Do hedge funds merit caution?

Date: Friday, October 12, 2007
Author: Economic Times

Keep them on a leash; we need safeguards

Until now, only the FIIs, such as pension funds, insurance companies, mutual funds, foundations and endowments were permitted by SEBI to register with it for undertaking portfolio investment in India. Hedge funds were not permitted. Hedge funds circumvented SEBI’s restriction on them by becoming sub-accounts of some FIIs. The FIIs devised the system of issuing participatory notes (PNs) to the hedge funds. From the Indian perspective, this is a very opaque system.

The dangers which hedge funds can pose to the financial stability of even a large economy like the US were clearly exposed by the well documented collapse of the US-based hedge fund, known as Long-term Capital Management (LTCM), about a decade ago. It had to be bailed out through the intervention of the US Fed authorities.

The objective of the US authorities was really to save the US banking system which had lent huge amounts to LTCM. It is well-known that most hedge funds operate with high leverage of something like 90% in the form of borrowings from the banking system.

Hence, a large fund’s insolvency can lead to failure of banks. Moreover, hedge funds are not long-term investors. They go on switching their funds from one asset class to another, and from country to country, thereby adding to market volatility.

SEBI has been proceeding very cautiously by calibrating its approach. It has allowed just about half a dozen hedge funds to register with it, as reported in ET recently. This move of SEBI is like tokenism. It is unlikely to pose any serious threat to the stability of our financial system. The majority of hedge funds, accounting for an estimated 50% of the PNs, remain outside SEBI’s regulatory reach.

By registering the hedge funds and requiring them to fulfill certain conditions, SEBI would be able to keep them on a leash. Since hedge funds usually derive the bulk of their funds by borrowing from the banking system, an important safeguard to be adopted should be to not allow them to borrow from any of the banks operating in India, including the branches of foreign banks. The cautious way in which SEBI is already proceeding seems to me to be right.

(*Society for Capital Market Research & Development)