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Should hedge funds be regulated?
This paper is non-committal but essentially skeptical. The authors make a few points:
1. Hedge fund customers are wealthy and sophisticated; there is no customer protection motive for regulating hedge funds.
2. Hedge funds serve some useful purposes, including private research, price discovery, and provision of liquidity.
3. Secrecy is the essence of hedge fund activity. For that reason, the standard regulatory recipe of disclosure has limited applicability in this context.
4. There is not much evidence that hedge funds are destabilizing at the macro level, or involve significant levels of systematic financial risk.
I believe these views are likely correct. The more important question is what is the best course of action -- in terms of expected value - if they might be wrong. Systematic risk is the real issue.
Posted by Tyler Cowen on November 1, 2006 at 06:41 AM in Economics | Permalink
Comments
Note that hedge funds are now appearing in activities far from the securities markets. Hedge funds have loaned money to insurance companies [sic], and bought immense amounts of real property for development. The demand for unregulated investment vehicles, and the corresponding power to raise capital, seems powerful enough to make them a dominant source of investment for almost any purpose.
Posted by: sammler at Nov 1, 2006 8:04:51 AM
"4. There is not much evidence that hedge funds are destabilizing at the macro level, or involve significant levels of systematic financial risk."
What about LTCM?
Posted by: Anon at Nov 1, 2006 8:16:39 AM
This paper was written last year. In the first part of this
year the size of hedge funds in certain categories rose by
50%. At a minimum this is unusual and probably drove NY Fed
Geithner to his worried remarks at Jackson Hole. The policy
approach that the authors take amounts to having the New York
Fed president handle it privately with those involved as was
done with LCTM. Geithner has openly worried about the systemic
risk problem, to which there is clearly no easy solution.
I also note that the paper recognized that the funds could
contribute to herding and bubbles, but in the end said the
evidence on whether they have done so or not is mixed.
Posted by: Barkley Rosser at Nov 1, 2006 8:33:08 AM
If I engages in leveraged investment strategies I risk loosing not only my cash investment but also all the money I borrow, but if I use an entity called a hedge fund to do it, my risk is limited to my cash investment and someone else assumes the risk for the money I borrow. This seems to me to be little more than method of shifting part of the risk elsewhere while collecting the entire risk premium. If my understanding of this is correct, what purpose do hedge funds serve that makes them worth the risk they put on financial markets and ultimately the public.
Posted by: joan at Nov 1, 2006 8:52:41 AM
Is the first claim about hedge fund clients still true?
Posted by: spencer at Nov 1, 2006 9:32:23 AM
#1 is not true - the effect of hedge fund trading extend far beyond their particular investors. Additionally, why should we value these investors assets less than others? Wealth and the financial sophistication require to evaluate hedge fund investments are not linked. If its a marginal utility of dollars style answer, then additional taxation on them shouldn't be an issue either.
#2 Absolutely true, but has no relevance as to the regulation question. Mutual funds also do research.
#3 not entirely true. The secrecy is more to protect intellectual property than to protect investments. The amount of secrecy in hedge funds is overrated in any case - you can usually figure out positions pretty easily, just from a description of what the fund does. For many funds, they could give you a complete position snapshot over time and it would be useless to figuring out their risk or their strategy. Very few funds are creating new trading styles, or implementing ideas that really require the secrecy. Also, position disclosure style regulation is not the only option and would be unhelpful in most cases anyway - unless you had a risk management system that was capable of handling this information.
#4 is just wrong.
LCTM was a huge system risking problem that was only solved through govt. intervention. It wasn't the dollar valye of the loss that was a big deal, it was the leverage and cash behind the leverage- it could have exploded into a much, much larger loss with a little more movement in the market and the associated defaults that come with this. The defaults if they had occured, because of the sheer number would have placed stress everywhere. It was much closer to disaster than anyone thinks. The asian currency crisis was pretty bad too.
One reason we've had an explosion in AUM for HFs is that risk managment has become better - in effect, increased regulation. While this was provided by the private market, I would seriously consider some minor additional regulation of hedge funds, providing it was intelligent. Economists for some reason discount the effect of 'trust' in transactions, but in the real world, its one of the critical components of every economic interaction we have. Proper regulation can be a huge component of trust. As I think that hedge funds can and should be an important part of the world markets and capitalism, they should be regulated to a little greater extent than they are.
