Hands Off Hedge Funds

Sebastian Mallaby

From Foreign Affairs, January/February 2007

Summary:  The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international financial system. In reality, hedge funds do not increase risk; they manage it -- and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well.

Sebastian Mallaby is a Washington Post columnist and the author of The World's Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations.

Banks are also exposed to the possibility that trouble at one hedge fund will create trouble at others. Hedge funds tend to invest on margin: they borrow money so that they can buy stocks, bonds, or various derivative contracts, and the lending banks then retain those financial instruments as collateral. If an investment loses value, the bank issues a margin call, demanding that the hedge fund pony up fresh capital to replenish the collateral; this can force a fund to sell its holdings just as they are losing value. If a hedge fund is a big player, the pressure of its selling could potentially drive prices down further -- triggering another round of margin calls and another round of forced selling. If such a vicious cycle drove down the value of a particular part of the market, others who invested in it could also see their assets wiped out.

The nightmare scenario involves a host of hedge funds making similar bets. If the bets turn out to be wrong, a fund could unravel, causing the others to unravel in turn -- and banks that could comfortably swallow the default of one or two funds might find themselves overwhelmed by the default of dozens. The banks themselves, moreover, may have made similar bets through their own proprietary trading desks, meaning that their own capital would be taking a hit just when it was needed to cushion losses on hedge-fund lending. When Timothy Geithner, the president of the New York Federal Reserve Bank, sounded a warning about hedge funds this past September, this is what was worrying him.

Geithner was not, however, saying that the nightmare scenario is likely. In financial markets, there has to be someone on both sides of each trade; if a group of hedge funds is betting heavily on a fall in energy prices or the convergence of Latin American interest rates, somebody else must be betting just as heavily on the opposite outcome. Viewed globally, this system of wagers is a giant zero-sum game. In order to be worried, you have to believe that one side of some risky bet is concentrated in a particular corner of the financial system, and that it could collapse without the other parts of the system coming to the rescue.

Such a possibility is real, but it does not justify a clampdown on hedge funds. To the contrary, the proliferation of hedge funds actually diminishes the risk of the nightmare scenario, and so regulation that discouraged the creation of new funds would be counterproductive. The more hedge funds there are, the less likely it is that they will all be concentrated on one side of a given trade, and the more likely it is that if trouble at one hedge fund initiates a downward spiral in a particular corner of the market, falling prices will draw in other funds smelling a bargain.

This is precisely what happened after Amaranth's collapse this past September: the fund had to sell its positions fast, and others (including other hedge funds) were only too happy to accept the resulting discount. Because they are global, opportunistic, and nimble, hedge funds are likely to pile into any market where the distress of other institutions creates anomalous pricing.

It is true that if hedge funds become very large, they pose a more serious risk. If Amaranth had lost $26 billion rather than $6 billion, it might have been harder for other market players to take over its trading positions. Troubling concentrations of risk can occur within banks as much as within hedge funds: part of the nightmare scenario lies in the direct risk to the banks from their own proprietary trading desks, and banks such as Morgan Stanley have been building up their asset-management business by buying stakes in hedge funds. But imposing some arbitrary regulatory cap on the size of hedge funds would unjustly penalize successful firms. The best safeguard against the risk posed by large funds is the presence of other large funds.

THE AGE OF UNCERTAINTY

If it is wrong to discourage the formation of new hedge funds and wrong to impose a limit on funds' size, what of other possible regulatory options? Some call for limits on funds' borrowing. But that might curtail their ability to act as opportunistic buyers in a crisis: it would ration the fire fighters' access to the fire hydrants.

Others call for more disclosure, which would allow lenders and regulators to gauge whether funds are crowding dangerously onto one side of a particular trade. But periodic snapshots of a fund's positions might reveal little if it trades intensively, and even extensive disclosures can fail to reveal a fund's real risks. In a 2005 paper for the National Bureau of Economic Research, Nicholas Chan, Mila Getmansky, Shane Haas, and Andrew Lo demonstrated how a hedge fund could report strong and consistent returns over 96 months and still present a risk of sudden implosion. A further reason to be cautious in demanding disclosure is that hedge-fund privacy can serve a useful purpose. Without a right to privacy, funds could not be sure of capturing the value of their intellectual property, as there is no patent protection for trading strategies. Forcing disclosure indiscriminately on all funds could thus damage their incentive to discover and correct market inefficiencies.

Rather than forcing more disclosure, it would be better to allow the market to promote it. As the hedge-fund industry has grown, it has gradually become more transparent. Brokers that supply leverage to hedge funds have grown more insistent on understanding their clients' risks. Proliferating funds of funds demand at least a general description of their exposure from the hedge-fund managers to whom they entrust capital. These pressures give hedge funds an incentive to disclose more than they have in the past, since the more they reveal, the more readily they can raise capital. And in some cases, funds may choose to reveal a lot. In November, Fortress Investment Group, which manages private equity funds and hedge funds, took the radical step of seeking a public listing, with all the disclosure requirements that come with it. Other funds may decide that secrecy is so important to their business model that it is worth accepting higher costs of capital, and they should be free to make that judgment.