THE TROUBLE WITH

HEDGE FUNDS

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Adam Eannes York Universi@

Harm-: The ‘Itoable with Hedge Funds

ABSTRACT

This article examines the impact of hedge funds on the workings of international financial markets and their implications for public policy. In contrast to the neoclassical view of hedgefunds, which views them as being ‘too-small-to-matter ’, this article argues that the activities of hedge funds are signifcant for policymakers because of their ability to become extensively overleveraged and to act as market leaders. I consider the role played by hedge fufirndr in financial crises, market volatility, market manipulation and systemic risk. The article concludes with a critical review of recentproposals for dealing with the public policy issues raised by hedge funds.

ith the recent near-coltapse of Long Term Capital W Management LP (LTCM), governments have once again begun to target their regulatory gaze upon the secretive activities of hedge funds. When hedge funds lose money, they can pose a threat to the stability of the banks and securities f m s who finance their activities as well as to that of the global financial system as a whole. Had the U.S. Federal Reserve failed to organize a bail- out for LTCM, the results could have been disastrous with a ‘fire- sale’ of billions of dollars worth of securities causing havoc on already fragile world markets.

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Of greatest concern is ,the ability of hedge funds to make massive, high-risk bets with borrowed money and the inability of lenders and regulators to assess the risks to which the funds - and indirectly themselves - are exposed. Given this concern, there has been a renewed impetus to force greater disclosure and prudential requirements upon the banks and securities firms that lend to hedge funds. The argument of this article is that, while such measures may help to limit the damage caused by hedge funds which fall victim to unpredictable market turmoil, they will fail to deal with the way that these funds help to cause financial turmoil in the first place. More precisely, hedge funds may be causing more trouble when they are making money than when they are losing it and, as a result, that more direct regulation of hedge fund activities may also be necessary.

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WHAT ARE HEDGE FUNDS?

While there is no legal or universally accepted definition of a hedge fund, they can be regarded most simply as an unregulated form of mutual fund which caters exclusively to wealthy individuals and institutions and which makes use of alternative investment strategies and instruments. By structuring themselves as unregistered private offerings or chartering themselves offshore, hedge funds are exempt from many of the reporting requirements that apply to other institutional investors and, therefore, obtaining precise information about the industry is difficult. As a result, this article relies heavily on media reports, research by the international financial institutions and synthetic analysis in examining their activities. Given the dearth of information available on hedge funds and the resulting methodological limitations, my arguments should be regarded as suggestive rather than conclusive.

As of mid-1998, estimates place the size of the hedge fund industry at between 2500 and 3500 funds managing somewhere between $200 to $300 billion in investment capital with some of the largest funds (known as macro hedge funds1) controlling up to $6 billion in assets under management (Sachs, 1999; Eichengreen and Mathieson, 1998).* While these assets are significant, the neoclassical view tends to hold that hedge funds, for the most part, are ‘too-small-to-matter’ in terms of public policy. As Stephen A. Lonsdorf, President of Van Hedge Fund Advisors argues, the assets controlled by hedge funds “are not a significant amount of capital when compared to the level of capital in the global financial markets” (1998, p. 296). Also important, according to the International Monetary Fund, is the fact that these assets “pale in comparison with the capital of other institutional investors such as pension funds, mutual funds, insurance companies, and investment and commercial banks, which, in the mature markets alone, exceeds $20 trillion” (IMF, 1998:4).

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At the same time, to the extent that hedge funds do matter, the neoclassical view tends to perceive their growth as a positive development. Specifically, because hedge fund managers are compensated on the basis of absolute performance (i.e. a percentage of returns) rather than on the basis of relative performance (i.e. in relation to the median fund and to their net assets), and because their funds are composed of wealthy and risk-tolerant individuals and institutions, hedge funds are better positioned to act as contrarian investors making markets more liquid and efficient. As The Economist observes, “[mlany [hedge funds] see themselves not as speculators at all but as arbitragers. That means they are looking for assets whose prices are temporarily out of line with their fundamental values, selling those they deem expensive or buying any they think cheap. By doing this, in principle, the hedge funds can help to make markets more efficient” (1998).

