The Sunday Review

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SHOULD HEDGE FUNDS BE REGULATED?

Economies As Dart Boards

LATE in 1996, a half-year before the Thai government was forced to devalue the baht, a group of speculators in the United States had reportedly done a confidential analysis of the Thai economy and decided that huge profits were available for the taking by betting on the baht's peg to the US dollar coming loose.

By early 1997, according to an authoritative report, "the wolves, an amorphous group that includes secretive hedge funds as well as groups within banks with names as familiar as Citibank", had begun to circle.

Then the attacks began, intensified, and on July 2, 1997, Bangkok dropped its futile and expensive defence of the baht, setting off the regional contagion.

According to economist Paul Krugman, whose critical 1994 article demythifying East Asian "miracle" economies supposedly set the wolves smelling blood in Asia -- he admits only to advising Citibank to reduce its Asia exposure -- it is not certain if hedge funds were the dominant source of speculation and whether they had acted in collusion.

If they did, he says, it could have been tacit. But whoever is to blame, Asia continues to reel from the ravages of hot money flows. And much of the blame -- fairly or otherwise -- is laid at the door of hedge funds.

The latter as an investment vehicle are exactly 50 years old this month. The first fund began trading in New York and was started by Mr Alfred W. Jones as a private partnership and sold stocks short and used leverage.

Today, there are at least eight types of funds, including macro funds that take positions on changes in global economies, global funds dedicated to emerging markets and specific regions, sectoral hedge funds which focus on specific industries and the fund of funds -- those that allocate their portfolio among a number of hedge funds.

Yet the image persists of hawk-eyed speculators borrowing stocks and money cynically which they hope to repay when their values drop, thus earning them profits on the differential.

Indeed, the term "speculator" actually evolved from the futures market, in which participants are considered to be hedgers if they own the underlying assets and take physical delivery, or speculators if they look to profit from short-term movements.

Rich individuals -- the minimum investment in a hedge fund is between US$100,000 (S$167,000) and US$500,000 usually -- use them as vehicles to invest in often-risky ventures, in search of a higher rate of return.

Van Hedge Fund Advisors, based in Nashville, United States, counts some 2,700 hedge funds worldwide, of which about 1,500 are in the US.

Because much of the rest are registered in tax havens like Bermuda and the Cayman Islands, they are out of the reach of key regulators: The "double play" attempted supposedly in Hongkong by some rogue funds would have been illegal in the US.

According to Mr George Van, who runs the Advisory, a few very large hedge funds do have enough influence to sometimes affect specific markets.

However, he says, the vast majority of hedge funds are dwarfed by the investment portfolios of large banks, brokerage houses, insurance companies and others which play the markets using investment strategies similar or identical to those employed by many hedge-fund managers.

He says that these large players are a good deal more secretive about their actions and results, so they rarely make headlines if some bets go wrong. Also, he adds, their mis-steps are diluted and therefore masked by their other activities.

Adds a London-based fund manager said to have profited immensely from stock and currency trades in South-east Asia: "At the end of the day, it's not us but the big banks and pension-fund players that are important factors in influencing your market."

That much is true. The trading divisions of banks move far more money across the globe than hedge funds ever do. Some even park funds with hedges.

Late last year, Reserve Bank of Australia Governor Ian Macfarlane recognised this when he told a Sydney conference: "There is a continuum running from commercial banks, to investment banks, to hedge funds and it is hard to see why some of this should be within the supervisory net and some without," he said.

"The big macro hedge funds have become, to some extent, an extension of the proprietary trading arms of major banks."

FLEET-FOOTEDNESS SETS OFF THE HERD

WHY then are hedge funds taking so much of the rap?

For one, because of their razor-sharp reflexes, which often lead markets, hedge funds have always been in focus in times of financial instability.

Mr George Soros made his name in the European crisis of 1992 when his trades against the sterling contributed to its withdrawal from the European Exchange Rate Mechanism.

Indeed, Mr Michel Sapin, finance minister of France in 1992 - 93, was so exasperated by speculators attacking the franc under his watch that he once said that in the days of the French Revolution, they would have been dubbed "agitateurs" and executed.

Two years later, they were again in the limelight during the turbulence of the bond markets. In Asia, of course, it was the Thai devaluation that raised their profile so immensely.

The scamps blamed for the Asian turmoil are largely the short-sellers -- funds that borrow securities they judge to be overvalued, hoping to buy them back at a lower price when repaying the broker.

But, some think that hedge funds -- and "foreign speculators" in general -- may be more sinned against than sinning.

Dutch academic Eduard Bomhoff, this year's inaugural Winsemius chair at the Nanyang Technological University and his country's best-known monetary economist, told Sunday Review recently that studies had shown that many a time, runs on the market were often caused more by local firms and individuals than overseas companies.

"I think if you look at facts, what you will see is that far more often it's domestic insiders who become concerned and change their positions first," he said, citing a study done on South Korean stock-market transactions.

"The politicians will never say their well-connected friends have sold their stock-market holdings. They will blame it on foreigners and the media reports it thus."

Nevertheless, hedge funds can be very lethal for an altogether different reason: the immense leverage they bring to the market and the herd instincts they set off.

