Current method of regulating hedge funds is best: Bank of Canada report

By James Langton, Investment Executive

The existing indirect method of regulating hedge funds is probably the best approach, suggests a Bank of Canada discussion paper that assesses the risks that hedge funds pose.

The paper, authored by Michael King and Philipp Maier (the views in the paper are attributed to them, not the Bank), looks at the potential threat that hedge funds pose to financial stability. They find that hedge fund failures are not uncommon, but that these failures typically don’t have systemic implications.

The biggest source of systemic risk, they argue, is the failure of a large fund in an “important market,” because that could affect market liquidity and possibly spill over into the real economy. A failure in a niche market, such as natural gas, is less of a concern because large financial institutions are less exposed to these markets, they say.

The paper also reviews the debate over hedge fund regulation. It concludes that indirect regulation imposed on hedge funds through their counterparties’ risk management is a “more promising” approach compared with imposing direct requirements on the funds themselves.

“It is not clear that more transparency — in the extreme, hedge funds reporting on their positions in a timely fashion — would substantially limit systemic risks, since processing this information is difficult and time consuming. Also, high transparency might limit hedge funds’ trading strategies, reduce overall market efficiency, and create moral hazard problems,” they say.

So far, indirect regulation has made the international financial system more resilient, they say. “Better market discipline, indirect regulation via prime brokers, and improved counterparty risk-management practices have reduced the risks that a disorderly unwinding of a large hedge fund might have systemic effects, as occurred in the $6.2 billion collapse of Amaranth.”

Although, they caution, that the relationship between prime brokers and hedge funds is very complex and must be monitored closely. “When prime brokers also operate hedge funds, the risks to the financial system increase. How this tension will be resolved in the future remains to be seen.”