With hedges, there is no fence to sit on

Next time Charlie McCreevy thinks of making a speech about why hedge funds don’t need more regulation he should look at a book published back in 2001, When Genius Failed: The rise and fall of Long Term Capital Management by Roger Lowenstein.

In so far as there is such a thing, Long Term Capital Management (LTCM) was a typical ‘hedge fund’. Such financial institutions do not ‘hedge’ financial risks, that is try to reduce them, but speculate on a grand scale, sometimes on tiny movements in asset or commodity prices, sometimes on shares and takeover bids.

In September 1998 LTCM’s bets went pear shaped. In

weeks it lost over $3 billion of the $4.7bn of capital it had,

leaving it with $1bn of capital supporting $100bn of assets under management. Lowenstein says its gross exposures at one stage hit $1 trillion. As it careered towards disaster the situation was so threatening to America’s, and the world’s, financial system, that the Federal Reserve, the US central bank, had to organise a private sector bail out.

Last month another US hedge fund had to shut down: Amaranth Advisors. It bet wrongly on the direction of natural gas price futures and quickly lost $6bn of the

$9bn investors entrusted to it. Hedge funds have been growing like topsy. Last week John Gieve, deputy governor of the Bank of England, made an attempt to estimate their size. Whereas, they were managing about $200 billion in 1998, today the figure might be $1.25 trillion. Some take comfort from the fact that this sum may be only 2% of the global value of assets managed by pension and mutual funds and their ilk. But Gieve’s figure is only an educated guess. From one minute to the next outsiders do not know the scale of the risks these firms are taking.

And hedge funds are only part of a wider problem of so-called dark pools of money in increasingly unregulated financial businesses.

Many of what the Bank of England calls Large Complex Financial Institutions, which include some investment and universal banks, also operate internal hedge funds. The banks, of course, are watched over by regulators, although how effectively is another question.

A decade or more of global cheap money has coincided with dramatic technological and operational advances (if that’s the right word) in the way financial markets and the financial institutions using them behave. So, at a time when the world economy is precariously poised, and the question of who is the banks’ lender of last resort in our globalised financial markets too often opaque, the threats to world financial markets have increased.

The most authoritative judgement, from New York Federal Reserve President Tim Geithner, is that, while market innovation has dispersed risk, so increasing market resiliency to small financial shocks, "it may have increased the severity of large ones".

Under the so-called Lamfalussy process for shaping financial market regulation, the European Commission’s Directorate-General for the Internal Market is responsible for promoting co-ordination and co-operation among the EU’s regulators. So McCreevy is, albeit at one stage removed, a regulator himself. His bland opposition to greater controls on hedge funds suggests either that he has not taken on board this role, or that he is far less concerned about the way hedge funds are adding to market risk than some of the most respected financial experts in the world. That is quite a brave position in which to be.

• Stewart Fleming is a freelance journalist based in Brussels.

Next time Charlie McCreevy thinks of making a speech about why hedge funds don’t need more regulation he should look at a book published back in 2001, When Genius Failed: The rise and fall of Long Term Capital Management by Roger Lowenstein.

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