As money trading becomes increasingly an end in itself, daily forex trades today total some US$1.5 trillion on average, more than 70 times the US$18.3 billion daily average of 1977. Much of this -- up to 90 per cent some days -- is inter-dealer transactions or pure speculative play.

Academic Ramkishen Rajan of the Institute of Policy Studies in Singapore also points out that because currency brokers' performance is often rated vis-a-vis their peers, there is a tendency for herd instincts to develop.

"For instance, consider the incentive structure of fund managers, who are agents or trustees of the funds under their control. If a fund manager makes a loss/wrong decision when most other competitors do likewise, it is unlikely that she will be punished by her institution," he notes.

EXCESSIVE LEVERAGE THE REAL PROBLEM

BUT it is excessive leverage that is often cited as the key problem. Although only about one in six is said to borrow more money than he holds, the better ones easily command funds that are several times their paid-up capital. The best -- as Long Term Capital Management supposedly was -- could perhaps be leveraged 50 times over.

The moral hazard arises from the fact that much of this is money protected by the security of depositary insurance, which takes the issue right back to the question of adequate supervision.

This is a point made by Hongkong Financial Secretary Donald Tsang, who has been pushing the international community to take a serious look at their activities and evolve mechanisms to check their excesses -- without resorting to controls.

As Mr Tsang, who acknowledges that not all hedge funds are rogues, told Sunday Review recently, some of the damage to Asian economies had been caused by disruption from large and sudden capital flows. "To the extent that hedge funds had been the main players directing such private-sector fund flows, effected through their financial size and leverage, they were able to lead markets," he noted.

The situation for the smaller and medium-sized economies, he said, was not helped by the lack of disclosure requirements of hedge-fund activities and herd behaviour from other market participants.

"The priority now is to increase the transparency and disclosure of the exposure of hedge funds. Information sharing... and international cooperation on monitoring hedge-fund activities are essential," he added.

So, what is the solution? There is an increasing chorus of suggestions revolving around reporting standards, bankers' codes and exchange of information between authorities in the key financial centres of the world.

Britain's Financial Services Authority chairman Howard Davies is calling for more transparency -- a banker's code for forcing the funds to lay open their exposure and leverage on the markets. The Bundesbank, the German Central Bank, and a new centre-left government in Germany have similar ideas.

But then would not hedge funds simply shift to a tax haven, to avoid regulatory prying? Some think they would not be able to escape if the key financial centres were integrated.

"All we need is to integrate the markets in New York, Tokyo, Hongkong, Singapore, Sydney, London, Frankfurt, Paris and perhaps, Toronto," Hongkong's Mr Tsang once said.

Even Mr Jon Corzine, co-chairman of Goldman Sachs, one of Wall Street's biggest movers, agrees: "In specific areas... targeted approaches may be appropriate. That is a significant difference, though, from controlling the repatriation of funds."

But hedge funds do have their uses -- even for developing economies. First, they bring in first-class research. Then, they bring in funds.

Often, points out a senior economist at Merrill Lynch, they are the only ones brave enough to enter markets heretofore regarded as untouchable, bringing in badly-needed liquidity and capital into markets. True, too, that they are often the smartest and the first to flee.

SINGAPORE'S RESPONSE

SINGAPORE'S own response to hedge funds appears to be that it does not recognise sacred cows and the funds are welcome, as long as they follow the rules, and improve the state of play in the industry.

Deputy Prime Minister Lee Hsien Loong told Parliament on Wednesday that Singapore had no specific policy either to ban or attract these funds. He said that MAS' supervisory approach was to ensure that financial institutions were not over-exposed to any particular counter-party or type of asset.

Singapore would continue to emphasise that banks and funds reported large trade and positions as well as prudential exposure limits and ensure that the country's disclosure and reporting requirements meet international best practice.

It would also participate in ongoing international discussions to evolve improved disclosure and reporting standards.

In an interview with Sunday Review after the autumn meetings of the World Bank and the IMF, which discussed the hedge-fund issue, Finance Minister Richard Hu said the preferred way of regulating them would be through the intermediaries.

"In other words, you regulate them by imposing conditions on the banks which lend them the money."

This was possible because the banks already had prudential requirements which limit their ability to lend to entities, he said.

"So the route we would prefer would be to suggest to the IMF and the BIS to introduce rules which impose new prudential requirements on the banks to firstly identify the entities or hedge funds to which they lend and to aggregate the information."

This way, regulators will know to what extent the banks they supervise are exposed to the various hedge funds. Then it may be possible to try limiting the banks' exposure to these companies by imposing a cap on their leverage, based on their capital, he added.

Hongkong's Mr Tsang agrees that the route to checking them is through the lending banks. "More stringent regulation on bank lending to the hedge funds would be an important way to prevent excessive leveraging by hedge funds," he says.

Of course, every country has the right to devise a common or individual circuit breaker or power-surge protectors.

But at the end of the day, the key to a good defence of the economy from extreme rapaciousness is to improve transparency of the market, strengthen settlement and payments systems, and reduce the need and the opportunity for sudden shifts of the "herd" to develop.

As an IMF study, published before the Long Term Capital Management crisis last year, put it: "The most important action policy-makers can take to protect their economies against uncomfortable market movements is to avoid offering one-way bets in the form of inconsistent policies and indefensible currency pegs."

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