Economic Report President

about the potential impact of large price movements on other investmentsby these firms and on the investments of the many individualsand institutions not associated with LTCM.By investing several billion dollars of new capital in LTCM, its principalcreditors and counterparties prevented the firm’s immediatedefault. These firms probably saved money as a result, becauseunwinding LTCM’s portfolio gradually was expected to be much lessdisruptive to markets and prices than a sudden liquidation.Regulation of Hedge FundsThe near collapse of LTCM raised questions about the proper regulatorystance toward hedge funds and other institutions that activelytrade securities and derivative instruments. Currently, hedge fundsface far less regulatory scrutiny than do many other financial institutions.No government agency is charged with their direct supervision.For example, hedge funds are exempt from the Investment CompanyAct of 1940 (which provides for regulation of mutual funds) because oftheir restrictions on participation. However, hedge funds’ creditors andcounterparties provide some degree of “market regulation” by evaluatingthe funds’ collateral, investment positions, and equity capitalbefore doing business with them. The care exercised by these creditorsand counterparties is, in turn, monitored to some extent by the governmentregulators of those institutions. These regulators include theFederal Reserve Board and the Office of the Comptroller of the Currency(OCC) for banks, the Securities and Exchange Commission(SEC) for broker-dealers, and the Commodity Futures TradingCommission (CFTC) for futures commission merchants.Of course, lending institutions’ techniques for managing their creditrisks are not perfect, and market regulation cannot prevent all problemsarising from hedge funds. Moreover, some financial firms that arelikewise largely unregulated, such as certain broker-dealer affiliates,also engage in leveraged trading strategies. Following the near collapseof LTCM, the Secretary of the Treasury called on the President’sWorking Group on Financial Markets, which he chairs, to study theimplications of the operations of firms such as LTCM and their relationshipswith their creditors. (This working group was established byexecutive order in 1988. Its members are the Secretary of the Treasury,the Chairman of the Board of Governors of the Federal Reserve System,the Chairman of the SEC, and the Chairperson of the CFTC.Additional participants are the Federal Deposit Insurance Corporation,the Office of Thrift Supervision, the New York Federal ReserveBank, the OCC, the National Economic Council, and the Council ofEconomic Advisers.)Should there be more government regulation of hedge funds andother highly leveraged financial institutions? One justification for regulatingfinancial institutions generally is to reduce systemic risk—the65