Hedge Fund Regs Loom

Date: Monday, November 17, 2008
Author: Greg Bordonaro, Hartford Business.com

Signs the government will intervene in the hedge fund industry were evident last week when five of the world’s richest hedge fund managers were grilled by a congressional committee about their secrecy, earnings and risks to the financial system.

“I think in view of the market failure and the perceived role that hedge funds played in it, it’s more than likely that there will be substantial regulation over hedge funds,” said John Brunjes, a partner at the Hartford-based law firm Bracewell and Giuliani.

As of January, Connecticut had 30 hedge funds with at least $1 billion in assets under management, most of them in Greenwich, Stamford or Westport, according to HedgeFund Intelligence, a London-based research firm.

Nearly 10 percent of the $2.6 trillion industry is based in the state.

Hedge funds are taking part of the blame for the current crisis because they are major players in short selling and credit default swaps, investment tactics accused of putting intense pressure on the stock market.

The Secrecy Threat

But their secrecy may pose an even bigger threat to the system.

Basic information about hedge funds, including who they are, what they do and how much they own, is not readily available to regulators. That creates deep concerns over how the industry operates and what risks it poses to the financial system.

“Ultimately, it’s in the interest of hedge fund managers to provide an adequate level of confidence to the investment community,” Brunjes said. “They need to facilitate the flow of information.”

Even organizations that lobby for the industry concede that regulation is inevitable. “The pendulum has swung. Regulation is coming,” said Benjamin Allensworth, senior legal counsel for the Managed Funds Association, the largest U.S. lobbying group for hedge funds.

Allensworth spoke to 50 or so Connecticut hedge fund managers, investors and lawyers last month at the state Banking Department’s securities conference in Stamford.

“We must be proactive or else legislation will just hit us,” said Allensworth, who noted that his organization is working to develop best practices guidelines.

The Securities and Exchange Commission is the primary regulator of securities companies, but lawmakers will also be involved, Brunjes said.

Regulators already have taken action. In September, for example, the SEC temporarily banned short selling — the tactic of borrowing shares that must be repurchased later in a bet a stock will decline. That type of trade, commonly used by hedge funds to bet against a stock they believe is overpriced, was accused of putting intense downward pressure on financial stocks in particular.

Now hedge funds must disclose the shares they are wagering against.

The Federal Reserve is seeking to become the lead regulator over a clearinghouse for credit default swaps, a $55 trillion market of unregulated financial instruments that act like insurance contracts by promising to cover losses on certain debts if they default.

CDSs are continuously purchased and sold by investors, including hedge funds, without anyone making sure that the buyer has the money to cover losses.

A clearinghouse would be similar to a stock exchange, providing more pricing and volume transparency. Brunjes said regulators may also try to limit the types of investors who can participate in hedge funds or raise net worth requirements in order to restrict access to them.

They may also try to force hedge fund managers to become registered as investment advisors.