According to an article published in The Financial Times, the European Central Bank claims that hedge funds are a major risk to the stability of the financial markets. In a report published on Friday, the ECB said that the collapse of a single major fund or several smaller funds could trigger major disruptions in worldwide markets.
Really? You don't say? Hard to believe that this is considered "news."
Don't we all know that hedge funds — as witnessed with the Long Term Capital Management debacle in 2000 — can cause disruptions in world markets? But how are hedge funds any different than banks in this regard? Both banks and hedge funds can threaten the stability of the financial markets.
At the heart of the ECB report was the issue of regulation and transparency within the hedge fund industry. This is the main difference between banks and hedge funds. Banks are regulated. Hedge funds are not. Due to Bayou Hedge Fund's fraud ($440 million) and recent bankruptcy filing, the hedge fund industry is coming under scrutiny by federal regulators and journalists alike.
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Some European politicians have expressed frustration with hedge funds after their influence on major firms. Germany's current deputy chancellor last year called them "locusts" after funds influenced the departure of a top German CEO, the report said.
The [European Central Bank] report cited the "herd instinct" among hedge funds - the tendency of the funds to use similar investment strategies - as a danger. On the other hand, U.S. regulators and the International Monetary Fund have both said that hedge funds have primarily positive effects on markets."
Hedge funds generally have a positive effect on the economy, until something goes awry and then "disaster" could potentially cause what Alan Greenspan refers to as "cascading cross defaults."
But I fail to see how hedge funds differ from banks when it comes to their capacity to cause damage to the stability of the financial markets. Both could cause equal damage, in my opinion. Many people fail to realize that banks are often involved in risky derivative transactions including commercial mortgage backed securities, swaps and other highly leveraged investments. I think the issue is more about increased regulation and monitoring of investments.
Hedge Fund Law Changing?
Due to the continuing hedge fund scandals (fraud, bankruptcy, dissolution) many have speculated that hedge fund law (as it applies to regulation and transparency) may soon be changing.
Some argue that any company with the capacity to destroy/severely upset the financial markets should be regulated. Others, however, claim that hedge funds can regulate themselves and function better outside the bounds of government oversight.
Time will tell what happens to the laws governing hedge funds. My bet, however, is that as more money flows into hedge funds, these "alternative investment vehicles" will experience increased monitoring and regulation.
