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Hedge funds and regulators can work together

Date: Wednesday, June 6, 2007
Author: Ian Morley, Financial Times

When the verdict is "guilty", it seems petty to worry about the facts of the case. Germany is asserting once again that hedge funds pose a possible threat to financial stability. Of course they do. So do the US deficit, the Chinese surpluses, the various global asset bubbles, the Middle East situation and the views of Father Christmas.

In fact almost every serious report issued by academics and regulatorshas (mostly) come to the conclusion that hedge funds are a positive force in markets by providing liquidity. They act as buyers when others are selling and as sellers when others are buying. As private capital they serve the interests of their investors rather than any amorphous concept of public good. However, if one believes in the efficiency of capital and Adam Smith's concept of the invisible hand, by serving their investors they are doing public good as well.

About 85 per cent of the global hedge fund industry is located in the US and the UK. Both these governments and their regulators feel that hedge fund regulation is not specifically necessary. Therefore, the Germans have changed tactics in the last few weeks by suggesting that the hedge fund industry should itself "spontaneously" and "voluntarily" compile a code of conduct. The words "spontaneous" and "voluntary" sound like an oxymoron when used in the same sentence as "regulation" and "Germany". Despite that, many of these codes already exist.

The Alternative Investment Management Association, the only global hedge fund trade association, has produced a plethora of guidelines on sound practice.It has worked in public and in private with UK and international regulators to improve understanding of the industry to a level that helps avoid more overt regulations.

The situation in the US is not as clear. The Managed Funds Association, the US hedge fund trade association, has done a remarkable job in lobbying Washington. Unfortunately, the existence of two regulators, the Securities and Exchange Commission and the Commodity Future Trading Commission, has created uncertainty. The CFTC knows a lot more about the hedge fund industry owing to its years of derivatives experience, but has lost out in the turf war, muddying the regulatory waters. This has been compounded by the unfortunate US national sport of litigation, which results in a more confrontational and less transparent relationship between the industry and regulators. Despite this, the overall view of the US government and its regulators is both positive and non-interventionist at this stage.

The problem with regulation is that it is often forced by some market or systemic event that is probably unfairly blamed on the hedge funds. This will result in a hedge fund equivalent of the Dangerous Dogs Act: the law of unintended consequences. It is best avoided by regulators endorsing and then enforcing the guides or codes of practice created by the trade associations, or working with them to achieve acceptable ones.

Yet there is an additional, critical role for regulators. In reality, trade associations are not and cannot be enforcement agencies; they do not have the staff or the legal power for it. Regulators cannot have it both ways. They cannot force a "voluntary code of practice" and then ask the trade associations to come down heavily on perceived breaches, when they know that the trade associations cannot, by law, do this against their members.

Hence the only effective voluntary solution is that the trade associations' guides or codes are agreed with the regulators and then enforced by them in a principles-driven environment, not in a rules-driven approach. Thisprinciples-driven world of UK regulation offers a blueprint of what could work on an international scale.

We should not allow prejudice about hedge funds to sway the verdict on regulation. Hedge funds are generally a positive factor in the markets. The perception is they cause instability. The reality is that they enter markets when others are fearful: some funds riding trends, others looking for under-priced opportunities and sometimes deflating overpriced ones. They are more likely to be the solution than the cause of market problems. Voluntarily, most of the codes are already there. If other regulators are as transparent and open as the UK's Financial Services Authority has been, then I am sure the hedge fund industry will react as the Germans would like it to: "positively" and "spontaneously".

The writer is chief executive of Dawnay, Day Brokers and founder chairmanof AIMA. The views expressed are personal