[A-List] EU: financial regulation

[Keaney Michael]

The dangers of hedge funds
Hans Eichel says the investment vehicles may need extra supervision to
reduce threats to the global financial system
Financial Times, February 7, 2002

[Personal view]

In a largely integrated international financial system, distortions in
national financial markets and financial institutions can pose a threat
to global financial stability.

These distortions are the result of several factors but two are of
particular concern: weak banking supervision in offshore financial
centres; and insufficient monitoring of risk positions of hedge funds.
Greater supervision in these areas would help eliminate important
sources of potential instability.

Offshore financial centres (OFCs) are potentially de-stabilising because
they often have poor supervisory regimes and can conceal financial
transactions and their risks. They should be made to comply with
international standards.

Some progress has been made. Two years ago, the Financial Stability
Forum, an initiative launched by the Group of Seven finance ministers
and central bank governors, published a list classifying 42 OFCs in
terms of their level of supervision and willingness to co-operate. That
encouraged a number of OFCs to overhaul their practices. In addition,
the International Monetary Fund is providing OFCs with technical
assistance via a programme expected to end next year.

Nevertheless, the FSF, which meets next month, should review and reissue
the list once the IMF has concluded its assessment programme. This would
send an unequivocal signal to those OFCs that still lag behind. Further
measures, such as sanctions for institutions from jurisdictions with
weak supervision, should also be contemplated.

Hedge funds are another potential threat to financial stability. Anyone
who doubts it should remember the near-collapse of Long Term Capital
Management, the US hedge fund, in 1998. Carelessness in granting credit
to hedge funds and other highly leveraged institutions, coupled with
inadequate risk assessments, had enabled some hedge funds to concentrate
large positions in individual markets whose abrupt liquidation would
have triggered market disruptions.

In view of this, the FSF issued in March 2000 recommendations aimed at
improving risk management by hedge funds and their creditors, making
risk positions more transparent and ensuring good practice in foreign
exchange trading.

But more should be done. The FSF should devote special attention to the
recent increase in the sale of hedge-fund certificates to a broad range
of investors. The value of the certificates is linked to the performance
of a basket of different hedge funds.

Besides issues of financial stability, this also lends greater
significance to aspects of investor protection that have hitherto played
no significant role in hedge-fund investments. The international bodies
of securities regulators should consider whether additional
internationally agreed rules are needed to protect customers, such as
clearly defined disclosure requirements or rules extending the liability
of hedge-fund share issuers.

As hedge funds are not subject to any restrictions on their investments,
they are able to respond very rapidly and flexibly to changing
conditions and also to engage in short-selling, which in times of market
turmoil can lead to a general price collapse. The reactions of financial
markets to the events of September 11 gave a clear indication of the
risks involved. In view of this, the German government has included in
its draft of a fourth Financial Market Promotion Act a clause enabling
short-selling of shares to be temporarily banned in Germany. Given the
interdependence of financial systems it should be possible to
co-ordinate appropriate measures at the international level between the
supervisory authorities in big financial markets.

The lack of disclosure requirements for hedge funds means that
information on trends in this market is generally available only from
assessments by market operators and statistics voluntarily provided by
commercial data vendors. There are no official statistics allowing
financial market authorities reliably to monitor trends in the
hedge-fund sector and to identify those funds posing a systemic risk.
Transparency in the hedge-fund market should be enhanced by extending
the scope of statistics provided by the Bank for Inter-national
Settlements or by setting up an inter-national credit register.

While the number of hedge funds has grown in recent years - and they now
manage assets amounting to about $500bn - most are now smaller and not
as highly leveraged as before. Moreover, the risk awareness of fund
managers and their partners in banking has increased.

But that should not blind us to the fact that unregulated financial
institutions pose a threat to the stability of financial markets
worldwide. Should the rules on risk management, transparency and
investor protection prove inadequate, it might even be necessary to opt
for direct supervision of hedge funds. But this will call for
international consensus. The FSF will deal with these issues in March.

The writer is German finance minister

Full article at:
http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3NX4WKDXC
&live=true

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney at mbs.fi