Hedging against funds

The Securities and Exchange Board of India's (Sebi's) move to lay down a set of regulations to enable hedge funds to operate in this country is the latest attempt to solve a problem that has vexed regulators across the world.

Ever since the Asian crisis and the crash at Long Term Capital Management, hedge funds have been looked upon with deep suspicion by regulators.

Former Malaysian Prime Minister Mahathir Mohammad blamed them for the Asian crisis, and introduced capital controls in his country in an attempt to ward them off.

More recently, after a series of frauds, the chief of the Securities and Exchange Commission in the US has put forward controversial proposals for regulating hedge funds.

The South African Financial Services Board has recently issued a discussion paper on the need to regulate them.

Sebi's action, therefore, is part of a worldwide effort to lay down the ground rules for hedge funds, in an effort to ensure that markets have the benefits of investment by these funds while minimising the risks.

Three reasons have been advanced to regulate hedge funds "" to protect investors, to protect the integrity of markets, and to prevent systemic risk.

The first reason doesn't apply, because wealthy hedge fund investors know exactly what they are getting into.

The second and third reasons are more important for emerging markets, which can be destabilised more easily.

For instance, research has shown that hedge funds had a short position on Thai baht to the extent of 5 per cent of that country's GDP just before the Asian crisis exploded.

In India, hedge funds have entered the country through the participatory notes route, a route that received much adverse publicity recently.

Sebi's dithering on regulating P-Notes was supposed to be the reason why the markets were going down, a theory that exploded when the figures for investment by foreign institutional investors showed that they continued to pour funds into the Indian market.

Later, Sebi's very liberal rules with regard to registration of hedge funds paved the way for hedge funds to continue to operate through the P-note route.

However, these rules for P-notes could change without notice, which is why hedge funds may prefer to register themselves with Sebi.

But as Alan Greenspan put it in the context of hedge fund regulation in the US, "I grant you that registration is not a problem in and of itself. The question is what is the purpose of that, unless you're going to go further." Clearly, while transparency is important, the more pressing problem is to ensure that systemic risks are not built up.

Registration will help that objective, as Sebi will be in a position to monitor more closely the actions of hedge funds, taking preventive action such as hiking margins whenever necessary.

As for safeguards, our lack of full capital account convertibility, the RBI's control of the currency market, our foreign exchange hoard, and the increased interest of mainstream international funds to invest in this country, coupled with a watchful Sebi, are enough to prevent any manipulation by hedge funds. Given all these advantages, this is the right time to press ahead with registration for hedge funds.