But, coincidentally, on that same day, the Senate Banking Committee held a hearing on hedge fund regulation, and one of the panel discussants called to testify, Richard Bookstaber, explained clearly exactly why such rules could make a big difference in protecting the U.S. economy from the risk of another financial meltdown.

One excerpt:

To control the systemic risk posed by hedge funds we must be able to measure crowding, the unintentional concentration of separate funds in the same trade. This means knowing the positions of the individual hedge funds and then being able to aggregate those positions. Whatever their own risk management capabilities, the individual funds -- and regulators that might be providing oversight on an institution-by-institution basis -- cannot keep systemic risk in check because they do not have this aggregate information.

It is as if each fund is sitting in a darkened theater unaware of how many others might run for the exit. To regulate and monitor the systemic risk arising from manipulation, the first task again is for the regulator to know the positions of the hedge funds that are capable of such manipulation, and know those positions on a frequently updated basis.

Thus an essential task for the regulation of hedge funds is to get data on leverage and positions from the institutions. We must be able to track the concentration of hedge funds by assets and by strategies to understand how the failure of one firm might propagate out to affect others. This is missing in the current regulatory structure, and is at the core of systemic risk.

Maybe it's not Glass-Steagal, or equivalent to the creation of the FDIC or SEC, but it would definitely be an incremental improvement from the situation as it now stands. It's also encouraging to see the White House submit legislation in actual draft form, rather than just articulate priorities and then wait for Congress to act. Accumulate enough incremental improvements like this, and eventually you might actually have something that resembles real reform.

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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