LTCM AND THE SYSTEMIC RISKS POSED BY HEDGE FUNDS

The first problem with the ‘too-small-to-matter’ view of hedge funds relates to their use of leverage (the amount of money they are able to borrow against their existing capital). Unlike other institutional investors, hedge funds are set up as either limited partnerships of less than 100 investors or they are chartered offshore. In either case, they are not subject to the U.S. Investment Company Act of 1940 which imposes leveraging restrictions on investment companies. As a result, hedge funds are able to borrow up to twenty times their capital from commercial and investment banks in order to take highly leveraged positions. They are also able achieve leveraging through the use of derivatives which allows these funds to purchase an asset without paying its full cost up front. Taken together, this means that hedge funds are able to take much larger positions than would be warranted by their capitalization.

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Long Term Capital Management LP is a hedge fund that was formed in 1994. The investment strategy of LTCM was to identify temporary price discrepancies between different interest rates (known as fixed-income arbitrage) through the use of sophisticated mathematical models and to profit from these discrepancies through extensive leveraging. Until its near-collapse in 1998, this strategy proved to be immensely successful, generating returns of over 40 per cent in 1995 and 1996 (and slightly less in 1997). In 1998, LTCM had taken on even larger and more leveraged positions to the extent that it was estimated to have leveraged approximately $4.7 billion of its own capital into almost $1.3 trillion in nominal investment positions. LTCM’s problems began on 17 August 1998 when - in the context of growing investor uncertainty in the wake of the East Asian crisis - the Russian government announced an effective devaluation of the ruble and declared a debt moratorium. As panic began to spread among investors, equity and debt markets became increasingly volatile and credit spreads started to abruptly widen. For LTCM, which had bet heavily on a narrowing of credit spreads, losses grew rapidly and on 2 September the partners reported losses of 52 per cent. As lenders began to call in their markers, LTCM attempted to raise money by liquidating its positions. The problem was that, with such large positions, it was difficult to sell without sharply driving down prices and, thus, LTCM had difficulty in raising the capital it needed.

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It was at this point that the Federal Reserve stepped in and arranged a bailout by fourteen commercial and investment banks totaling approximately $3.5 billion. The reason for the Fed’s intervention was that LTCM was so extensively over-leveraged that it posed a threat to the financial system as a whole. As William McDonough, President of the Federal Reserve Bank of New York, notes:

Had Long-Term Capital been suddenly put into default, its counterparties would have immediately ‘closed-out’ their positions ...[ and] ... if many firms had rushed to close out hundreds of billions of dollars in transactions simultaneously, they would have been unable to liquidate collateral or establish offsetting positions at

Harms: The Wuble with Hedge Funds

previously existing prices. Markets would have moved sharply and losses would have been exaggerated. Several billions of dollars of losses might have been experienced by some of Long Term Capital’s more than 75 counterparties (1998: 18-19).

Moreover, just as a fire-sale of securities had the potential to cause failures among some of LTCM’s counterparties, so too could it have hurt other investors as well as corporate and household borrowers in that a panic may have led to increases in the cost of capital. Therefore, rather than being ‘too-small-to-matter’, LTCM was leveraged to the extent that it became ‘too-big-to-fail’.

THE MARKET LEADERSHIP ROLE OF HEDGE FUNDS

The second problem with the ‘too-small-to-matter ’ view relates to the increase in herd behavior within the financial markets and to the ability of hedge funds to act as markets’ leaders. In terms of the former, the growing power of hedge funds owes much to the rise of large institutional investors - such as mutual funds and pension funds - and to the way that they are serving increase the collective or herd nature of the capital allocation pro~ess .~ In theory, mutual funds and pension funds - which are characterized by professional management and long-term liabilities - are supposed to make financial markets more rational and efficient. As Thomas A. Hockin, President and CEO of the Investment Funds Institute of Canada argues, mutual funds and pension funds “are based on long-term commitments ... It is not ‘hot money’, volatile and fickle” (1998: 142).

In practice, however, investment funds have a number of characteristics that lead to trend-chasing behavior and the quest for short-term profits. Chief among these characteristics is the growing competition within the money management industry and the pressures upon fund managers to attract and retain customers by ensuring that their funds perform strongly in the short term. As a 1994 report by the International Monetary Fund notes, “mutual funds need to meet performance standards over a very

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short time horizon, and open-ended funds face the risk of sizeable net redemptions if their quarterly performance lags behind the competition” (1 994: 18).

