Outlook: Now there's a thing; FSA makes hedge funds a special case

You can almost hear the collective sigh of relief emanating this morning from London's Mayfair, preferred home to Britain's burgeoning army of hedge fund managers. The Financial Services Authority has been examining the case for a regulatory crackdown on these modern-day speculators but, perhaps surprisingly, has decided to do virtually nothing about them.

The FSA sees no case for curtailing the practice of short-selling, a key ingredient in most hedge fund investment strategies; no case for greater regulatory supervision of their activities; and little case even for improved standards of transparency so as to open them up to public scrutiny. Indeed the discussion document published yesterday bends over backwards to encourage their proliferation by suggesting all manner of ways in which the market for hedge funds might safely be opened up to retail investors.

Since George Soros's infamous attack on the pound, hedge fund managers have tended to be demonised by left-leaning politicians and commentators as shadowy alchemists, stealing from hapless central bankers and innocent savers further to enrich their already super-rich backers. With the bear market has come the allegation that they have made matters much worse through heavy short-selling of technology, telecommunications and media stocks.

The FSA refuses to support this view. In truth, hedge funds perform a positive service to markets by providing them with extra liquidity, the FSA says.

Few would have expected a super regulator intent on getting its tentacles into all aspects of the financial markets to adopt such a grown-up stance. Hedge fund activity is one of the fastest-growing areas of securities trading and investment, and it would ill become the FSA to drive it offshore by making it impossible for managers to operate effectively from London. Even so, the FSA is perhaps being a little too sanguine about it all.

Most hedge fund managers operate out of the world's leading financial centres – London, New York and Hong Kong – but their funds tend to be domiciled for reasons of tax and secrecy in offshore havens. As a consequence, many of them are unauthorised by regulators in the countries they are managed from. For investor protection purposes, this doesn't matter most of the time. The sort of people who invest in hedge funds are generally rich and sophisticated enough not to need protection from unscrupulous operators.

In some cases, the managers regularly dip their hands into the fund's profits in a manner which would be regarded as criminal in any onshore, authorised investment business, but so long as the fund is producing a decent return, nobody much complains. Investors know the risks, and if they end up losing their shirts, they only have themselves to blame. The rich can look after their own affairs. There's no case for regulatory interference.

There may, however, be a case for greater oversight of the trading strategies operated by hedge funds, some of which are beginning seriously to undermine public trust in markets. In 1998, the collapse of Long Term Capital Management nearly brought financial markets to a grinding halt. This relatively small fund, advised by two Nobel prize-winning economists no less, became like a doomsday machine at the heart of the financial system. Eventually the Federal Reserve had to arrange for a posse of the world's leading investment banks to be sent in to turn it off.

Nothing quite as serious as that has happened since, but there is no doubt that the meddlesome activities of hedge funds and their like are capable of real systemic damage. Countries whose currencies have been subjected to the relentless selling pressure of hedge funds and other speculators have good reason to feel aggrieved. Mr Soros has described the capital markets in full flight as like a wrecking ball, casually and unthinkingly imposing economic ruin and deprivation on countless millions. On a more localised level, many chief executives believe the short-selling activities of hedge funds are doing substantial and unjustified damage to the value of their companies.

To see the dangers, look no further than Enron, which by the end had become little more than a giant hedge fund. Ken Lay, Enron's founder, spent much of his time lobbying politicians to keep the regulators out of the new markets he was creating in power, bandwidth, gas and everything else that nobody had thought of securitising before. He even managed to create a market in weather hedging securities and pollution emissions. To everyone's eternal regret, he was largely successful.

OK, so it wasn't the hedging activity in itself that sank Enron. Rather it was the undisclosed off-balance sheet finance Enron organised to support those activities. None the less, the end result was that huge amounts of capital went down the pan supporting what turned out to be an almost entirely vacuous endeavour.

Mr Lay was a passionate believer in the power of markets to reduce risk and improve efficiency. That belief is hardly supported by the great Enron experiment, and it is not clear that conventional hedge fund activity supports it either.

Hedge funds were created as a solution to a familiar problem with investment. A company's prospects may be excellent, but that's no guarantee the stock will go up. If the market as a whole is going down, even the best stocks are likely to go down with it. To guard against this possibility, a hedge is established. Stock in a similar company is sold short, thereby limiting the risk in the initial trade. Any loss on the long position is offset by the gain on the short position. Trades like this, known as pairing, are hedging at its most simplistic, and if it stopped there, nobody could much complain about it.

But it doesn't. In a typical hedge fund, extraordinarily complex trades are created, using a huge array of different securities, each trade backed up with another in a way which may not even be properly understood by the computers used to design them, let alone the responsible trader or his manager.

Ken Lay was right about one thing at least. With modern technology and a degree in advanced mathematics, everything is capable of being securitised. Derivative instruments are then created on top for those with a different appetite for risk, and then yet further layers are introduced to customise the product out yet further into the marketplace.

Does all this frenzy of activity really make economic activity more efficient? The theory has yet to be unambiguously proved, but what it certainly does do is make markets much harder to understand and their faultlines far less easy to see. This may be an old-fashioned view, but simplicity and transparency are generally the badge of reliability. Obfuscation and complexity are its very antithesis, and the truth is that this is what hedge funds specialise in.

The reason hedge funds domicile themselves in places such as the Caymans and the Bahamas is not just for tax reasons, but because it makes them largely immune to the prying eyes of securities regulators. Nobody really knows what they are up to, least of all the FSA, and it sometimes seems doubtful they properly understand it themselves.

The FSA may be right to leave the hedge funds alone. But for an organisation that deems it necessary to interfere in just about everything else, they make an odd choice for regulatory bypass.

jeremy.warner@independent.co.uk