Top Hedge Fund Managers Urge Derivatives Exchange

Several prominent hedge fund managers told Congress they support a new central exchange to open the murky world of some complex investments partly blamed for the global financial crisis, but stopped short of endorsing stricter regulation of hedge funds themselves.

Koji Sasahara / AP

The managers testified at a House hearing examining the role of hedge funds in the crisis, and the risks that critics say they pose to the financial system.

• Watch George Soros's Testimony
• Full Text of John Paulson's Testimony (PDF)

Hedge funds, vast pools of capital holding an estimated $2.5 trillion in assets, operate mostly outside of government supervision.

Billionaire investor and liberal activist George Soros, who runs a hedge fund, said new regulations were needed to gauge the underlying financial strength of banks. But he warned against "going overboard" with regulations that could do more damage than good to the financial system.

Highlights From Hedge Fund Hearing

George Soros: — Crisis Was Generated By Financial System Itself — Financial System Pricing Somewhat Distorted In Proportion To Actual Problem — Regulators Must Accept Responsibility For Controlling Asset Bubbles — Controlling Credit Means Using Regulations That Have Fallen Into Disuse — Financial Market Reforms Must Be International In Scope — Basel Accords Need To Be Replaced By New Rules Reflecting New Paradigm — Hedge Funds Need To Be Regulated Within New Framework — Underregulation Helped Cause CurrentProblem, But Overregulation A Danger As Well — Hedge Funds Helped Cause Bubble, But Have Been Devastated By Its Bursting James Simons: — Rating Agencies Are Among The Most Culpable For Current Problems — Hedge Funds Were Not A Major Cause of Current Systemic Risk — Additional Regulation Focused On Market Integrity Would Be Appropriate — Most Important Step We Can Take Is To Keep People In Their Homes — More Transparency From Hedge Funds Could Be Helpful — Any Change In Tax Policy Should Be Appllied Equally To All — PIMCO, Others Should Sponsor A New Derivatives Rating Agency Philip Falcone: — Hedge Funds Have Positive Role In Financial Markets — Compensation In Hedge Fund Business Is Performance Based — Short Selling Is A Valuable Long Standing Feature of our Markets — Our Analysts Perform Thorough Due Diligence, Not Relying On Rating Agencies Kenneth Griffin: — Champions The Idea of Building Clearinghouse For Credit Default Swaps — Proper Regulation Is Key To Health Of Financial Markets — Congress, Regulators, Industry Must All Work Together — We Must Not Stifle Best Innovative Qualities Of Our Financial Markets

Soros, who amassed a fortune betting on global currency markets and has given heavily to Democrats' campaigns, has criticized the Bush administration for what he said was a slow reaction to the financial crisis and measures to effectively address it.

The House Oversight and Government Reform Committee is attempting to assess the role of hedge funds in the financial crisis and what could go wrong with them in the future, said its chairman Henry Waxman, D-Calif.

Two fund executives, Citadel Investment Group Chief Executive Kenneth Griffin, and Philip Falcone, senior managing director of Harbinger Capital Partners Funds, said they support the creation of public exchanges or clearinghouses to provide transparency for credit default swaps.

"An open and transparent market for these transactions would reduce confusion and improve understanding" of trading in complex derivatives such as credit default swaps, Falcone said in testimony prepared for the hearing.

Credit default swaps, a roughly $60 trillion worldwide market, played a large role in the credit crisis that brought the downfall of Lehman Brothers Holdings, a government rescue plan for giant insurer American International Group, and Merrill Lynch selling itself to Bank of America.

The swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults.

Hedge funds are major purchasers of complex derivatives such as credit default swaps.

A central clearinghouse or exchange for the instruments would reduce financial risks and provide greater transparency around them, the hedge fund executives said.

The five hedge fund managers called to testify each earned on average more than $1 billion annually in an industry that became stunningly profitable and powerful in recent years.

Hedge funds have grown explosively in recent years while operating secretively and with scant government supervision.

They have lured an increasing number of ordinary investors, pension funds and university endowments—meaning millions of people now unwittingly invest in hedge funds indirectly.

Earlier this year, the implosion of hedge funds at Bear Stearns cost investors $1.8 billion and began a domino effect that pushed the investment bank itself to the brink. It was purchased by JPMorgan Chase in March with a $29 billion federal backstop.

Hedge funds "now pose a very public peril when the bets go bad," said Rep. Tom Davis of Virginia, the committee's senior Republican.

As the market crisis has deepened, hedge fund selling has been widely cited as one of the reasons for the increased volatility that pounded stock and bond markets last month—when the Dow Jones industrial average fell 14 percent and the Standard & Poor's 500 index dipped 17 percent.

Hedge fund assets dropped by $100 billion in October as investors withdrew their money and funds were forced to sell stock, worsening the volatility.

Roughly $60 billion of the $100 billion in asset losses came from investor redemptions, according to a report released Wednesday by Eurekahedge, a data and research provider.

© 2008 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.