Hedge funds be warned: The Germans just keep coming. Last month, at a meeting of the Group of Seven finance ministers, Germany's Peer Steinbrück persuaded his fellow members to reexamine the risks hedge funds pose to the capital markets. The decision was a coup for Germany's political elite, whose distrust of the $1.4 trillion industry is profound -- Vice Chancellor Franz Müntefering's 2005 comment comparing British and American activist investors to "locusts" remains graven in the collective memory.
Although German Chancellor Angela Merkel has been less bombastic, she too has voiced concern. Before the G-7 meeting, in Essen, Germany, Merkel signaled that hedge fund regulation would be at the top of her agenda in 2007, the year the Group's presidency goes to Germany. Speaking at the World Economic Forum in Davos, Switzerland, Merkel declared: "We want to minimize the systemic risks in international capital markets and raise their transparency. Above all, I see the need to catch up with hedge funds." Never before has such a high-ranking politician taken aim at hedge funds.
The challenge of translating politics into thoughtful regulatory guidance will fall to the Financial Stability Forum, a broadly international committee that represents major market regulators, central banks and treasuries from a dozen countries. To many in the hedge fund industry, the FSF is by far the most reasonable place for the question of market risk to be assessed, not least because the group has undertaken the task before -- in the wake of the Asian currency crisis and the failure of Long-Term Capital Management in 1998.
Howard Davies, former chairman of the U.K.'s Financial Services Authority, headed the FSF's first working group on hedge funds, which was responsible for drafting the initial report on highly leveraged institutions in 2000. That seminal document will serve as the foundation for the FSF's renewed examination of hedge funds. But time is short: The finance ministers want an update before a May meeting scheduled as part of the run-up to the G-8 summit in Heiligendamm, Germany, in June.
This is not the first time the German government has clamored for increased regulation, says Davies, who is currently director of the London School of Economics and Political Science. He attributes the Germans' sense of regulatory entitlement to historical precedent: The Bundesbank has had a long-standing practice of tracking credit extended to market participants, but its register was designed to provide data on loans -- not the kind of complex financial instruments now in widespread use -- so it doesn't reflect true exposures. Even so, German regulators still yearn for that level of transparency.
What they fail to grasp, Davies says, is that requiring such disclosure is unworkable, if not downright anticompetitive, in the context of modern financial markets. "Obviously, we would all love to have our counterparties' positions disclosed to us. That would be nice," Davies says. "But normally, you can't require wealthy investors to disclose their positions unless they hit certain equity ownership thresholds that are already in place to protect the markets.
"If what you really want is to constrain hedge funds' leverage, the best answer is to constrain the leverage they receive from their providers, namely the banks," Davies adds.
But the Germans are nothing if not tenacious -- so much so that high-ranking market regulators in the U.S., the U.K. and the European Union are pushing back. After the G-7 meeting, EU internal market commissioner Charlie McCreevy, U.S. Treasury Secretary Hank Paulson and U.S. Federal Reserve chairman Ben Bernanke have all been quoted as discouraging purely reactive hedge fund regulation. Moreover, a high-level U.S. policy group, the President's Working Group on Financial Markets, led by Paulson, recently endorsed the current hands-off approach, arguing that the financial system is best served by a principles-based approach focused on adequate disclosure of risk.
Pointing to various rules and regulations that already touch hedge funds, McCreevy says bluntly that in Europe there is no pressing need to take action. He notes, however, that "the fear of LTCM lingers on, and banking regulators are afraid of something like that happening again. Remember, it's the job of banking regulators to worry. But you have to base your worry on some facts before you rush off to do something to try and kill off this business, which has really been very innovative and created great liquidity."
Still, no one can dispute that hedge funds are larger and more powerful than ever -- and, as Davies says, the question of systemic risk in the event of a market shock or major default cannot be dismissed. Hedge fund executives certainly don't dismiss it; none of them wants a catastrophic failure.
Gay Huey Evans, a former director of markets at the FSA and president of Citigroup's hedge fund platform in London, Tribeca Global Management (Europe), believes U.K. and U.S. regulators are doing exactly the right thing by monitoring regulated entities such as banks more closely. Now they just need to hone their communication skills. "The FSA already collects an immense amount of information from prime brokers, and the SEC has started collecting more too," she says. "If they see something that worries them, the onus should be on them to share their concerns with the other major jurisdictions."
With Germany holding the G-8 presidency this year, however, political pressure is unlikely to abate in the months ahead. What remains to be seen is whether hedge fund managers are as adept at navigating political risks as they are the risks inherent in their own portfolios.