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Also, within the funds themselves, these competitive pressures have become formalized in institutional structures which, in turn, reinforce a short-term and herd mentality among managers. Important in the former case is the fact that the performance of most fund managers is evaluated on a quarterly or annual basis and that many are employed under very short- term contracts. Important in the latter case is that most fund managers are evaluated and paid in relation to the performance of their peers (known as ‘relative performance’). As a 1997 report by the World Bank demonstrates, this leads to trend-chasing behavior because “fund managers will follow the investment decisions of other fund managers in order to show clients that they know what they are doing. If they follow other fund managers’ decisions and the investment turns out to be unprofitable, they are more likely to be thought of as unlucky than as unskilled, since other fund managers will have made the same mistake” (p. 126).

Also relevant to the tendency of fund managers to chase trends are the costs and difficulties associated with the collection and analysis of fundamental information. As a result, “observing the choices of others is often a cheap and helpful alternative” to analyzing economic fundamentals (Hirshleifer and Welch cited in Economist, 1994b:ll). Given this fact, many fund managers will often allocate capital in response to, what Shleifer and Summers (1990) term, ‘pseudo-signals’. Pseudo-signals are any source of information, other than fundamentals, that investors believe will convey information about future returns. Prominent here is the tendency of some managers to either follow markets gurus (who are perceived as having better information about relevant fundamentals) or to buy and sell assets on the basis of price movements. In terms of the latter, one investment strategy which reinforces collective behavior is the use of technical

Harmem TheTroublewithHedgepllnds

analysis. Simply put, “[t]echnical analysis typically calls for buying more stocks when stocks have risen (broke through a barrier) and selling stocks when they fall through a floor” (Shleifer and Summers, 1990:24). In other words, fund managers will buy and sell securities on the basis of aggregate demand shih without assessing whether or not they are in response to shifts in fundamentals.

Within the context of this trend-chasing behavior, one way that macro hedge funds act as market leaders stems from their ability to unilaterally move asset prices. Through a combination of leverage and directional (rather than diversified) investing, hedge funds can often single-handedly influence the movement of an asset’s price. Combined with the extensive use of technical analysis among institutional investors, these price movements can lead to a similar response by other investors in a manner that invokes significant herd behavior. As the manager of ECU Fund Management, Michael Petley, notes, “[i]f a market is rammed hard enough by hedge funds at strategic technical levels, a ‘domino’ effect may occur in which a predetermined series of stop-loss orders4 will carry the market further and further down quickly precipitating those fund managers who are [leveraged] up in a market moving quickly against them, to run for cover, irrespective of any arguments about ‘fundamentals”’ (cited in Kelly, 1995:221).

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In addition to their ability to unilaterally move asset prices, macro hedge funds are also able to lead markets because of the normative authority which they possess. As Rosemary Bennett and David Shirreff note, “[tlhe attention paid by investors and traders to the activities of hedge funds does ...magnifl their impact on the markets” (1 994:30). For example, in 1993, George Soros - the now famows manager of one of the largest macro hedge funds, Quantum Fund - purchased between two and three million ounces of gold at $345 per m c e as well as ten million shares in Newmont Mining. When Soros’ purchases became known, and with no change in umbrlying economic funhmtals, speculation

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increased markedly when the price of gold rose to over $350 an ounce. Pointing to this example of normative authority, The Economist noted that “[hlis reputation as the ‘man who broke the Bank of England’ [discussed below] has put Mr. Soros in the position that all gurus aspire to; his prophecies are now self- fulfilling” (1 993c, p. 2 1).

