When drug runners and terrorists want to park illicit cash, there may be no better haven than hedge funds. Despite tough new anti-money laundering standards put out by U.S. regulators for banks, mutual fund companies, insurers, and money transmitters, the highly secretive hedge fund industry has no restrictions whatsoever. Says Peter Djinis, an attorney and former executive assistant director for regulatory policy at the Treasury Dept.'s Financial Crimes Enforcement Network (FinCEN): "The lack of controls is conspicuous."
And perhaps dangerous. For more than three years, the Securities & Exchange Commission and the Treasury Dept. have been discussing how to include hedge funds in the USA Patriot Act, the 2001 legislation designed to protect against terrorism. Yet during that time, the $1.3 trillion hedge fund industry has collected record amounts of cash, some of which could well be from questionable sources. Intermediaries who introduce hedge funds to investors often don't divulge clients' names, and funds rarely ask. "This is a very opaque industry," says Jeff Brenner of Intelysis Corp., a corporate intelligence firm with offices in Cherry Hill, N.J. "There's no indication of who is behind these accounts."
As it stands, hedge funds have no responsibility to determine the sources of investor funds or to analyze whether they're questionable. The industry argues that there's no evidence that funds are conduits for abuse. But many observers counter that the lack of oversight creates an imbalance in the overall regulatory system -- and a lure for wrongdoers. "If you regulate from A to Y, the bad stuff goes to Z," says Jonathan M. Winer, former deputy assistant Secretary of State and partner at the Washington office of law firm Alston & Bird.
FinCEN proposed in September, 2002, to amend regulations under the Bank Secrecy Act (which itself was amended by the Patriot Act) to include hedge funds. Its plan would subject funds to anti-money-laundering rules unless investors were locked into the fund for more than two years. Funds would have to designate an individual or a committee to oversee an anti-money-laundering program. And offshore funds would be subject to regulations if they sell ownership interests to people in the U.S., among other requirements.
So what's the holdup? Winer says the reasons for the delay are mostly bureaucratic, with a measure of political maneuvering as well. "We tend to legislate and regulate by crisis," he says. "In the absence of crisis, things go slowly."
Treasury doesn't have a lot of expertise when it comes to hedge funds, so it has had to bone up on the industry and find a way to protect the financial system without burdening it with ineffectual rules. A FinCEN spokesman acknowledges that hedge funds have presented a "particularly complex challenge." Former Goldman Sachs Group (GS) CEO and new Treasury Secretary nominee Henry M. Paulson Jr. should be a help on that front.
Some securities industry experts say the SEC and the Treasury have also been in a battle over who should take the lead. Neither agency would comment. While there are those who say the SEC is the logical choice, others doubt that it has the necessary resources.
U.S. regulators are also bumping up against foreign watchdogs, such as Britain's Financial Services Authority. In a global investing world, the issue of which regulator prevails is becoming more complicated.
Some funds are taking matters into their own hands. Peter Turecek, a managing director in the business intelligence and investigations group at risk consul-tant Kroll Inc. (MMC) who works on hedge fund matters, says well-heeled funds that want to distinguish themselves as clean and aboveboard have been doing background checks since September 11. But plenty of small funds -- and less civic-minded big ones -- still accept just about anyone who shows up with a check.
Regulating money laundering in hedge funds isn't only about protecting investors; it's also about preventing crime. "There's every rationale in the world to have them comply with anti-money-laundering regulations," says Thomas R. Westle, a hedge fund attorney in the New York office of law firm Blank Rome. "Somebody ought to figure out how to monitor the flow of money."
By Mara Der Hovanesian, with Dawn Kopecki in Washington