Last July, the International Organization of Securities Commissions released a report on the regulation of hedge funds. Now, with financial regulation proceeding in the U.S. and the E.U, securities regulators have settled on this report as a template for necessary fund disclosures to keep an eye on the systemic risks posed by hedge funds. I give the report a B+ because, while vague and missing a market-based approach to the regulation of systemic risk, it focuses more on limiting spillovers than restricting activities.
As most of you know, hedge funds are like mutual funds except that they require large minimum investments, face less regulation and typically restrict withdrawals. The assumption is that, since the minimum investments are large, their investors are more savvy (or at least more able to lose money without becoming destitute) and so these investors do not need (much) regulatory protection. Thus hedge funds engage in complicated and often highly risky investment strategies and charge high fees to do so. And in the recent credit crisis, hedge funds lost lots of money. So far no problem.
But when financial institutions got into trouble, they cut back lending to hedge funds. This meant that all hedge funds had to unwind their positions together, which pushed down prices of what they were selling and holding, which made their investments look more risky and increased their measured leverage ratios, which lead to a further reduction in what large financial institutions were willing to lend them, which meant that all hedge funds had to unwind their positions together, which . . . a vicious cycle. Add to this that some hedge funds were hidden inside (formerly) large financial institutions (like AIG, Bear Sterns, etc.) so that as hedge funds lose money, so do the large financial institutions, further restricting credit flows to hedge funds and increasing losses and . . . another vicious cycle. And you can see the potentially systemic implications.
So back to the report – posted here, it lists six overarching principals for hedge fund regulation. Some are useful – like mandatory registration for managers and advisers, and the development of standards on operations, conflict of interest, and disclosure – but some are so vague as to be almost hopeless – like ongoing regulatory requirements relating to prudential regulation, and requiring the provision of relevant regulator information for systemic risk purposes. The report expands more than this, and in some sense the details must be left to country legislators or maybe even regulators.
But some of the reports suggestions are great. For example, I like the focus on cutting the spillovers from a hedge fund crisis into a more general financial crisis. The report for example recommends the regulation of prime brokers to ensure risk management in general and specifically with respect to their counterparty exposure to hedge funds. I love this. Let hedge funds play with their money, but do not allow them to bring others down if they lose it. In extreme, this cuts off lending to hedge funds, at least from the financial sector (there is no problem with hedge funds issuing bonds that private investors hold in their portfolios). In a more moderate version, a regulator might only allow collateralized lending to hedge funds and set high haircuts for this lending. A good investment strategy should be able to raise equity and not rely on debt that is safe only when you really don’t need safety and loses money in the states of the world when you really need your financial institutions not to lose money. Let the hedge funds seek alpha without society holding the downside beta.