Are hedge funds a source of instability in the global financial system? While their role in the Asian crisis remains controversial, the LTCM incident shows clearly that on occasion hedge funds can be destabilising, through their sheer size and leverage. Banning hedge funds altogether is not the solution. Many other institutions make similar plays as the hedge funds. Indeed hedge funds can play a positive role in international financial markets. Their signature contrarian and arbitrage strategies can help to stabilise and even enhance the efficiency of financial markets. However, checks are necessary to prevent them from accumulating excessive positions, unknown to the market and to regulators. Directly regulating hedge funds will also not work. There is the practical problem of regulatory arbitrage – such players can easily relocate if regulation is forced on them. Besides, not all hedge funds are large and highly leveraged. There is no need to regulate all of them in the same way. One possible approach is indirect regulation, through their lenders and other counterparties. This means bringing the private sector into the surveillance picture. We should create incentives in the supervisory framework for the counterparties of hedge funds to become more vigilant and prudent. Lenders must strengthen their own credit assessment systems, while regulators should find ways to encourage risky borrowers to disclose more, voluntarily, to their creditors. For example, we could introduce a higher risk weighting for borrowers who are large and highly leveraged and who do not disclose enough to either their creditors or the credit rating agencies.
This would spur hedge funds to disclose more or to obtain a credit rating. Global financial supervision The crisis has set off debate as to whether the global capital market needs a global regulator. I doubt this is workable, or even desirable. A global financial super-regulator requires countries to give up national sovereignty. This is politically unrealistic; witness how carefully the IMF had needed to 2  George Soros in The Crisis of Global Capitalism, Ch. 7 The Global Financial Crisis, p. 136. 5  BIS Review 93/1999  canvas its major shareholders to support its prescriptions and how closely the US Congress scrutinises the IMF’s actions. A more practical, albeit modest, solution is the establishment of the Financial Stability Forum. This brings together both the G7 countries as well as non-G7 financial centres and international organisations such as the IMF, World Bank and the BIS to discuss the vulnerabilities of the world system. The Forum should be able to get best practices and supervisory standards implemented more widely and effectively. The FSF has set up three working groups to study areas of vulnerability highlighted by the crisis: capital flows and exchange rate regimes, highly leveraged institutions and offshore financial centres (OFC). Singapore has been invited to participate in the FSF, together with Australia, Hong Kong and the Netherlands. We are also in the OFC working group. OFCs have attracted considerable attention because of the significant capital flows they generate.