Posted by: mickslam at Nov 1, 2006 9:33:20 AM
A little regulation is similar to being a little pregnant. Hedge funds are doing things that use to be done with other instruments till they were regulated. Regulate Hedge funds and something else will spring up under a different name. Say Risk Analysis Mutual Bond Organizations (RAMBO for short).
Posted by: Huggy at Nov 1, 2006 9:52:38 AM
No, they should not. We already have contract law, which is all these guys need. Everyone in the HF business know what they're doing, including the investors. Mom & Pop may be invested in an HF through their pension plan or insurance company, but the intermediaries know what they are doing and spread the risk around.
LTCM and (more recently, Amaranth) are proof of #4. They were huge, went poof, and the system moves on.
Lastly, to my mind, is growth & demand. Unregulated funds get higher returns than their regulated bretheren. I think there should be less regulation at the mutal fund level (and perhaps a new intermediary for retail investors: the independent portfolio manager) so that MF's can compete. Also, there is demand from sophisticated investors to unregulated products. If HF's were regulated too heavily, the investors would just go elsewhere.
Posted by: Brock at Nov 1, 2006 9:55:58 AM
My suggestion to fix the problems is more auditors to find the doggy schemes and shut them down quietly. Hedge funds use regulated entities which can be used to form a picture of what is going on.
Posted by: Huggy at Nov 1, 2006 9:56:59 AM
Get rid of the limited liability put. That's the only regulation you need.
Posted by: guest at Nov 1, 2006 10:26:28 AM
All it will take are a couple more spectactular failures like Amaranth. It is rather hard to say where the 4-5 billion dollars disappeared to when they collapsed - did it vanish in bad bets, or did some of the participants pocket it while claiming it vanished in bad bets? Will the incompetent/guilty parties manage to hide their participation in the next hedge fund they set up?
Amaranth's prospectus flat out said that no investment subject to ERISA reporting were permitted in their fund. That meant they knew they were doing something that wouldn't/couldn't stand the light of day.
>4. There is not much evidence that hedge funds are destabilizing at the macro level, or involve significant levels of systematic financial risk.
LTCM almost took down the financial system. "Not much evidence" means you're practising selective amnesia. The secrecy of hedge funds, lack of regulation, oversight, and opacity of the system guarantee that you can neither prevent nor remediate the risk of another LTCM from happening until it is too late, and they endanger the rest of us.
Posted by: Peter at Nov 1, 2006 10:33:44 AM
I'll concede that hedge funds could conceivably be a systemic risk just as soon as soon as the two largest risks to the financial world are properly dealt with, Fannie Mae and Freddie Mac. Running a mismatched mortgage portfolio worth a trillion dollars and fraudulently representing huge derivative losses as gains are a much bigger source of problems than any single hedge fund. Once that's finished, move on to Goldman Sachs, a 26-1 levered hedge fund masquerading as an Investment Bank with 34B in equity. Or deal with Morgan Stanley, which now controls over 1T in assets on an equity base of 34B.
Please, if you think hedge funds are a systemic risk, there are a lot of others in line before them
Posted by: joe at Nov 1, 2006 11:12:19 AM
I have worked at a major hedge fund and at regulated financial institutions. Some comments:
-- The effect of any regulations is likely to be to move more hedge funds offshore, and to replace American capital with foreign capital. Do we really want to decrease the spread between what the US earns on foreign assets and what foreign capital earns on US assets?
4. Stability -- note that LTCM DID NOT destabilize the system. The LTCM crisis is an example of existing regulations working, not of the need for more regulations.
3. Secrecy -- mickslam says secrecy is overrated and that "only a few" funds actually need secrecy to protect their investment styles. Should we abandon medical research because "only a few" new drugs are really new innovations, and many more are copycats?
Posted by: DK at Nov 1, 2006 11:35:09 AM
A few comments:
(1) Amaranth didn't burn up 4 billion dollars, it made a bunch of bets which lost its investors 4 billion dollars, and made 4 billion dollars for the investors who took the winning side of those bets. Why should anyone who didn't take one side or another of these bets care one bit?
(2) If sophisticated lenders provide leverage to hedge funds, and fail to properly ensure that their loans are repaid, why should we care more about them than about the investors who lost money? (If the lenders hold *our* bank deposits, of course, it does matter, but that should be more a concern of banking regulation than of hedge fund regulation.)
