Hedge Fund Loss Rumours Re-Ignite Debate On Regulation

by Phillip Morton, Investors Offshore.com

16 May 2005

After a week in which the financial markets were rocked by rumours of massive hedge fund losses linked to a debt downgrade of automakers General Motors and Fords, the US Federal Reserve has indicated that the hedge fund industry is unlikely to face tougher regulation to protect the stability of markets.

Last week, the Wall Street rumour mill shifted into top gear as news of supposed losses by several hedge funds amounting to $8 billion filtered through to the markets, causing all major US equity benchmarks to slip.

While the rumours were never substantiated, parallels with Long Term Capital Management, which collapsed spectacularly in 1998 after losing a massive bet on Russian debt, were drawn by those critical of the power hedge funds now hold over the markets.

However, speaking in San Francisco last week, Federal Reserve Vice Chairman Roger Ferguson argued that hedge funds do not pose an undue risk to the stability of the financial system.

"I think hedge funds are not at this stage a source of instability nor likely to become one," Ferguson said, adding that regulators and officials in G7 countries continually monitor the activities of hedge funds.

"Importantly, post-1998, hedge fund counterparties have recognized the importance of managing their own exposures to hedge funds ... (and) the hedge funds themselves have become somewhat better at their own internal risk management," he said.

Meanwhile, Timothy Geithner, president of the Federal Reserve Bank of New York has warned that years of stability in the US economy may be leading the financial markets into a false sense of security and to under value risk.

Rather than more stringent regulation, Geithner called upon the counterparties to hedge funds themselves to police the system by adopting more stringent diligence policies when providing credit to hedge funds.

However, the Federal Reserve Chief Alan Greenspan, who perhaps holds the most laissez faire approach to the hedge fund industry, has argued consistently that regulation will be ineffective in reducing the risk of hedge fund failures due to fraud, especially as the industry is constantly evolving.

"Remember that collecting data on hedge funds may appear to give you a degree of transparency, but most of the data that you will get will tell you about their strategy of last night. This morning, they will have a new one," he told a conference on derivatives last week.

However, Greenspan's views on hedge funds are in sharp contrast to the hawkish line of the chief US regulator, William Donaldson, who repeated his warning that an untamed hedge fund industry is storing up trouble for the future.

"Every week seems to bring another article in the press about the crowding of hedge funds into similar investment strategies and the difficulty that this implies for hedge fund managers eager to post market-beating returns," the SEC chairman stated in remarks to the Foundation Financial Officers in Washington, DC

"If history is any guide, it is just this sort of pressure that can lead otherwise well-intentioned professionals to pursue practices that can ultimately result in disaster for the investors that they serve," he warned.

Donaldson pushed hard for new regulations designed to crack down on trading abuses, which were only narrowly approved by SEC commissioners in October, under which hedge funds are obliged to register with the securities regulator by February 2006.

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