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Much like central banks, macro hedge funds exercise normative authority because they are perceived as having stronger analytical capabilities and better access to information about relevant economic fundamental^.^ As one anonymous foreign exchange trader observed, “[hledge fund managers undoubtedly have good political sources’’ (cited in Bennett and Shirreff, 1994: 30) and these sources, in turn, may result from their superior

access to networks of elite interaction. That many hedge fund managers have become elites is illustrated by Fortune magazine’s 1994 listing of the richest people in the United States. Of the top ten listed, six were managers of hedge funds (cited in Bennett and Shirreff, 1994:32). The normative authority of hedge funds also stems from their higher tolerance for risky investments. This is the case as these funds, due to their need to limit their numbers to under one hundred partners, have minimum investment requirements ranging from $250 000 to $10 million and are, thus, composed of wealthy and risk-tolerant individuals and institutions. Due to this higher tolerance for risk, “[hledge funds, for example, were amongst the first to venture into emerging markets. Their success made these markets respectable for mutual funds and pension funds” (Economist, 1994a: 18).

HEDGE FUNDS, VOLATILITY AND FINANCIAL CRISES

As the LTCM incident illustrates, the ability of hedge funds to become extensively over-leveraged means that they can be large enough to cause trouble when losing money. At the same time, when this leverage is combined with their ability to act as market leaders, it means that hedge funds can also be large enough to cause trouble when making money. Important here has been the

Hacmes: The lhouble with Hedge Funds

seemingly growing impact of hedge funds on price volatility. For example, prior to 1994, the trading of oil futures contracts on the New York Mercantile Exchange was done primarily by industry participants as a way of managing risk. Since that time, according to George Yates, chairman of the Independent Petroleum Association of America, “we’re seeing more and more hedge funds buying crude oil futures contracts” to the extent that they now represent approximately 10 per cent of the market (Perin, 1998). The ability of hedge funds to purchase crude oil futures for as little as $2 per barrel has introduced a high degree of speculation into the market which, in turn, has increased price volatility. As the Houston Business Journal notes, “[olver the last two years virtually every time the large speculators - primarily

. hedge funds - have held ‘long’ market positions, the price of oil has gone up, and whenqver they have held ‘short’ positions, the price has gone down” @erin, 1998). Given that the hedge funds seem to be basing their trades on isolated pieces of information, such as weekly oil inventories which are only one of many relevant fundamentals, the efficiency of the market seems to be in decline as prices are increasingly volatile and often do not reflect underlying economic fundamentals. Commenting on this trend, Houston oil analyst Matt Simmons notes that the “fact that the price makes no economic sense does not seem to matter-and it is destroying the industry” (Perin, 1998).

In a similar fashion, hedge funds have also been accused by officials at the London Metals Exchange (LME) of increasing volatility in the price of metals. David Humphreys, chief economist at Rio Trinto, the world’s largest mining group, argues that “[wlith $120 billion under management compared with the combined value of LME warehouse stocks of less than $2 billion, it is clear that these funds have more than enough muscle to move metals prices substantially” (Solman and Gooding, 1998). In fact, short selling (selling an instrument you do not own in the hope that its price will fall) by hedge funds was viewed as one of the key factors accounting for the price fall of aluminum, copper, nickel and other base metals in the summer of 1998; to the extent

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that prices reached their lowest levels for several years. By increasing price volatility in the markets for commodities, hedge funds do seem to be having a negative impact on market efficiency.

While increased price volatility is an unintended result of hedge fund activities, their role in provoking speculative attacks against currencies may be much more deliberate. In ‘first- generation’ models of speculative attacks against pegged currencies, it is assumed that speculators (large or small) will attack a currency when economic fundamentals (such as balance of payments deficits and the depletion of foreign exchange reserves) indicate that a peg is becoming unsustainable.6 In this situation, a speculative attack (and potential collapse of the currency) is perfectly foreseen because it is rooted in unsustainable economic fundamentals. In ‘second-generation’ models, an attempt is made to explain speculative attacks on pegged currencies that are not foreseen; that is, to explain attacks that are not made inevitable by economic fundamental^.^ 166

Important in these models is the role played by large traders and their ability to attack an otherwise sustainable currency peg. In situations where there is some uncertainty about the future of a government’s exchange rate policies, large traders can attempt to provoke a devaluation by selling the currency. Selling the currency in significant amounts can force the central bank to defend the currency by raising interest rates which, in turn, increases the domestic political costs (in terms of rising unemployment and slower growth) of maintaining the peg. Therefore, as Eichengreen and Mathieson note, “[wlhereas in first- generation models currency traders simply anticipate the abandonment of a currency peg made inevitable by imbalances in the underlying fundamentals, in second-generation models they actually provoke the change in fundamentals that makes their speculative attacks profitable” (1998:24). In this way, large traders such as hedge funds may have the ability to ‘create’ currency crises in conditions of uncertainty.