(3) A few recent articles have mentioned the putative envy that the merely rich have for the ultra-rich. I would guess that one of the purposes of hedge funds is to give the merely rich access to investment strategies that would otherwise only be available to the ultra-rich. If hedge fund regulation reduces the options for the merely rich, is this good or bad? Or should regulation be thought of protecting the merely rich from negative outcomes that only the ultra-rich could really afford?
(4) What Huggy & DK said -- increased regulation will cause some funds to go offshore, and some hedge fund investments to go instead into other forms of investing that are unregulated. Ad hoc private equity partnerships, anyone?
Posted by: Alex R at Nov 1, 2006 12:13:58 PM
Misklam.
Regulation is paid by taxpayers.Why make average Joe to pay for the risk the rich want to take?
Posted by: S at Nov 1, 2006 12:48:45 PM
Brock and DK,
LCTM did not prove that "existing regulations work." It was
resolved by going outside the system of regulations and having
the NY Fed work out an extraordinary deal. That was possible
as long as the major players were all in New York. But the volume
of these funds is now orders of magnitude larger than in 1998,
and much of this now involves players not so easily accessible.
I think what has Geithner really worried is that the spread of
the players may make such an extraordinary deal impossible, if it
comes to be needed.
Posted by: Barkley Rosser at Nov 1, 2006 2:06:21 PM
I'm going to outline my amateur concern:
1. Hedge Funds are only available to weathy and sophisticated investors.
2. Wealthy and sophisticated investors are of a more homogenous mindset regarding economics and finance than the entire population at large.
3. Therefore any significant errors of judgement resulting from that particular economic and financial mindset have less counterbalancing forces at work in the market. For instance, if the consensus of enthusiasm about China turns out to be misplaced, there are less likely to be Hedge Funds that would profit from a Chinese slowdown or crash than there otherwise would be.
4. There is more systemic risk with restricted investment than if Hedge Funds were made available to the general public.
Posted by: Jonas Cord at Nov 1, 2006 2:40:07 PM
If we're worried about systemic risk stemming from (say) shadowy OTC derivatives transactions, shouldn't we be regulating shadowy OTC derivatives transactions?
Put another way, if risky hedge fund trading is restricted, what's to stop some wealthy persons from starting a prop firm to pursue exactly the same trades with less legal oversight?
Don't overlook the role investment banks had in LTCM--both their prop trading (which had similar positions) and their clearing operations (which profited from LTCM's trading). If there's ever a financial systems meltdown, hedge funds will hardly be the only players involved.
Posted by: gundryggia at Nov 1, 2006 3:03:23 PM
The hedge fund structure is the most efficient form for managing investments in today's market, from the viewpoint of the manager. Particularly in regard to trading books and illiquid / unrated positions. Many hedge fund strategies are/were the province of commercial and investment banks. It is often more regulatorily efficient for a bank to conduct business with a hedge fund as counterparty than to keep the business on book, and the freedom and compensation's notably better for the managers. Fund investors put up with the illiquidity and opacity, but aren't too much worse off than owning these businesses through, say, Goldman Sachs stock.
Remember that the definition of hedge fund is a negative one -- it is an entity that fits below the level deemed necessary for regulation, as it has too few investors and no unsophisticated ones.
The secrecy point is a canard, as others have pointed out. Sarbanes-Oxley hasn't killed off bank prop desks.
OK, back to running the fund...
Posted by: mkl at Nov 1, 2006 3:09:36 PM
#1 is only partly true (and even then only partly true in the United States). There is sigificant retail participation in hedge funds outside the U.S., and inflation has eaten into what a "sophisticated" investor is even in the United States. You can argue that anyone who makes $250K or more per year is not in need of government-provided investor protection, but why you would choose that cut-off point seems pretty arbitrary and not logically linked to any investor protection objectives. (Of course, if you believe market mechanisms handle investor protection issues adequately as it is, that's fine. But if you believe some types of investors need more protection than others, I would think you would be hard pressed to explain why a doctor making $250K is not in need of investor protection, while a finance professor making $150K is.)
I agree that #2 is irrelevant for regulatory purposes. Research and price discovery are virtues provided by most regulated financial activity.
