Global Policy Forum

By Christian Reiermann

Germany wants increased international supervision of hedge funds and has placed the issue high on the agenda of this weekend's G7 meeting. The US is skeptical. Guess who will win.

The Villa Hügel in Essen has always been frequented by the rich and powerful. Politics and business went hand in hand in the generously proportioned sandstone villa above the Ruhr River. This Saturday, it will be just like old times when the men responsible for the politics of world finance visit southern Essen. German Finance Minister Peer Steinbrück has invited his colleagues from the world's leading industrial countries, the so-called G7 states, to discuss the stability of financial markets.

Topping the agenda is the risk hedge funds -- until now largely uncontrolled -- pose to the world and its economy. And how those risks can be avoided. Never before has such an illustrious round of people taken a hard look at the issue. Up to now, hedge funds have largely been a topic for experts at the world's central banks, supervisory authorities or universities.

But that may begin to gradually change if German Chancellor Angela Merkel has her way. She has placed the topic on the agenda for Germany's year-long presidency of the G8 (the G7 plus Russia, which will not be present in Essen). Steinbrück has been charged with testing the waters in Essen. His job is to find out what regulatory measures his colleagues in the United States, Canada, Italy, France, the United Kingdom and Japan would be prepared to accept. A working paper called "Challenges of the Hedge Funds Industry and Associated Political Measures" has already been prepared.

That Steinbrück's colleagues from the United States and the United Kingdom, Henry Paulson and Gordon Brown respectively, are even prepared to discuss the issue must be seen as a success. Until now, they have both been disinclined to confront the hedge fund industry -- though Paulson has recently warned about the growing risks. And he should know: Paulson headed the Goldman Sachs investment bank before he entered US politics. Still, caution will be the name of the game this weekend. Even Steinbrück deputy Thomas Mirow on Wednesday warned against high expecations. There will be "no far-reaching consequences" from the Essen meeting, he said. It is the beginning of a "continuous process."

They don't even know what they don't know

Many hedge funds are registered in tax havens such as the Cayman Islands, even as they operate primarily in financial capitals such as New York and London -- perhaps explaining why Paulson and Brown have been reluctant to act. But the situation has changed in recent months. Even the British and the Americans are gradually realizing that were one of the larger hedge funds to actually collapse, it could cause a chain reaction across the world's financial markets. The consequences for the world economy would be incalculable.

"International sensitivity to the issue has increased," says Steinbrück. His initiative aims at curbing the "systemic risk" inherent in the hedge fund industry. And there have already been some close calls -- in 1998, for example, when the billion-dollar Long Term Capital Management (LTCM) fund could only be saved thanks to the intervention of the US Federal Reserve.

In preparing for this weekend's meeting, Steinbrück's experts, headed up by his deputy Thomas Mirow, had a difficult time convincing their colleagues that Berlin wasn't trying to crusade against " locust" investors or ruin a prosperous industry with excessive regulation. They just want to create better oversight, Steinbrück's emissaries insist. They want "transparency" -- more light.

And that's indeed what's missing -- government supervisory authorities are very much in the dark when it comes to hedge funds. All they have is a rough estimation of the number of hedge funds in the world: about 9,000. But no one knows exactly how much money these constructs control, how much they've hoarded and then borrowed on credit. Estimates as to how much money is involved are as high as $1.3 trillion (see graphic). But the supervisors have little idea of where the close-lipped managers have invested the money -- and what risks they've decided to run in doing so.

This lack of knowledge contrasts starkly with the disclosure obligations that supervisory authorities impose on garden-variety credit institutions. For example, Germany's supervisory authority knows precisely how much money every little savings bank has lent to prospective home owners. But international financial supervisors have no idea what a financial acrobat like Peter Thiel, the 39-year-old star of the hedge fund community, is doing with his billion-dollar Clarion Capital fund.

The threat of rising interest rates

The reason: In the end, hedge funds are simply pools of capital that wealthy investors entrust their money to. Much of that money is borrowed. They use highly complicated financial mechanisms, so-called derivatives, speculating on whether the oil price will fall or the dollar will rise. It's an activity that promises high revenue, but which also involves high risk.

When everything goes well, hedge funds can free banks of credit risks. But things get ticklish for investors and the world economy when hedge fund investors give in to herd instinct and concentrate their assets on investments assumed to be safe. If a major hedge fund were to run into difficulties, or if several of them were to make a false step, banks could suffer too. But that's not all. The crisis on the financial markets could be passed on to the "real" economy, via rising interest rates. As a result, investments would be held back, economic growth would decline and mass unemployment could break out as well.

Until now, Steinbrück and his colleagues have been deferent to the rapidly growing sector. They've refrained from imposing strict disclosure obligations or even creating a trans-national supervisory authority. The German Finance Ministry's current model proposes a step-by-step strategy for tackling the problem.

The first step calls for banks to have a clear idea as to where funds invest the money they borrow. The state supervisory authority already in place to monitor banks would thus gain some insight into the distribution of risk taken on by hedge funds. But it's a weak measure, as are many others in the paper. It relies primarily on voluntary compliance -- and reads more like an appeal with plenty of "ifs" and "shoulds." For example, the funds should rethink their information policy towards investors, banks and the public, the paper says. It also speculates that international cooperation in financial accounting "could" lead to a "voluntary code of conduct."

A further possibility for creating more transparency is only hinted at: The hedge funds might allow themselves to be examined by ratings agencies qualified to determine their credit standing. The funds would then be ranked by the ratings agency. The paper Steinbrück will present in Essen also suggests national governments should think about measures they could use to create greater transparency. In some countries, for example, managers of hedge funds need to formally register. That way, the biggest rogues are kept out. The group of ministers wants to charge the Financial Stability Forum -- a working group formed by finance ministries, banking supervisors and central banks -- with developing further control mechanisms.

Steinbrück and Merkel likely already know that they won't be able to do much more than get the ball rolling. Still, at the G8 summit to be held in Heiligendamm on Germany's Baltic coast in early July, the gathered leaders are to present a joint statement on the topic. But a snappy statement isn't yet a guarantee for success. Plans for how to save the world are often debated for years within the G8. And it's almost never clear how the debates will end. Accordingly, a high-ranking member of Chancellor Merkel's staff is already working to keep expectations low: "We will already have achieved a great deal if our proposal is followed up on during future G8 presidencies."