European Affairs

Yet even though hedge funds proved themselves to be islands of sanity in a financial system otherwise gone mad, they have not escaped regulatory restrictions. On both sides of the Atlantic, the new rules that they now face reflect post-crisis delusions among policy-makers.

The Dodd-Frank reform passed in the United States requires any fund with more than $150 million in assets to register with the Securities and Exchange Commission. Supporters of this reform say that it imposes only a modest burden, but this is no defense if the benefits are zero. Clearly, hedge funds with a mere $150 million in assets pose no risk whatever of financial contagion: in 2006 a hedge fund named Amaranth, which was fully sixty times bigger than that, blew up without disrupting markets. Equally,  registration with the SEC will not necessarily protect investors. The most famous con artist of recent years, Bernie Madoff, registered his investment vehicle with the SEC. A fat lot of good that did his clients.

Meanwhile the European Union has agreed on a new set of rules for hedge funds. It has created a “passport” that will allow hedge funds to be marketed across borders, and promises U.S. funds access to this scheme —   both promising developments. But the price of the passport may be high. In return for granting it, regulators presume to micromanage hedge fund compensation policies, even though risk-inducing compensation is a far bigger problem at banks. (At hedge funds, most managers keep personal savings in the fund, so they have a powerful incentive not to take excessive risk.)

The EU also threatens to impose caps on leverage for hedge funds. In reality, here again the really reckless leverage is to be found at banks. (Unlike banks, hedge funds cannot borrow money via government-insured deposits and are not too big to fail; as a result, they borrow far more cautiously.)

Finally, the EU wants to oversee hedge funds’ liquidity management, lest funds use unstable short-term borrowing to buy illiquid assets. But this sort of mismatch poses a far greater risk at (yes!) banks, whose access to emergency liquidity from central banks creates a standing incentive to gamble on holding hard-to-sell assets.

On both sides of the Atlantic, in other words, policy makers are hounding hedge funds with rules that will achieve little or nothing.

This might not matter if hedge funds provided no social good. But the reality is that financial risk is not going away: currencies, interest rates, and so forth will continue to spike up and down, and somebody has to absorb the consequent risks to the world’s stock of savings.

Policy makers seem content to allow too-big-to-fail banks, investment banks and insurers to continue to manage those risks, even after a crisis that has shown many to be untrustworthy. The superior approach would be to encourage these risks to shift into small-enough-to-fail hedge funds, which have a better track record of managing them.

Sebastian Mallaby is a senior fellow at the Council on Foreign Relations and the author of “More Money Than God: Hedge Funds and the Making of a New Elite”  (Penguin Press: 2010).