The Germans have the right idea on hedge funds
By Wolfgang Munchau
Published: February 12 2007 02:00 | Last updated: February 12 2007 02:00
How strong is the case to regulate hedge funds? Germany, the current president of the Group of Eight industrial nations, has argued for some time now that the case for global regulation is overwhelming. Not everyone is convinced.
In my view, the Germans are right on this, though not necessarily for the right reasons. The extreme degree of hostility towards hedge funds and private equity groups by some German politicians and trade unions - hedge funds are so loathed they are known as "locusts" - has undermined an otherwise legitimate case.
Peer Steinbrück, Germany's finance minister and host of Saturday's Group of Seven meeting of finance ministers, went out of his way to explain that Germany accepts the wider economic benefits of hedge funds. His main concern is a lack of transparency that could increase systemic risk for the financial system as a whole.
There are good and bad reasons to regulate hedge funds. A bad reason is to protect investors, or worse, to protect the companies hedge funds are invested in. Nor is it logically coherent to argue that hedge funds should be regulated because of their size - a widely quoted estimate is that the global hedge fund industry has some $1,300bn (£667bn) under management.
A much better reason to regulate hedge funds is that they have become structurally very similar to commercial banks, where the need for regulation is largely undisputed. Banks are regulated because of network externalities. An insolvent bank can damage the financial system at large. While banks are often private companies, the financial system is a public good.
So why are hedge funds increasingly similar to banks? Dresdner Kleinwort, the investment bank, last week published a report on the hedge fund industry, which argues that the hedge fund bonanza will eventually unwind. (See Paul Murphy's report in FT Alphaville for a summary of the report's conclusions*.) The report also contains a fascinating comparison between hedge funds and commercial banks, which analyses their similarity in terms of both their respective strategies and their balance sheets.
Why should this be? The business of a bank is to borrow money from a central bank, lend it to customers at a premium and apply leverage to maximise profits. How does a modern hedge fund manager operate? Most hedge funds employ a "long-short strategy". They buy high-risk, high-return assets and short-sell low-risk, low-return assets. For example, they buy a high-yield corporate bond with a risk premium of, for example, 300 basis points over a Treasury bond, and they short a high-quality corporate bond with a risk premium of only 50 basis points. Provided there is no default during the time horizon of the two deals, they make a decent profit. The more leverage, the bigger the profit.
Another strategy is to borrow cash in yen - where interest rates are close to zero - and invest in countries with higher interest rates, for example in the US or the eurozone. In this case, the main risk is the exchange rate. A sudden and large appreciation of the yen would kill this particular gamble, just as a default on a junk bond would end the spread-game between commercial bonds.
This type of strategy is also known as the carry trade. While the expression "carry trade" conjures up images of wily speculators, it is in essence not fundamentally different from what an old-fashioned commerical banks does: it borrows cheap, lends dear and incurs a risk in the process. If a particular large borrower defaults, the bank could face insolvency. The same could happen to a hedge fund with a long-short strategy if the yen suddenly appreciated.
There is more to the similarity between banks and hedge funds. As the Dresdner study pointed out, both have large nominal balance sheets, both generate a relatively small return on assets, both employ substantial leverage, and both generate a comparable after-tax return on equity.
The similarities between the two types of company are striking, except for one thing: banks are regulated and many hedge funds are not.
I am aware that there are many practical problems with regulating hedge funds. For a start, how do you deal with the problem that many hedge funds are domiciled on exotic islands? The G7 finance ministers agreed to hold direct talks with hedge fund managers and to ask the Financial Stability Forum, a panel of top-level financial regulators, to update its seven-year-old report on the hedge fund industry. The outcome of this consultation may well be a voluntary code, a credit register or a market-based form of regulation.
It is not at all clear whether the world will have a regulatory system in place before the great unwinding of the hedge fund hype starts. What is much more certain, however, is that the need for regulation will become painfully obvious when that happens.
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