The G-7 on Hedge Fund Risk: Politics Abound, But Getting the Right Answers

There was much speculation as to what would come out of the G-7 meetings in Essen, Germany concerning hedge fund regulation. Most industry observers with a sense of history would have expected the obvious: a lot of saber-rattling with little concrete results. And you know what - they were right. But that's ok. The good news is that the stuff the G-7 should be focused on - systemic risks, an emphasis on better understanding regulated institutions like banks and self-regulation among hedge funds - is the stuff they are focusing on. Funny, that's the stuff I've been focusing on for some time:

• 01/30/2007: "Implicit" Hedge Fund Regulation: Moving in the Right Direction
• 01/09/2007: Who Says Hedge Funds Aren't Regulated?
• 07/16/2006: Much Ado About Nothing - The Hedge Fund Regulation Debate

Be that as it may, the desire of Germany to be more overbearing (as usual) in their regulatory regime was (at least temporarily) beaten back, though they hope to push through some concrete measures concerning transparency at next year's G-7 summit.

From the Financial Times:

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Although the global financial system has been relative free of financial crises in recent years, European central bankers and finance ministers in particular have expressed concern about hidden “systemic” risks that may have been created by hedge funds, particularly given the opaqueness and complexity of many deals. The US has also stressed the importance of investor protection.

The UK and US were wary of any initiative that could have created regulatory hurdles for hedge funds and the German presidency had tailored its proposal accordingly, scaling back its original ambition to agree on a set of instruments to monitor hedge funds by the end of the year.

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Speaking after the Essen summit, Jean-Claude Trichet, president of the European Central Bank, said that there had been “a lot of reflection in the industry” but there had not yet been agreement on standards and codes that would form a system of self-assessment. “I’m sure that the industry will crystallise on an appropriate concept,” he said.

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Axel Weber, president of Germany’s Bundesbank, said that “vigilant means that we are anything other than complacent”. Rodrigo Rato, managing director of the International Monetary Fund, said that the evolution of recent financial markets had helped spread risk “but there are maybe new vulnerabilities possible”.

I don't know if I've ever heard JC Trichet so rational, conciliatory and laid back. Unfortunately, I can't say the same thing about Mr. Weber; his comments were predictably goofy, politically-motivated and vacuous. He was engaging in the chest-thumping that characterizes one whose power is sharply limited by objective reality. Sorry, Axel.  But you're just not driving the bus. Thankfully.

I made a few comments in a Bloomberg article shortly after the G-7 meeting broke up:

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``We're seeing a maturation in the way governments are viewing hedge-fund risk,'' said New York-based Roger Ehrenberg, former head of DB Advisors LLC, a subsidiary of Deutsche Bank AG that managed hedge funds.         

``Hedge-fund managers recognize that they've done a poor job at public relations,'' Ehrenberg also said. ``They recognize that they have to cooperate given the size to which the industry has grown.''

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Turns out Hank Paulson also has a similar view (from the FT article):

“Whenever something is growing as quickly as this (the hedge fund industry), it bears looking at,” said Hank Paulson, US treasury secretary.

Hey, Hank and I are rational guys. Hedge funds have grown to the point where you just can't deny their importance or their impact in the global financial landscape, and they need to be better understood. The SEC has been working on better understanding hedge funds for at least 5 years, since they walked into Deutsche Bank (and several bulge bracket firms and their prime brokerage units) and interviewed a bunch of us on an exploratory mission. This was a healthy and smart thing to do in light of the obvious expansion in industry AUM and the growing institutionalization of the business that was going to cause AUM to rocket for the foreseeable future. The FSA intelligently underwent a similar exercise.

It is this type of deep understanding that makes regulators effective and less apt to make knee-jerk, destructive decisions laden with unintended consequences. The results of the G-7 deliberations directly reflected this base of knowledge that exists today, and are now focused on those areas where more data needs to be collected and more learning needs to occur. Let's hope these positive trends in the regulatory environment persist and that the G-7 membership is able to keep the regulatory-happy German politicos at bay. For the good of the hedge fund industry and the global financial system.