I’ve been covering hedge funds for about 10 years, and in that time I’ve seen them shift from investments most people had never heard of to topics of conversation among friends of mine with no connection to finance. I used to say I wrote about hedge funds and get a blank stare. The other night I was at a college alumni function with a bunch of younger people I’d never met and every person I talked nodded knowingly when I said “I cover hedge funds.” Reactions ranged from “Oh, Madoff” to “Oh, Greece.”

Granted, not everyone understood the hedge fund connection to the home of the Gyro, but the perception was that hedge funds are somehow, possibly illegally, making money off the misery of another country.

I tried to tell people there’s nothing “illegal” about it, at least not yet. Speculation is legal, and has been encouraged in financial markets, especially since the passage of the Commodity Futures Modernization Act of 2000, which threw open wide the door to trading the same esoteric over-the-counter derivatives upon which much scorn has been heaped the past couple of years.

I remember those days well. They were among my first covering risk management and derivatives at Pensions & Investments. I knew very little about the industry then (it could be argued that I know only a little more today), and the phrase that stuck in my mind when people talked about the proposed derivatives legislation was “legal certainty.”

At the end of the day, the CFMA eliminated concern a court could rule that swaps and other since-popularized derivative instruments had to be traded on regulated exchanges. That would have killed the business, many argued. The idea behind the eventual treatment of these derivatives by the legislation was that the pre-CFMA 2K uncertainty was constraining innovation and denying investors access to important risk management tools. Everybody, it seemed was on board with this notion.

A Bloomberg story last month noted that Gary Gensler, the chairman of the Commodity Futures Trading Commission, who was a big supporter of the CFMA 2K and fought hard for its passage, has now come to the conclusion that the very over-the-counter instruments exempted from regulation by the CFMA 2K now must trade on-exchange. Gensler is far from the only CFMA 2K supporter to have been converted in this way. Alan Greenspan and Arthur Levitt Jr. have both seen the light, as it were, according to Bloomberg.

“Former Federal Reserve Chairman Alan Greenspan and former Securities and Exchange Commission Chairman Arthur Levitt Jr., both of whom supported the 2000 law, have expressed regret that derivatives were not more tightly controlled.”

What did looser control bring? Well, in the Credit default swap market it brought explosive growth. What was a $180 billion market in 1997 grew to $5 trillion by 2004 and an estimated $62 trillion by the time the bottom fell out of the credit markets in 2008. That’s a ridiculous growth rate, and far more indicative of a frenzied speculative bubble than a rush to embrace a new risk management tool. Of course, it’s easy to say that in hindsight, but when it’s happening it’s exciting, and much of the supposed “watchdog” financial press was caught up in reporting on the superheated growth rate, but decidedly less focused on its implications.

And so here we are, at a point in time where hedge funds and naked credit default swaps are being blamed for exacerbating Greece’s financial woes, and both are facing tighter regulatory scrutiny.

Today’s Wall Street Journal details the expanding criticism of the swaps market by people with the power to shape policy, both in Europe and the United States. The Journal discusses Gensler’s most recent views, while the Washington Post does a deep dive into the European Commission’s moves toward banning credit default swaps in sovereign debt. The Irish Times goes after naked credit default swap trading. And Janet Tavakoli warns on Huffington Post today about naked CDS on U.S. debt

Swaps and other derivatives, and hedge funds’ use of them, is no longer a topic only for finance geeks and traders. That’s probably not good news for the laissez-faire/Chicago School/free market crowd, but good news for the Keynesians. The pendulum is on its way back.

This entry was posted on Wednesday, March 10th, 2010 at 3:51 pm and is filed under Wednesday's Random Shots. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.