Harm-: The Trouble with Hedge Funds

Possibly the most notable example of this process occurred in the summer of 1992 during the European Exchange Rate Mechanism ( E M ) crisis. Prior to the crisis, George Soros held the view that there were problems in the E M and that the British pound was vulnerable. Backing this view to a leveraged tune of $10 billion, Soros’ Quantum Fund began to sell sterling short in massive quantities. Combined with similar actions by other hedge funds, “Soros’s sales of sterling provided the momentum that put the pound into an uncontrollable spin” (Lycett, 1993, p. 36). Significant here was the way that Soros’ move served as a signal for institutional investors to also begin dumping sterling. In response, the Bank of England spent over $15 billion in foreign exchange reserves and hiked interest rates from 10 to 15 per cent in an attempt to defend the currency. While significant, these efforts were overwhelmed by institutional investors unwinding their positions in sterling and sterling-denominated assets. Echoing this point, the IMF notes that, “[wlhile hedge funds acted as market leaders, the real financial muscle was provided by institutional investors” (1993, p. 11). At the end of the day (16 September, now dubbed ‘black Wednesday’), Britain was forced to leave the ERM and George Soros became a household name for reportedly making over $1 billion on his leveraged bets.*

More recently, in the context of the devaluation of the Thai baht and the subsequent contagion to other East Asian currencies, Prime Minister Mahathir of Malaysia has charged hedge funds in general, and George Soros in particular, with responsibility for the crisis. Challenging this somewhat conspiratorial view is a recent study by Brown, Goetzmann and Park (1 998) which focuses on the fact that the ten largest funds which they studied did not have large exposures to Malaysia’s ringgit and that Soros’ funds only broke even in the afiermath of the Thai devaluation. While this study absolves hedge funds of any direct role in the case of Malaysia, it does not adequately deal with the Thai devaluation which, in any case, triggered the contagion that eventually hit the ringgit. In fact, research by the IMF found that two of the most prominent hedge funds did make

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decent returns of around 10 per cent speculating against the baht. Therefore, the next question to be asked is whether or not hedge funds played any decisive role in the speculative attack against Thailand.

One reason to suspect that the speculative attack on Thailand may conform to ‘second-generation’ model explanations is the fact that the crisis was not perfectly foreseen. While key economic and financial indicators showed a vulnerability to crisis, they did not indicate that a crisis was inevitable. As Steven Radlet and Jeffrey Sachs argue, “we can identify conditions of vulnerability, and the need for modest adjustments, but we can not predict the actual onset of crisis, since the crisis requires a triggering event that leads short-term creditors to expect the flight of other short-term creditors” (1998:8). For the IMF, hedge funds were not the triggering event because “[a]lthough they apparently sold some long-dated forward contracts on the baht in February 1997, the bulk of hedge funds’ forward sales to the Bank of Thailand appears to have occurred only in May at the tail end of the process.

If herd behavior contributed to the crisis, then the hedge funds were at the rear, not the fi-ont of the herd” (Eichengreen and Mathieson, 1998: 18). However, this view seems to be at odds with recent statements made by Soros who notes that “it must be admitted that hedge funds like mine did play a role in the Asian currency turmoil. Because hedge funds tend to be more concerned with absolute rather than relative performance, they are more likely to be actively involved in precipitating a change in a trend ... For instance, by selling the Thai baht short in January 1997, the Quantum Funds managed by my investment company sent a signal that it may be overvalued” (1998:142). Overall, while it does seem unlikely that hedge funds played as decisive a role in Thailand as they did in the case of the ERM, there does seem to be enough conflicting evidence to warrant further study.

Harm-: The ’houble with Hedge Funds

HEDGE FUNDS AND MARKET MANIPULATION

As noted earlier, the neo-classical view argues that, because of their higher tolerance for risk, hedge funds are better positioned to act as contrarian investors and should, therefore, make markets more liquid and efficient. At times, this may be true. At other times, however, their ability to act as market leaders gives hedge funds an increased incentive to manipulate, rather than to arbitrage against, other trend-chasing investors. At least in terms of potential, macro hedge funds would appear to have the ability to deliberately manipulate markets for their own economic benefit. Noting this potential, the IMF argues that “[wlith greater concentration of wealth in the hands of professional fund managers, financial markets must cope with the effects of the attendant increase in the market power of market participants. Chief among these effects is the increased likelihood of market manipulation and even less efficient markets” (1 995: 167).

