Regulate Thyself

The President's Working Group on Financial Markets (a.k.a., the "Plunge Protection Team" - yes, Wikipedia has everything) awoke from a seven-year slumber yesterday and decided it was time to do something about hedge funds and private equity.

Or not.

Cognizant of the danger in attempting to fix something that is not yet clearly broken (you'll surely be blamed if something goes wrong), the group instead opted to provide a set of a "principles" and vague guidelines, leaving it up to the market to figure out what it meant.

Lots of wiggle room there.

From the Treasury Department, this report of the group's most recent activity includes a new acronym (PWG, for President's Working Group) likely intended to supplant the more popular "PPT", and another opportunity to link to the hi-resolution picture of Treasury Secretary Hank Paulson from the much smaller image below (brace yourself).

The agreement among the PWG and U.S. agency principals, which will serve as a framework for evaluating market developments, specifically concentrates on investor protection and systemic risk concerns.

"The President's Working Group believes that public policy toward private pools of capital should be governed by consistent principles that set out a uniform approach to specific policy objectives," said Secretary Henry M. Paulson, chair of the group. "These principles demonstrate that U.S. regulators and policymakers have a unified perspective and are committed to providing forward-leaning guidance for the industry and its participants. These guidelines should serve as a foundation to enhance vigilance and market discipline further, which will strengthen investor protection and guard against systemic risk. We will continue to monitor developments in this ever-evolving market with these principles in mind."

The group has designed the principles to endure as financial markets continue to evolve. They provide a clear but flexible principles-based approach to address the issues presented by the growth and dynamism of these investment vehicles.

The principles are intended to reinforce the significant progress that has been made since the PWG last issued a report on hedge funds in 1999 and to encourage continued efforts along those same lines:

• Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
• Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
• Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
• Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.

The PWG, chaired by the Treasury Secretary and composed of the chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, was formed in 1988 to further the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of financial markets and maintaining investor confidence. The PWG worked with the Federal Reserve Bank of New York and the Office of the Comptroller of the Currency in developing the guidance.

With words like "maintain and enhance" (two places), "consider the suitability", "commit sufficient resources", and "work together", it's not clear what, if any, impact the guidance will have on hedge funds and private capital.

In this report from Forbes, there were similar concerns.

Connecticut Attorney General Richard Blumenthal said during a television interview Thursday afternoon that the working group's conclusions offered very little in the way of guidance, and he expressed frustration that more wasn't being done at the federal level to force greater disclosure by hedge funds.

"A lot more teeth and a lot more specificity is required" to oversight of the hedge fund industry, said Blumenthal, whose state is home to many of the biggest funds but who nonetheless has been pushing for reform in how they are regulated. "There will be efforts on the part of states to provide guidelines if the federal government doesn't," Blumenthal said.

Most, including Blumenthal, agree that hedge funds benefit the markets by adding liquidity and forcing better pricing of securities. But there can also be blow ups, such as last fall's meltdown of the energy trading fund Amaranth Advisors.

In the last year, as pension and other institutional money has flooded the hedge fund market in search of better investment yields, there have been concerns that average investors are not adequately protected from problems that could arise from hedge fund blowups.

The SEC pursued a plan to get hedge funds to register, thus forcing greater disclosure of their risks and strategies to public scrutiny. But the agency did not appeal last summer when that rule was struck down by a Washington, D.C., Court of Appeals judge.

It's hard to have financial bubbles without hedge funds and even something as simple as requiring them to register with the SEC would surely cramp their free-wheeling style.

Since the world economy is now squarely based on a series of ever-larger bubbles, hedge funds and private capital are integral parts of a properly functioning system.