Speculative pain

G20/hedge funds: Financial speculators should brace themselves for tougher regulation. Buried in one of the papers published as part of this month's G20 summit is a suggestion that their access to credit should be more tightly controlled. That could hit hedge funds, traders working inside banks and the next generation of oligarchs during the next upswing.

Hedge funds might have thought they had a narrow escape. Despite a lot of grandstanding by France’s Nicolas Sarkozy, the G20 communiqué’s focus is on regulating “systemically important” hedge funds – and there are precious few of those.

An accompanying declaration on strengthening the financial system, meanwhile, says hedge funds will be required to provide information to the authorities about their leverage and other matters in order to determine whether they are systemically threatening. All this seems pretty anodyne.

The bigger threat comes in a separate paper from the Financial Stability Forum, which has been tasked by the G20 with finalising details of a new global regulatory regime. The FSF says countries should think about enforcing minimum “haircuts” for over-the-counter derivatives and securities financing transactions. The idea is to reduce leverage during an upswing. The FSF also wants these haircuts to be relatively stable over the economic cycle – so they are not increased in times of stress.

The paper doesn’t single out hedge funds for treatment. Indeed, the suggested regime does not identify any specific investor class but would apply to prop traders and other speculators, breakingviews has learned. But hedge funds would be among those particularly affected.

They typically leverage up their portfolios by pledging securities to the prime brokerage arms of banks, which then give them back cash to the value of those assets – minus a haircut. The bigger the haircut, the lower the leverage.

The FSF’s proposal would mean little at the moment, as banks aren’t providing lashings of leverage anyway. Even before the crunch, many banks were more disciplined with hedge fund collateral requirements than they were with their own. What’s more, this is currently just a proposal which would need to work its way through the global regulatory machinery - and so much will depend on the level of any minimum haircuts.

That said, the proposals would make the next upswing different from the last. Hedge funds won’t just be able to gear themselves up and ride the cycle. Instead, the outsize returns they promise their clients will have to come from being genuinely smarter investors. That would be no bad thing.