Sunday, April 5, 2009

One potential option for hedge fund regulation

ZH has closely been covering and providing commentary on the publicly released details of Geithner's "New Rules of the Game"; a couple of posts by Rick Bookstaber (here and here) make a convincing case for the most effective way to limit future market risk. Basically, much of the criticism leveled against the risk management industry has typically been lazy accusations that risk managers still believe that markets follow a normal distribution/don't understand fat tail risk. Given that even college juniors looking for internships can recite Taleb in their sleep, it seems unlikely at this point that this is the major knowledge gap in our system. Rick goes on to point out that for more effective risk management, we need to get beyond the "hey, be careful, something may happen" mode of thinking, into something more actionable.

The proposal therefore is a central body that has access to all the exposures of banks, large funds and other systemically important players. By seeing the positions and correlations, this central body could hypothetically spot seemingly uncorrelated unwinds ahead of time and provide guidance on how to avoid it.

ZH thinks this is a great idea in theory but has reservations about practical implementation. Basically, the architect of this system is facing a trade off between asking for increasingly proprietary trade positions from banks and hedge funds, and the ability of the central body to pull out these correlations. Given that this central body is likely to be a federal agency, paying federal salaries and benefits, it's unlikely that they will be drawing the brightest minds who are capable of coming up with innovative ways to see correlation links between extremely disparate asset classes across disparate market players from limited trade information. The other option is to legislate mandatory position reporting that is much more detailed than hedge funds are even considering right now; basically, to make it easier for the not-as-smart-as-if-they-were-being-paid-more regulatory employees to see the linkages.

This could see some pretty drastic moves by hedge funds and even internal proprietary bank desks to do as much as possible to evade the reporting standards. The publicly stated reason of course would be that these super secret hedge funds do not want to divulge their highly proprietary and ridiculously complex trade strategies. The cynics among us might argue that they simply don't want to be unveiled as glorified vol sellers and/or leveraged mutual funds.

In summary, it seems reasonable that Geithner & Co. have something similar in mind to what Rick mentions as a way to improve regulation going forward but there are three options to consider:

1) Pay more to get smart people into these regulatory jobs and face the music as politicians moan about those overpaid regulatory guys.

2) Impose extremely high position reporting standards to make it easier to find the hidden correlations in our markets and watch the hedge fund industry duck and weave to avoid this.

3) Do neither 1 or 2 and hope and pray that next time we'll get lucky. Sphere: Related Content
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Anonymous said...

Hedge fund manager David Goldman thinks Larry's 5.2 million pay day ought be explained. Goldman thinks it may be in line with Larry raising 500 million of investments in DE Shaw funds, possibly in funds investing in CDOs and other mortgage backed securities. Goldman's sources say Summers was promoting CDOs to SWF's and foreign banks in Asia.

5U said...

hey zero hedge...this is pretty ridiculous, no?

this has to be the most ridiculous week and a half ever

check this out..A HOUSING ETF..

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