Who are hedge funds dating?

November 12, 2011

The world of hedge funds is as mysterious as it is profitable, and remains highly opaque even after a raft of new reforms aimed at strengthening financial stability. While there is general agreement among policymakers that the the so-called shadow banking system was at the epicenter of the financial crisis of 2008, hedge funds still face little or no regulatory scrutiny, despite their size and importance in financial markets.

That worries Andrew Lo, a professor at MIT’s Sloan School of Management. For him, the basic registration requirements for hedge funds are not nearly sufficient to give regulators a broad sense of the potential risks present in the markets. On the sidelines of an International Monetary Fund meeting, Lo compared the relationship to that of a parent keeping tabs on a growing teenage child.

Let’s say you’re a parent and your child has started dating. You don’t necessarily need to know everything they are doing, but you’d at least like to know who they are going out with.

That’s a particularly apt analogy since the main concern for financial sector regulators is that losses in the unregulated sector might deal a large blow to the banking system itself, forcing another round of bailouts.

Lo, who also runs an investment fund called Alpha Simplex, said during his presentation that the Dodd-Frank financial reform law still leaves regulators powerless to manage this highly-influential part of the financial system:

Central banks simply don’t have the tools right now to deal with this sector. They cannot control leverage or stop runs that go on in the sector, in the same way that they couldn’t control Bear Stearns and Lehman Brothers, and in the same way that they cannot control what’s going on today with MF Global.

 

 

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The major factors that make hedge funds so dangerous are:

1) Leverage. IN some cases as in the carry trade, the funds are leveraged up to 100 to1.

2) Their time horizon is nano seconds rather than years which creates a speculative environment throughout the financial markets

3) There is no risk for failure since they don’t trade their own money, get rewarded hugely for profitable trades but have no downside risk if they lose money.

4) It is the banks’ depositors that are providing the funds for hedge funds to leverage, thus putting at risk the whole financial system. Remember LTC?

There should be no unregulated trading at all in the financial markets and margin rules should be strictly applied where there is at least an 80% collateral requirement for any trade, including futures and options.

Posted by Acetracy | Report as abusive