Markets Do Just Fine Regulating Markets

We've been listening to the media get it wrong for so long, we almost missed it when someone actually got it right. Last week, Jonathan Macey, a professor at Yale Law School, wrote an op-ed piece in The Wall Street Journal defending hedge funds.

Subscribers to The Wall Street Journal can access Mr. Macey's full commentary:

But allow us to summarize a few of his relevant points and a few of our own.

Every month a new line of reasoning for regulating hedge funds pops up in the media. With the $5 billion loss in natural gas by Amarath Investors, the current flavor of the month is the "systemic risk" posed by hedge funds. That is, some event, such as the collapse of a large number of hedge funds, could spark a massive financial system meltdown. Better to regulate now, before it is too late, the reasoning goes.

This logic is faulty at best and ignores salient facts. Cries about the threat of systemic risk first emerged in 1998 after the substantial losses by Long Term Capital Management. However, just like with Amarath last month, markets continued to function seamlessly. The MSCI World Index was up 24% in 1998 and is up 15% so far this year. Where is the collapse?

The fact is hedge funds are a positive for markets and are doing just fine without bureaucrats trying to tell them what to do. The very structure of the industry proves they do not pose systemic risk to the economy—it is highly disaggregated and diverse. As such, the economy essentially has a fully diversified portfolio of hedge funds. Some may do poorly. But others will do well because their strategies are not correlated.

Other commentators decry a lack of transparency. But the ability of hedge funds to operate without regulatory oversight prevents the "herding" behavior that actually might bring systemic risk. Also, because they are unregulated, hedge funds use derivatives and short sales, further increasing market efficiency.

The lesson is simple. Markets do just fine regulating markets. Imagine that.