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Hedge funds aren't too big to fail

Date: Friday, October 23, 2009
Author: Richard Beales, Financial Post

Galleon is sinking. It's no surprise that after founder Raj Rajaratnam was charged with insider trading, investors in the U.S. technology-focused hedge fund should head for the exits -- and the firm decide to wind its funds down. It's an extreme case, but at least Galleon Group isn't too big to fail and investors and the financial system can move on.

One thing in hedge funds' favour is that they live and die on their performance and reputation. Unlike their bailed-out brethren in the banking world, even the largest of them poses very little, if any, systemic risk. So if they blow up on bad trades, as Amaranth Advisors LLC did in 2006, for example, investors lick their wounds and move on without the government feeling the need to get involved. And if something else goes wrong and investors decide to pull out -- well, that's the market operating as it should.

Of course, investors don't want the kind of nasty surprise they got with news of Rajaratnam's arrest on Friday. In hindsight, they probably should have pressed Galleon to put in place top-notch checks and balances and to institutionalize the leadership of the firm so it didn't depend so heavily on one man. The episode may reinvigorate the efforts of investors who have been calling for such changes since the very different, and much larger, fraud of Bernie Madoff was exposed.

Yet while winding down Galleon in a hurry could cost investors a bit of money, if the firm's claim that its holdings are "highly liquid" holds true, investors won't end up being badly hurt. The firm's remaining assets will either be liquidated or sold to another firm. And financial markets will scarcely notice.

That's more or less how market forces ought to work on financial firms. The relatively small size of hedge funds ensures they aren't pivotal to markets, and the fact that investors can usually choose to vote with their feet -- except when fund managers throw up gates, of course -- means poor performance or reputational blots typically get punished pretty quickly.

While there's scope for somewhat more regulation of hedge funds -- at least in the areas of disclosure and transparency -- the Galleon situation shows why financial regulators' urgent priority should be with bigger, more complex institutions where shareholders can't so easily impose their will.