Should Hedge Funds Be Regulated?

In an update to their well-received research on the quantitative hedge fund meltdown of August '07, Amir Khandani and Andrew Lo of MIT try to piece together the event that heralded the start of the credit crunch.

Without access to any proprietary data, the duo simulate the returns of different quant fund strategies. You can read their reconstructed timeline of how it all went down on page 39 here. But this is the part I found most interesting:

we conjecture that part of the losses from August 8th and 9th also stemmed from a reduction in liquidity, most likely from certain hedge funds engaged in high-frequency marketmaking activities. Unlike NYSE specialists and other designated marketmakers that are required to provide liquidity, even in the face of strong price trends, hedge funds have no such obligation. However, in recent years, such funds have injected considerable liquidity into U.S. equity markets by their high-frequency program-trading activities.

It would seem that once the new administration gets around to reworking the regulatory system, it has to seriously consider bringing in hedge funds under the watchful eye of the government.

UPDATE
From earlier this week in the NYT, Lo on hedge fund regulation:

Among quants, some recognized the gathering storm. Mr. Lo, the director of M.I.T. Laboratory for Financial Engineering, co-wrote a paper that he presented in October 2004 at a National Bureau of Economic Research conference. The research paper warned of the rising systemic risk to financial markets and particularly focused on the potential liquidity, leverage and counterparty risk from hedge funds.

Over the next two years, Mr. Lo also made presentations to Federal Reserve officials in New York and Washington, and before the European Central Bank in Brussels. Among economists and academics, he said, the research was well received. "On the industry side, it was dismissed," he recalled.

The dismissive response, Mr. Lo said, was not really surprising because Wall Street was going to chase profits in the good times. The path to sensible restraint, he said, will include not only better risk models, but also more regulation. Like others, Mr. Lo recommends higher capital requirements for banks and the use of exchanges or clearinghouses for the trade of exotic securities, so that prices and risks are more visible. Any hedge fund with more than $1 billion in assets, he added, should be compelled to report its holdings to regulators.

Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.

"We've learned the hard way that the consequences can be catastrophic, even if statistically improbable," he said.

(HT: Amit Seru)