ERIC REGULY

The cautious effort to coax hedge funds into revealing their financial secrets took a new twist yesterday when a senior German banker said the funds should be rated by the ratings agencies.

Edgar Meister, until four weeks ago a member of the executive board of Deutsche Bundesbank, the German central bank, hopes the proposal will be considered by the G8 members this week as part of a “code of conduct” for hedge funds that has been under discussion among the funds, bankers and regulators for some time.

If adopted, the hedge funds ratings would take into account quality of risk management, operational risks, financing structure, the degree of liquidity maintained in relation to the trading strategies and corporate governance.

The information would be distilled into a simple risky rating, like triple-B, used by Moody’s, Standard & Poors and other ratings agencies.

“External ratings like this would make a great contribution to transparency,” Mr. Meister said in a presentation at the G8 media centre near the Heiligendamm Summit. “External ratings can be of major assistance to the pension funds, too, which have a major responsibility for large sections of the population.”

Mr. Meister stressed that the ratings would be voluntary and that the information provided to the ratings agencies would be confidential.

He said the ratings should apply to the 200 or so largest hedge funds, which together account for two-thirds of the $16-trillion (U.S.) in assets managed by the global industry.

The notion of rating hedge funds is not entirely alien. Last month, Moody’s suggested the idea of issuing credit ratings on the unsecured debt employed by the hedge funds. It suggested, for example, a “QQ1 Excellent” rating for funds that have a “very strong valuation process tailored to the their investment strategy” plus other factors such as “operations policies and procedures [that] are extensively documented, precisely executed and strongly enforced.”

Ratings make sense, Mr. Meister said, because the hedge funds are ubiquitous, have enormous market power, are being marketed to a broad range of investors, and could cause financial turmoil if they collapse. “The insolvency of one large hedge fund may trigger contagion effects that could contribute to destabilizing other market players and, therefore, the financial system as a whole,” he said. This is otherwise known as the “herd” effect.

John Kirton, the director of the G8 Research Group at the University of Toronto, thinks Mr. Meister’s idea has a very low chance of making it onto the G8 agenda this week.

“This seems to me one of the more unlikely ones,” he said. “The idea is premature. It’s premature because we don’t know yet what the problems with hedge funds might be, like how tightly wired they are into the financial system. We have to find this out first.”

Still, the G8 is worried about the power of hedge funds. Last month, at the G8 finance ministers meeting, in Potsdam, the ministers stated that “the assessment of potential systemic and operational risk associated with [hedge funds] has become more complex and challenging.”

The ministers essentially suggested that investors in, and lenders to, hedge funds beef up their hedge fund due diligence: “Counterparties and investors should act to strengthen the effectiveness of market discipline, including by obtaining accurate and timely portfolio valuation and risk information.”

Copyright Fund China 2009.

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