A Rant About a Misguided Defense of Hedge Funds

Before we get to the fun stuff, in which I foam at the mouth, let me stress one thing: I am not opposed to hedge funds. I have both friends and clients who run hedge funds. And philosophically, a certain amount of speculative capital helps the economy run more smoothly.

What I am opposed to is the idea that hedge funds should be given carte blanche, which is in essence the attitude expressed in the article, “Hedge Funds Can’t Reveal Secrets and Do Business,” by Matthew Lynn at Bloomberg.

It’s one thing to attack regulation that may be misguided and overreaching. But Lynn presents hedge funds as paragons of virtue and suggests that any interference in their sacrosanct operations would force them offshore (quel horreur!).

He seems to forget why it makes sense to oversee the operations of hedge funds: they are now at a scale where they can create systemic risk.

If hedge funds were merely playing with their own money and that of well-heeled individuals, as they did in days of yore, there wouldn’t be much cause for concern. But hedge funds control large amounts of capital, increasingly from fiduciaries, and perhaps most important of all, many run leveraged bets. The borrow primarily from the prime brokerage operations of major Wall Street firms. These same firms are on the Bank of England’s list of “large complex financial institutions” who represent a possible point of failure in the global financial system. If one of those 16 players were to become seriously impaired, global credit intermediation would fall, due to the direct impact of the loss of capacity and new-found conservatism among the other big players.

As the title of the article indicates, Lynn objects to requiring hedge funds to make more disclosures about their holdings. The amusing thing is that Lynn objects both to the level of disclosure set forth in a voluntary code proposed in the UK (any voluntary code, by definition, is a tame affair) and some tougher ideas bandied about by various regulators and investors. As Lynn argues:

First, asking a hedge fund to reveal its “strategy,” as the voluntary code does, is like asking Coca-Cola Co. to reveal its formula, or Microsoft Corp. to unveil its code. It isn’t incidental to their business: It is central to it.

Of course, the funds might simply be forced to put up some meaningless twaddle on a Web site: something like “We are committed to outperforming our benchmark index” or “Our vision is to deliver consistent alpha.” If they say anything meaningful, however, they are surely giving away genuinely competitive information. Why should they be forced to do that? It’s the only thing they have that makes them special.

Next, investors are already required to disclose shareholdings in companies. Now hedge funds may be forced to disclose when they have bought a stake using derivatives. But won’t that just move the whole problem back a stage? Before long, investment bankers will be offering derivatives of derivatives, and then putting an option on them.

Lynn’s first concern is way overblown. If any hedge fund could give away the keys to the kingdom in one, or even three pages of detailed text, they didn’t have anything all that special to begin with. What hedge funds are sensitive to is revealing positions, since others in the market can trade against them (and BTW, I’ve seen hedge funds that practice bottoms up investing in liquid markets that will even show prospective investors their position sheets, so the sensitivity isn’t universal).

As for his “Next” point, I don’t have much sympathy for arguments against closing a regulatory loophole.

Lynn’s argument continues:

Lastly, too much emphasis on transparency may crush innovation. It is difficult to try out new ideas when you are constantly under the spotlight and open to attack. Away from the limelight is usually where new things happen. Why should they reveal more than, say, commercial banks, which don’t advertise whom they have lent money to or how much?

For all the criticism they face, there is no real evidence that hedge funds have made the markets less stable. The facts point in the opposite direction: As the funds grow in power, the markets become more stable, not less. In August, when stock prices dropped on concern that U.S. subprime lending was leading to a credit squeeze, it was the heavily regulated banks that got into the most trouble. With a few exceptions, the “risky” hedge funds weathered the storm a lot better.

This is such a muddle it’s hard to know where to begin. Aside from a very few firms like D.E. Shaw, most of the innovation that Lynn wants to attribute to hedge funds took place instead at the proprietary trading desks of major investments banks, and then those traders went out on their own.

And commercial banks most assuredly DO have to reveal to whom they lend when their regulators come in for periodic reviews. And them getting into the SIV mess is the exception that proves the rule. Those vehicles were supposed to be off balance sheet, and the banks should have let them fail. But they have instead decided they have too much to lose, reputationally and perhaps even financially, to allow that to happen. Thus, the shortcoming wasn’t that the banks were “heavily regulated,” but that they escaped regulation.

It’s not at all clear that innovation has been as beneficial as Lynn suggests. We’ve have more financial crises in the last 15 years than the 15 years prior to that. The conventional wisdom on our Brave New World of finance is increasingly that it may have lowered volatility somewhat at the cost of increased systemic risk. That’s not a trade off any policy-maker would have signed up for ex ante. Now hedge funds are only a piece of this equation, but if you are going to blame innovation on them, you had better be sure you understand its true costs and benefits, and that calculus is being rethought as we speak.

Lynn isn’t wrong that more transparency may not work, but for the wrong reasons. The best solution would be to have a regime that increased the financial threshold for “qualified investors” (the standards are the same as in the early 1980s), and required any hedge fund that had more than a token amount of capital from fiduciaries like pension funds and used leverage from OTC sources (this would capture both prime brokerage operations and OTC derivatives) to be subject to regulatory oversight.

This construct would require a fair bit of international cooperation. However, its real weakness is that the regulators are likely to be inadequate to the task of inspecting hedge fund activities (not just their complexity but also the sheer number of funds). That’s why the idea of more transparency sounds appealing. You’d have more eyes, and in enough cases, well qualified ones having a look so as to have a good chance of catching anything dodgy.

So if the best remedy, of having regulators supervise hedge funds that operate in a way that could put the public at risk, is a non-starter, what might the next-best solutions be? That’s too big a topic to address in this post, but that’s the problem the authorities need to consider. Getting more trading to take place on exchanges may be part of that package.