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Hedge funds: Hedge funds have many reasons to thank President Barack Obama. His proposed curbs on proprietary trading should push assets from banks’ balance sheets into the hedge fund industry. They should reduce competition for trading ideas, translating into bigger profits for the funds. And they should make it easier for hedge fund managers to pick off star traders. But proponents of reform should be careful: moving risk about doesn’t make it disappear.
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It’s too early for hedge fund managers to pop open the champagne: the reform plan could still have negative repercussions. Compelling banks to exit proprietary trading positions could spark a disorderly unwinding if it is not well managed.
Also, it"s not clear how the proposed reforms will affect banks" prime brokerage businesses, which hedge funds rely on for funding.
In theory, prime brokerage is just a service that banks provide to their clients, not a proprietary trade, and should be unaffected. But there’s no certainty it will be left untouched.
Details of the proposed reforms are thin, and they may be diluted before being made law. However, assuming the end result looks something like Obama’s initial statement, the result should be that assets are shifted from banks’ trading books to alternative asset managers. Risk will be spread among a larger number of smaller institutions catering to sophisticated investors. That should reduce systemic risk.
But transferring assets away from banks won’t make those risks disappear altogether. Banks would still be able to lend to hedge funds. They will probably also still be able to own fund management businesses.
At the moment, there’s little evidence to suggest that’s a threat. Over 2,000 hedge funds have disappeared since the crisis started without sparking a systemic meltdown. However, if the hedge fund sector expands, banks’ potential exposure to a blow-up would increase.
Some hedge funds could also begin to take on bank-like characteristics, and eventually become systemically important. That is what happened with Long-Term Capital Management, the hedge fund that threatened to drag down the rest of Wall Street when it got into trouble in 1998.
Lawmakers in the United States and Europe are tightening up hedge fund-regulation, but the process is incomplete and highly political.
Shifting proprietary trading risk from banks into hedge funds should make the financial system safer. Nevertheless, Obama and other regulators need to make sure this piece of legislation doesn’t come back to bite them.