Through a strategy known as ‘pumping up the tulips’ (Train, 1989), a hedge fund manager could benefit from market manipulation in three ways. First, through a highly leveraged purchase of an asset, the manager could unilaterally push up the asset’s price and, thus, attract institutional investors making use of technical analysis. As these investors purchase the asset, its price rises further still and attracts even more technical and trend- chasing investors. Second, to reinforce the price movement with normative authority, the manager could signal the market by simply leaking out information of their purchase. Finally, when the asset price has risen sufficiently, the fund manager simply sells the asset at the higher price and realizes the profit, all without any changes in the economic fundamentals. (This can also work in reverse through the use of short selling; that is, by profiting from pushing an asset’s price down.)

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One prominent manager who is widely reported to make use of this strategy is Jeffrey Viik; the former manager of Fidelity Investments’ largest mutual fund- the Magellan fund-and who

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now manages his own hedge fund, Vinik Asset Management LP. As Business Week magazine reported, “[alt Magellan, Vinik had a reputation of building up a large position in a stock, which pushed up the price. When the action attracted other investors, he would quickly unload his position” (Sparks, 1997:98). As a hedge fund manager, Vinik has apparently reinforced this strategy through the use of normative authority; that is, he often takes a position of more than 5 per cent in a company’s outstanding stock which requires him to publicly disclose the move through a 13D filing with the U.S Securities and Exchange Commission. In July, 1997, for example, Vinik began purchasing shares in a company called Vivus. On September 15th, he disclosed a 7.2 per cent stake when the stock was trading at $26 and “[iln less than two weeks, with no other news, Vivus soared to [$]38” (Sparks, 1997:98).

In a similar fashion to Vinik, Soros also seems to have employed this strategy but on a much larger scale. In April of

7Q 1993, when Soros publicly announced his positions in Newmont Mining and gold, The Economist remarked that his public announcement was “[nlot a bad ploy: the price of gold began to soar.. .presumably increasing the value of his investment’’ (1993a:66). Of possibly greater significance-in terms of the power of hedge funds-is the reportedly real target of Soros’ attempt at manipulating gold prices. As The Economist speculated at the time:

There is a persistent rumor that Mr. Soros’ real interest in all this is not gold at all, but the bond markets. Suppose that he recently sold bonds short (i.e. promised to deliver in future bonds which he did not then own) when [bond] prices were at their peak. Now that [bond] prices have fallen, as gold prices roseg, he stands to make a pretty profit. The trillions of dollars in the bond markets have been jostled by a few judiciously placed millions in gold (1993b93).

Important to note here, therefore, is the way that a single hedge fund manager-through his market leadership role and clever tactics-may have been able to manipulate the incredibly large international bond market.

Harmes: The ’Ikouble with Hedge Fun&

In terms of large national markets, hedge funds also seem to have been involved in attempts at market manipulation in the wake of the 1997-98 Asian financial crisis. Reporting in Fortune magazine, MIT economist Paul Krugman notes that “a cabal of hedge funds apparently did try a squeeze play on Hong Kong’s currency and stock market” (Krugman, 1998a). In August of 1998, Hong Kong began to make massive stock purchases in order to support falling prices. Finance officials claimed that they were fighting a deliberate conspiracy designed to instigate, and profit from, panicked selling conditions. More precisely, it appears that hedge funds sought to short the stock market after attacking the Hong Kong dollar in the expectation that the resulting increase in interest rates would drive down share prices (Luce, 1998). In a widely-circulated letter, Finance Secretary Donald Tsang stated that “[rlegular patterns [of currency sales] suggested a co- ordinated manipulative play involving very large funds” which were rumored to include George Soros’ Quantum Fund and Julian Robertson’s Tiger Fund (cited in Krugman, 1998a). Moreover, Tsang implicitly accused the hedge fund managers of spreading rumors in the media about the imminent devaluation of the Chinese renminbi and the de-linking of the Hong Kong dollar in order to reinforce the impact of their short positions.

