THE BLOG

Insider Trading Probe Offers New Chance to Curb Hedge Fund Power

11/23/2010 12:35 pm ET | Updated May 25, 2011

It is never good to hear that large financial players may have broken the law, and the huge insider trading investigation unfolding on Wall Street is deeply troubling. But the upside to the probe is that it offers a chance to curb the outsized power of hedge funds.

Hedge funds are major players in the so-called "shadow banking system" and had a key role in the financial shenanigans that brought down the economy in 2008. Some large funds gorged on high-risk investments tied to mortgage-backed securities and made hugely leveraged bets. The failure of two hedge funds at Bear Stearns in July 2007, both of which had loaded up on collateralized debt obligations bought with borrowed money, helped start Wall Street on the road to crisis. And hedge funds may have accelerated the fall of Lehman Brothers by short-selling that firm's stock. A decade earlier, of course, Long Term Capital Management almost precipitated a financial disaster by over-leveraged speculation on foreign currency.

High-flying hedge fund managers also fueled Wall Street's culture of greed during the go-go years. The huge sums made by these traders created envy among investment bankers who took home mere eight-figure bonuses and pushed more of them to raise their sights -- which meant more leverage and risk.

Reformers in Washington hoped to quell the casino-like dynamics in America's financial sector and regulate the shadow banking system. But they didn't go far enough and it's not clear whether the new law will do anything to rein in hedge funds. The law, which will include regulations not yet written, does require that hedge funds register with the SEC and reveal certain information about their activities. So far, though, there are no rules to prevent hedge funds from making large-scale risky bets that could destabilize the financial system if they go wrong. The huge lobbying muscle of hedge funds in Washington is a big reason why they have escaped greater oversight. Another Long Term Capital Management could easily crash and burn in the wake of financial reform, perhaps with devastating consequences for the economy and investors.

The insider trading probe of hedge funds thus offers a welcome chance to make another run at curbing the power of these financial players. Beyond fueling the culture of greed in finance, hedge funds have pushed this sector's ethics in the wrong direction, with evidence growing that some funds used illegal or unethical tactics to make their billions.

Two big examples have already emerged of hedge funds operating on the dark side. The first was last year's insider trading case implicating Raj Rajaratnam and his Galleon Group, with involved the large-scale trafficking of nonpublic information. Fourteen people have pleaded guilty in that investigation.

Then there are the allegations involving Goldman Sachs and John Paulson's hedge fund. The story there, according to the SEC's complaint against Goldman, is that Paulson put together a special fund at Goldman to bet against mortgage-backed securities and the firm sold this junk to unwitting investors while Paulson made north of $1 billion.

The insider trading probe now under way -- which reportedly includes famous funds like Citadel and SAC -- offers an opportunity to uncover other shady doings of hedge funds over recent years. The intense new scrutiny of the sector will hopefully bring hedge fund managers down a few notches and federal authorities should take an expansive view of their goals here.

Meanwhile, let's hope that the emerging scandal will influence the policy debate in Washington. Regulators are still writing the rules that will implement financial reform and there are ways that the law can be interpreted to more strictly regulate hedge funds. The tarnishing of the industry should make it harder for them to resist such rules and raise the chances that the public interest will prevail over private power.