The collapse of Amaranth earlier this year, with a loss of about USD6 billion, was easily absorbed by the financial markets, a far better reaction than the collapse of LTCM in 1998, with a smaller loss (USD 4.5b).
An interesting speech by Lars Nyberg, deputy governor of the Swedish central bank, entitled “Are hedge funds dangerous?” goes through many of the issues that arise from hedge fund market operations very well and covers the three differing types of hedge funds quickly, but understandably.
Importantly, he also offers some conclusions on whether the funds need to be regulated in a more heavy-handed manner. His conclusion:
From a stability point of view, the central issue is that the systemically-important banks should manage their counterparty exposures correctly – take sufficient collateral, have appropriate limits and be capable of managing potential liquidity problems. The arguments for further regulation of hedge funds are in this context weak.
While the metrics are, for obvious reasons, relevant only to the Swedish market, the conclusion is, I believe, a robust one in most contexts. If the banks that the majority of people are using are doing their job correctly they form the “buffer” between the more adventurous in the markets, who provide much of the liquidity these days, and the relatively stable day to day environment most of us live in.
In short, we all benefit from their operation by the additional liquidity they bring, and from the consequent improvement in the price discovery mechanism. An attempt to regulate them further would only reduce the benefits they bring without serving any useful purpose in mitigating systemic risk.