NEW YORK (HedgeWorld.com)--Excessive leverage by hedge funds could threaten the world financial system ? la the Long-Term Capital Management affair, but more regulation is not necessarily the right approach, said International Monetary Fund official Hung Q. Tran.
He was speaking last week at a panel organized by 100 Women in Hedge Funds and hosted by Reuters. What interests the IMF is the effect of hedge fund activities on global financial stability. From this perspective, hedge funds play a very constructive role overall, adding liquidity and risk capital and improving the efficiency of markets, he said.
He added that hedge funds' ability to generate returns with low correlation to major indexes improves diversification for many investors and hence complements financial markets.
But at the same time, hedge funds could exacerbate liquidity risk and increase credit risk for financial institutions, Mr. Tran said. However, he and his colleagues at IMF's International Capital Markets department, where he is director, consider certain developments since the 1998 LTCM debacle as more promising in containing this hazard than increased regulation would be.
In particular, prime brokerages and banks, which are not only involved with hedge funds as service providers and counterparties but also directly offer funds to their clients, have strengthened controls since then; for example, in doing due diligence and requiring collateral for loans.
"That is very welcome," said Mr. Tran. The danger he sees is a weakening of credit standards and dilution of controls as more banks get into prime brokerage.
Another safeguard is for institutional investors to exercise their fiduciary obligations and investigate hedge funds. They should raise questions about risks and keep everybody on their toes, Mr. Tran suggested.
His broad market-oriented perspective contrasted with the viewpoints of the other panelists at the event, who were more concerned with the details of regulatory compliance and the effects of regulation on funds and investors. The panel included U.S. Securities and Exchange Commission's Division of Investment Management Director Paul Roye, Managed Funds Association President Jack Gaine and Columbia University Law School Professor John Coffee.
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