A similar strategy also seems to have been under way when the currencies ofAustralia, New Zealand and Canada came under heavy downward pressure in the summer of 1998. In the wake of the Asian financial crisis, Australia and Canada managed to weather the pressure on their currencies through policies of benign neglect toward their exchange rates. In the Australian case, financial markets viewed the decline as a short-term buying opportunity rather than as an indicator of future trends and, as a result, the currency initially stabilized itself. In late August, however, the Australian dollar came to the verge of a free fall as it reached a low of 56 cents to the U.S. dollar. As Krugman demonstrates, “a lot of the plunge had to do with hedge funds shorting the currency” and that “some people from the hedge funds actually told the Australians, in effect, that resistance was

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futile-that they were only a small piece of a coordinated play against Australia, New Zealand, South Afiica, and Canada-not to mention Hong Kong, Japan, and China” (Krugman, 1998b).

CONCLUSION: ISSUES FOR POLICYMAKERS

Identifying hedge funds as an important source of market turmoil is not to scapegoat or vilifj them as is the fashion among some East Asian leaders. Instead, it is to simply recognize ajunction at which governments might improve the efficiency and legitimacy of markets through regulation. At present, studies are being conducted, with an eye to potential regulation, by the President’s Working Group on Financial Markets, the Basle Committee on Banking Supervision and the International Organization of Securities Commissions. All three are emphasizing the need to improve transparency as well as deal with excessive leverage through both constraints on lending and improvements in risk management practices.

However, reflecting the concerns with systemic risk arising out of the LTCM incident, these studies seem to be focusing primarily upon lenders and not upon the hedge funds themselves. Consequently, many of the measures being discussed may not be sufficient in terms of dealing with the full range of public policy issues that emerge from hedge fund activities. For example, making lenders’ exposures to hedge funds more transparent is useful for dealing with issues of systemic risk but it does little to shed light on the activities of hedge fund themselves. Such transparency is necessary because, while there does seem to be enough anecdotal evidence to indicate a relationship between hedge funds and volatility, financial crises and instances of market manipulation, these are all difficult to ‘prove’ due to the dearth of information available. Useful here, therefore, would be measures identified (but not recommended) by the IMF which involve making existing U.S. reporting requirements on large trades and positions more comprehensive and, at the same time, expanding their use to other countries (Eichengreen and Mathieson, 1998).

Harm-: The ‘hmble with Hedge Funds

A second problem with the current focus on lenders relates to preventing the excessive use of leverage. Recent statements by members of the President’s Working Group seem to indicate a preference for constmining lending by domestic institutions rather than borrowing by hedge funds and for achieving these constraints through voluntary arrangements and a reliance upon ‘market discipline’ (which has increased somewhat in the aftermath of the LTCM incident).l0 The problem with voluntary and market discipline-based measures - and, thus, with the seeming focus of the current proposals - is that they will likely be insufficient. As the Wall Street Journal reports: “several bankers conceded that once the current crisis passes, it will take only one bank offering special breaks to hedge funds to begin the cycle all over again - that is, unless stricter regulation is imposed” (Pacelle, 1998). Therefore, if regulators are to focus on lenders alone, it may be necessary to legislate - rather than recommend - prudence by imposing increased margin and collateral requirements upon

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While regulating lenders, instead of relying upon market discipline, would be a more effective mechanism for preventing instances of excessive over-leverage (of the 28 to 1, LTCM variety) and systemic risk, it may not be sufficient to prevent instances of manipulation and destabilizing speculation. This is the case in that many of the problems caused by hedge funds have been based on leverage of only four to seven times combined with their ability to act as market leaders. As a result, if manipulation and destabilizing speculation by hedge funds is to be prevented, it may be necessary to regulate their specific activities more directly. For example, one option is to make hedge funds subject to some of the same regulations, relating to leverage and derivatives use, that currently apply to other institutional investors. As George Soros himself has recently argued, “hedge funds should be regulated like all other investment funds” (1998:192). In terms of dealing with issues of volatility and manipulation directly, it is possible for domestic exchanges to impose penal margin requirements on institutions which misuse

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large positions. The London Metals Exchange, for example, currently has these type of penalties for the misuse of dominant long positions and has been exploring the possibility of creating similar measures for dealing with short-selling. l1 Also useful here would be outright restrictions on short-selling (as Hong Kong imposed to deal with the speculative attacks noted earlier).

