Treasury warns hedge funds -- even as it won't regulate them!

US Treasury Warns
on Hedge Fund Risk

By Jeremy Grant
Financial Times, London
Monday, June 11, 2007

http://www.ft.com/cms/s/f17837dc-184a-11dc-b736-000b5df10621.html

WASHINGTON -- Hedge funds and those doing business with them were on Monday warned by the US Treasury not to operate "under the false illusion" that systemic risk from their activities was not a "real possibility" in spite of the increased sophistication of risk management.

The comments are the strongest sign yet of US policymakers' concern that markets should not take undue comfort from the relative lack of fallout from last year's multi-billion dollar losses at hedge fund Amaranth.

Anthony Ryan, the Treasury's assistant secretary for financial markets, said: "Some may posit that the increasing sophistication of risk management systems coupled with other developments and efforts has placed systemic risk on the endangered species list.

"For supportive proof they point to the lack of extensive ripple effects upon the financial markets following some relatively recent shocks. I believe that subscribing to this thesis is both potentially misleading and imprudent," he told a meeting of the Managed Funds Association, a hedge fund industry group, in Chicago.

Mr Ryan said market participants and regulators must not "get lulled into a false sense of confidence" because of the increased dispersion of risk; the existence of flexible financial instruments and strategies to manage and hedge risk; or "the abundance of liquidity characterising the recent benign market environment."

His comments echo concerns of European Central Bank president Jean-Claude Trichet about the risks hedge funds may pose to financial stability.

Mr Trichet said last month there was growing global consensus that a voluntary hedge fund code of conduct would be the best way to tackle system risk issues.

The President's Working Group on Financial Markets -- which includes the Treasury, the Federal Reserve, and other regulators -- in February issued a policy statement on hedge fund regulation arguing that the best way to guard against systemic risk was "market discipline."

Mr Ryan said this was "a call to action to foster preparedness" to reduce the impact of any future systemic risk event.

"Stakeholders in our markets must not operate under the false illusion that systemic risk is not a real possibility. Whether examining batting averages or financial market risk, we must account for the possibility of outliers," Mr Ryan said.

He cited five "environmental conditions" that needed to be watched, including "easy credit" that had fuelled a surge in liquidity to hedge funds, as well as leverage and "declining lending standards."

"We must ensure that the implications of this degree of leverage are well understood," Mr Ryan said.

He highlighted an increased correlation of hedge fund returns, which suggested an increasing concentration of risk.

A few large financial institutions were also acting as the main counterparties and creditors to hedge funds, raising the "spectre of a major market event having a systemic impact."

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