The End of Under-Sight

Although the hedge-fund industry has long relished the light touch of lawmakers and financial regulators, a new era is dawning for largely unregulated financial institutions, and rightly so. The huge systemic risks associated with hedge funds and other unregulated firms in the financial system have a ruinous potential in our economy. Yet these bodies have been allowed to operate with a minimal level of oversight for years. Treasury Secretary Timothy Geithner’s call for an expansion of financial regulation and increased transparency faces a long struggle through Congress but will prove a crucial framework for promoting future economic stability.

Mangers at hedge funds and other unregulated market players are often reluctant to open their bets to scrutiny or reveal their positions in the market because doing so allows competitors to mirror trades and dilute profits. Many also view the paperwork and bureaucracy associated with tight regulations as time-consuming and expensive distractions from a funds’ ultimate goal: making money.

These objections to oversight, however, ignore the potential damage that unregulated investing and high-risk betting can wreak. Unchecked hedge funds, unregulated derivatives traders, exotic trades, and obscure credit-default swaps all pose threats to the wider stability of the U.S. economy. Additionally, the government’s current inability to safely unwind financial institutions that pose systemic risk presents a gaping hole in federal resolution authority. Unfortunately, behaviors at hedge funds and on trading floors that pose substantial risk to all Americans have for too long been allowed to proliferate outside of the government’s gaze.

Geithner’s plan to address systemic risks in financial markets is comprehensive, if still relatively non-specific. Presented to lawmakers last Thursday, the proposal outlines general changes in four areas: the limitation of broad economic risks, the enhancement of consumer and investor protections, the closure of gaps in regulatory oversight, and the global coordination of any actions that are undertaken.

The most aggressive of Geithner’s reforms would establish a systemic-risk overseer—possibly the Federal Reserve—that would serve as a super-regulator in charge of making sure no firms took on too much risk. The plan would also raise capital and risk-management standards, ensuring that firms safeguard a larger proportion of their assets to protect against unexpected losses and more tightly manage their links to other financial bodies. By forcing big hedge funds to register with the Securities and Exchange Commission, thereby releasing their portfolio information, the government could determine which funds pose a threat to the economy and better regulate those funds. Geithner’s plan proposes this change as well as a more comprehensive oversight of derivatives (such as the regulation of credit-default swaps) that would be traded through a clearinghouse. Finally, endowing the government with the power to resolve large, failing financial institutions other than banks would fill the power vacuum plaguing the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation as of late.

Geithner’s plan is complex and still in its infant stages: Thursday’s proposal left many details up in the air so that productive exchange with lawmakers can occur in the near future. Surely, it will undergo much revision and debate as it works its way through opposition in Congress. Its principles of transparency, disclosure, centralization, and closer oversight, however, must not be lost on Capitol Hill. If executed properly and enacted swiftly, Geithner’s plan should work toward restoring market confidence and the security of American finance.