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A final area for regulatory consideration stems from the potential for hedge funds to avoid the domestic regulations of the United States and for the lack of many types of regulations applying to national markets. In the former case, imposing effective regulations on hedge fund activities will, generally, require multilateral action. As Soros notes, hedge funds “are difficult to regulate because many of them operate offshore, but if the regulatory authorities cooperate, this should not present any insuperable difficulties” (1 998: 192). Multilateral cooperation is also necessary to develop broader regulations that protect national markets from both manipulation and volatility. For example, as Krugman notes, “[ilf someone sold stocks in a U.S. company short, then spread rumors about problems with its products and feuds among its managers, he would soon face criminal prosecution. As far as anyone can tell, it is perfectly legal to sell a country short, then spread damaging rumors about its future policies” (1 998a). Protection for whole economies and markets has previously been viewed as unnecessary because, in contrast to individual assets such as stocks, they were perceived as being too large to manipulate. However, as this article has attempted to demonstrate, the rise of hedge funds and their ability to act as market leaders means that this may no longer be the case.

NOTE: An earlier version of this article was presented at the 7th Annual Conference of the York Centre for International and Security Studies, York Universi& Toronto, 30 September, 1999. I would like to thank Stephen Gill and Eric Helleiner for their comments as well as two anonymous reviewers.

Harm-: The lkoable with Hedge Funds

ENDNOTES

I . The term ‘macro’ refers to an investment strategy and not to the size of the funds. However, virtually all of the largest hedge funds employ a macro strategy. A ‘macro’ strategy seeks to profit from shifts in macroeconomic variables such as interest rates as opposed to profiting from individual stock movements and other more ‘micro’ shifts in fundamentals.

2. Figures on the hedge fund industry vary depending on whether ‘futures funds’ and ‘funds of funds’ are included in the estimate. The estimates above include these types of funds. For more details on the size and structure of the industry, see Eichengreen et al, 1998.

3. For a more detailed discussion of institutional investors and the collective allocation of capital, see Harmes, 1998.

4. A ‘stop-loss’ order is essentially is a computerized version of technical analysis which automatically sells an asset if its price drops below a predetermined floor.

5. Noting the similarity between the normative authority exercised by macro hedge funds and that exercised by central banks, The Economist remarked that George Soros’ “views have attracted at least as much attention as the head of the Bundesbank” (1 993% p. 66).

6. On ‘first-generation’ models of speculative attacks on pegged currencies, see Krugman, 1979; Flood and Garber, 1984a.

7. On ‘second-generation’ models of speculative attacks on pegged currencies, see Flood and Garber, 1984b; Obstfeld, 1986.

8. While many commentators have argued that Soros’ sales of sterling simply brought forward an inevitable devaluation and, thus, that the ERM crisis is best explained by ‘first-generation’ speculative attack models, “[tlhere are reasons” as Barry Eichengreen argues “to think that models of self-fulfilling crises [i.e. ‘second-generation, models] are applicable to the ERM” (1 996, p. 180). Most important here is the fact that-in terms of fundamentals-a devaluation was possible rather than probable and that, in the absence of the speculative attack initiated by Soros, the pound may have been able to remain in the ERM. For a full discussion of the ERM episode and the ‘second- generation’ model explanation, see Eichengreen and Wyplosz, 1993; Rose and Svensson, 1994; Obstfeld, 1996.

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". Gold prices are often seen as an indicator of inflation and tend to move, inversely, in conjunction with bond prices which also reflect expectations of inflation. By manipulating the price of gold, Soros was also able to push down bond prices.

I". See, for example, McDonough, 1999.

'I. For example, the LME suggested that penal margins of up to 150 per cent of the initial contract value might be imposed and on which no interest would be paid.

ABOUT THE AUTHOR

Adam Harmes is a doctoral candidate in the Depurtment of Political Science (it York University, Toronto and a researcher in the York Centre.for International und Security Studies.

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