US Authorities Cool On More Hedge Fund Regulation

by Mike Godfrey, for LawAndTax-News.com, Washington

18 May 2006

One year after the US Securities and Exchange Commission decided to impose a registration requirement on hedge funds, lawmakers, government officials and financial regulators have rejected arguments that further regulation is needed.

Testifying before the Senate Banking Committee in a hearing on hedge funds, Randal K. Quarles, Treasury Under Secretary for Domestic Finance stated that while the Treasury will continue to gather information on the fast growing hedge fund universe, he believed the need for further regulation now was unnecessary.

"I think, at this point, I wouldn't see evidence that would suggest that there should be greater regulation of hedge funds," Quarles told the committee.

However, Quarles conceded that there "are certain risks" that hedge funds may pose to the stability of the overall financial system. In particular, he noted that excessive leverage could "greatly magnify (the) negative effects" of a market shock.

Many of the world's regulators have grown nervous about the rapid growth of hedge funds in recent years. These largely unregulated private investment pools can use a variety of trading techniques and strategies that are out of bounds to more conventional and tightly regulated investment funds, such as the selling short of stocks and use of complex derivatives. There is concern in some quarters about the power and potential for these funds to upset financial markets and the guardians of the financial markets are keen to learn more about the dealings of hedge funds.

According to some estimates, total assets held by hedge funds now amount to $1.5 trillion, although this still represents only a small fraction of the world's total of fund investment.

However, in the United States at least, the various authorities seem happy with the status quo. Speaking on Tuesday evening, Federal Reserve chief Ben Bernanke also rejected the need for more stringent government oversight of hedge funds.

According to Bernanke, a system whereby the major regulatory role was assumed by government could create a "moral hazard" lulling private investors into thinking that they would be bailed out in the event of loss.

"Would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds' risk-taking?" Bernanke asked in a speech to a conference on hedge fund risk sponsored by the Atlanta Fed in Sea Island, Georgia.

Bernanke argues that the best people to keep an eye on the activities of hedge funds are the banks.

"A focus on counterparty risk management places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so," he stated.

While Congress is more split on the issue of hedge funds, with some lawmakers from both sides of the aisle calling for tougher regulation, others, including Mike Crapo (R - Idaho) argue that the SEC overstepped its jurisdictional mark by changing the definition of the Investment Act 1940 to force the vast majority of hedge funds to register as investment advisors, thus throwing them open to more scrutiny.

"While the SEC is an independent agency, it seems to me that it shouldn't be permitted to take the term 'independent' to an extreme," Crapo told the banking committee.

Sen. John Sununu (R - NH), concurred. "We have to ask very basically whether or not the SEC really is the appropriate agency to be undertaking that sort of regulatory requirement," he told the committee.

The hedge fund registration rule, controversially pushed through by former SEC chairman William Donaldson amid much criticism, is currently the subject of a legal challenge by Phillip Goldstein, portfolio manager at hedge fund Opportunity Partners in New York and some observers believe that the lawsuit stands a good chance of succeeding.

Recommended