Putting trillions of FX reserves to work could be best way to teach central banks about hedge funds

Date: Monday, December 18, 2006
Author: WSJ.com

Andrew Rozano, senior manager at State Street Global Advisors, writes in the WSJ: Central bankers have never had a comfortable relationship with hedge funds. George Soros infamously "broke" the Bank of England in 1992, while monetary authorities across Asia fought difficult battles with global macro funds in 1997-98. After the collapse of Long-Term Capital Management in 1998, the U.S. Federal Reserve stepped in to prevent the MAD scenario -- the "mutually assured destruction" of global financial assets. Since then, valuable lessons have been learned, risk systems improved and controls tightened. But at the same time the number of hedge funds and the amount of assets they control have risen significantly, just as their strategies have become ever more complex and dynamic.

Hedge funds have become a bigger and systemically more important part of our financial markets. True, they provide liquidity, enable better price discovery and make markets more efficient and complete. But arguably the pace of hedge-fund growth and innovation has outstripped the ability of central banks and regulators to keep up. One typical knee-jerk reaction is to propose more regulation. But that's a blunt instrument that may do more harm than good. ... But there may be a better, subtler way for monetary authorities to get back on top of the hedge funds' game.

Many central banks have amassed enormous foreign-exchange reserves, arguably well beyond what they need for traditional policy purposes. Ironically, this was at least partly in response to earlier currency crises and hedge-fund attacks. But it may now be prudent to concentrate less on the amount of reserves and more on how efficiently they are being used.... A more active involvement from the investment side may be a very effective way to supplement their more formal regulatory and financial stability oversight.