Hedge funds move to limit rules burden

Regulation is coming to the hedge fund industry, and the world's top traders know it. In Britain and the US hedge funds have set up new codes of conduct in an effort to head off heavy-handed regulation, while industry lobbyists have hired senior central bankers and politicians.

The latest to switch sides is Todd Groome, who moved last month from the Inter-national Monetary Fund to become chairman of the Alternative Investment Management Association, the London-based trade body for hedge funds.

Richard Baker, a former US congressman, and Antonio Borges, a former Portuguese central banker, already head hedge fund bodies, while Sir Andrew Large, former deputy governor of the Bank of England, stepped back from a similar role last year.

But even as Mr Groome was being appointed, it was becoming clear that hedge funds would not escape sweeping changes to global financial regulation.

"I worry that we have been coming down a route for five or seven years where hedge funds and the proper type of supervision is a rational conversation," Mr Groome says. "Because of the economic climate we have now come to a point where that could unfold in a non-constructive way."

The pressure for change was headed off last spring, when an effort by Germany to push through a mandatory code of conduct - a retreat from Berlin's idea of a global database of hedge fund holdings - was rejected by the US and the UK.

Now, though, the demands appear impossible to ignore.

The G20 club of developed and developing nations has made hedge funds one of the three items on the regulatory agenda for its London meeting in April. The European Commission is drawing plans for tighter controls. And in Washington, expectations are growing that hedge funds could be brought into the regulatory net under a widely predicted shake-up.

Even Mr Groome's best-case outcome involves more regulation: putting existing voluntary codes of conduct on a formal basis, and demanding greater information disclosure to watchdogs trying to prevent the next financial meltdown.

This won't satisfy the critics - including European politicians who want to stop hedge fund activists assaulting underperforming corporations - but would help those worried that a hedge fund blow-up could destroy a bank, so-called systemic risk.

There is no doubt hedge funds have the potential to cause serious damage to banks: in 1998 the collapse of Long Term Capital Management had to be averted by a bank bail-out led by the New York Federal Reserve.

Yet, in spite of the problems of hedge funds in the past 18 months, they featured as victims of bank failures, rather than the cause.

Still, the question politicians and central bankers are now addressing is not whether to regulate hedge funds, but how.

There are three main options. First, regulating funds indirectly through their banks, the prime brokers who provide loans and facilitate short-selling to profit from price falls. This approach, combined with voluntary codes of practice, emerged as the winner last year. But it is unlikely to satisfy those worried about the fragile financial system.

Second, regulating the managers of the funds, about three-quarters of which are based in London, New York, or Greenwich, Connecticut. This is relatively easy, but does not touch the actual pool of money, which is typically in an offshore tax haven.

The third approach is the most interventionist: that favoured by many in Europe, of directly regulating the funds, much as mutual funds are controlled.

Mr Groome, an American, argues that the British approach of regulating the manager, not the fund, is the best way. This would allow regulators to ensure risk management and gather data, he says, without strangling funds in red tape.

His hope is that the codes of best practice - including AIMA's own, and codes created by London's Hedge Fund Standards Board last year - can be merged.

Add to that disclosure to the regulator of the amount of borrowing and ease of trading of assets in a fund, and watchdogs can work out how much danger hedge funds pose to banks.

"The key is leverage, liquidity and volatility around the asset," Mr Groome says.

"If you get that information into the hands of the supervisor they can come in [to a fund] and say we are really concerned about the leverage. There could be some sort of teeth put into it in the supervision process."

Mr Groome comes from his role as a financial stability adviser at the IMF with a fat book of contacts at the world's leading financial watchdogs as well as at hedge funds (he has just taken a job at Canada's Diversified Global Asset Management, a $3bn - £2bn - fund). But he will need luck as well as friends in high places to stop watchdogs biting a chunk out of the ind-ustry.