#3 is also true for any non-index based trading activity--or any issuer, for that matter. The trade-off between proprietary trade secrets and market transparency is always an issue with securities regulation. One of the current concerns about hedge funds is that because so much of the trading is based on easily replicated mathematical models, there is not nearly the degree of diversity out there that we are led to believe. This, in turn, touches on several regulatory issues: First, as these mathematical models become more diffused among traders, the superior returns hedge funds have traditionally offered disappear; rents are no longer available and HF returns revert to historic averages. Second, as with the dot.com bubble, because investors nonetheless expect above-market returns, there is a fear that individual HF managers will face pressure to cheat around the edges to provide the appearance of the expected but now-unrealistic returns. It was these kinds of market pressures that led to the Worldcom, Enron and other frauds. There is no reason to believe that HF managers are immune to these temptations, particularly since so much of what they do is in the dark. Third, because these mathematical models are so easily copied, there is a risk that a large number of HFs, despite their apparent diversity, are really engaging in exactly the same trading strategies. Under the wrong circumstances, this could be disasterous and lead to enormous systemic risks.
Which leads to #4. The truth is we know almost nothing about hedge funds in the aggregate. We don't know how many there are, how big they are, or how leveraged they are. What we do know is that they have caused the outstanding value of credit derivatives contracts to rocket up $9 trillion in just 6 months and that they now fuel much of the $3.5 trillion syndicated lending business. Hedge funds have taken over much of the mezzanine lending business from banks--and, indeed, have taken over much of the corporate lending business generally. If you believe there are reasons for regulatory oversight of the banking industry because of financial stability concerns, it doesn't make sense to then argue that hedge funds pose no comparable systemic risks.
The truth of the matter is that we know next to nothing about the hedge fund industry as a whole--nothing about the risks or benefits. It may be true that this is an area that shouldn't be regulated; but to say that this is clearly so is to make a statement based on faith rather than one based on data or analysis.
Posted by: M.D. Fatwa at Nov 1, 2006 3:10:32 PM
My sense is that #4 is really the only one that matters.
If you're going to play in the public capital markets, then play by the same rules that govern the other players. HF have long since stopped being passive investment vehicles by which institutions and the rich had top-notch talent managing their money. HF and their close cousins, private equity investors, are today the big swinging dicks on Wall Street. Exactly how big can't be answered because their activities lack transparency.
All the arguments that HF are fundamentally benign in terms of their net effect on the financial system as a whole are true -- until something happens and they stop being true. That's when we see that HF do indeed affect all the other players and not in a good way.
Posted by: Auto at Nov 1, 2006 3:26:02 PM
Barkley, do you think that (1) the Fed was acting outside its legal authority in dealing with LTCM? (2) that involving the SEC as well as the Fed would make future crises easier to solve?
I don't. Systematic crises are generally about liquidity and bank solvency, which the Fed is best equipped to address. And in a real crisis today, a large portion of the money lost is likely to be from non-US hedge funds out of the reach of the SEC. SEC regulation isn't going to affect the risk of a crisis, only to move a greater portion of the crisis beyond the reach of US law.
Posted by: DK at Nov 1, 2006 4:31:15 PM
Misklam.
Regulation is paid by taxpayers.Why make average Joe to pay for the risk the rich want to take?
Because I think they should be available for retail and small investors.
Posted by: mickslam at Nov 1, 2006 4:36:05 PM
Mickslam,
What do you mean when you say you want hedge funds to be available to small and retail investors, and that this justifies regulating them? If retail investors can handle funds with the ability to short a stock or take leveraged positions, then why not just deregulate mutual funds in the relevant areas?
Posted by: Carl Shulman at Nov 1, 2006 5:13:36 PM
DK,
What was done in 1998 was extra-legal, not illegal,
but also outside the standard regulatory structure.
They played it by ear entirely, and from what I have
heard it was a much more dangerous situation than has
ever been publicly acknowledged.
I never said a word about the SEC. I am not sure what
should be done about this, but I share Geithner's concern
that we are in an unprecedented and increasingly dangerous
situation. There is literature that suggests that one
may gain local and short-term stability at the cost of
global instability, aka systemic fragility. The enormous
surge of these funds just in the last year, along with
the proliferation of every higher orders of derivatives
that are interlocked with each other in ways that simply
nobody knows or understands is reason to be worried,
although given that little can be done, not to get
worried that one loses sleep over.
Posted by: Barkley Rosser at Nov 1, 2006 5:57:42 PM
