Commentary: Reining In Hedge Funds: How To Break The Impasse

Six months after Long-Term Capital Management's near-collapse, Washington's regulators are quietly but fiercely debating the lessons to be learned.

In one camp, Securities & Exchange Commission Chairman Arthur Levitt Jr. insists that tougher regulation of hedge funds is needed to prevent a repeat of the financial-system risks exposed when LTCM's $125 billion portfolio tottered on the brink. In the other corner stands Federal Reserve Chairman Alan Greenspan, who argues that lenders were so burned by the LTCM affair that, with some extra prodding by regulators, they'll watch hedge funds' borrowing and risky trading far more effectively than anyone in Washington could.

Stuck in the middle: Treasury Secretary Robert E. Rubin. Top regulators say the Treasury chief sympathizes with Levitt--and has put out word that it might be a good idea to make hedge funds report their complex currency and interest-rate trades to the authorities. But Rubin is also swayed by the Fed's insistence that stiffer U.S. rules could drive the big funds offshore. He also knows the GOP Congress won't grant sweeping new powers to rein in funds. Result: Stalemate. The hedge-fund report that Rubin promised to deliver to Congress by February has slipped to late April--or maybe June.

Who's right? Greenspan is--but his prescription is incomplete. Given rapidly changing financial markets, regulators may have to depend on market-based regulation. Still, regulators need safeguards to stiffen bankers' resolve to manage risks properly--and to make it clear that lenders will pay the price the next time an LTCM crashes.

Hedge funds escape regulation now because they're pitched to a few wealthy, sophisticated investors who can take care of themselves. The debate isn't over any losses investors might suffer but the threat these funds' highly leveraged, complex trades pose to the financial system at large. When LTCM was foundering, the Federal Reserve Bank of New York feared that unwinding the firm's huge positions would drive global markets down so far so fast that many innocent investors would be sucked into the whirlpool.

Making hedge funds report trading positions to regulators--favored by Levitt--wouldn't curb those risks. Even if the SEC could closely monitor some 600 large hedge funds, the agency would be hard-pressed to weigh the risks of each fund's complex, fast-moving trading strategy. Quarterly or even monthly position reports would be outdated long before they were filed.

PUBLIC AND PRIVATE MOVES. Better to forgo the false security of federal monitoring in favor of private-sector watchdogs whose own money is at risk. Hedge-fund investors are forcing managers to disclose more about their positions and strategies. "Investors have a right to keep tabs on what's going on in the portfolio," says Seth Tobias, general partner at Circle T Partners, a $190 million New York-based hedge fund. Lenders, too, need to maintain vigilance. An SEC-backed group of bankers, chaired by former New York Fed President E. Gerald Corrigan, will recommend ways that banks and brokers could better understand and monitor the risks they're taking when they lend to hedge funds. Regulators must follow through by leaning on lenders to demand far more thorough reporting.

A financial penalty would help drive the message home. The Fed and its counterparts in other nations are considering requiring banks to set aside extra capital--12% of loan value vs. the usual 8%--for loans to highly leveraged borrowers such as hedge funds. Linking capital levels to the quality of a bank's risk-measurement systems would make that move even more effective.

The answer to hedge fund risks isn't new regulation, but better banking. In the case of LTCM, lenders awed by the hedge fund's cadre of PhDs forgot to mind their ABCs. Washington's goal should be to make sure that lenders remember--and apply--the lessons of LTCM.

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