Hedge funds are fast approaching the $1 trillion mark and a lower level of investor, while growing increasingly influential and potentially disruptive in the capital markets, SEC chairman William Donaldson told the Senate Banking Committee on Thursday.

Just one day after announcing that the SEC has voted 3-2 in favor of proposing a rule that would require hedge funds to registered with the agency, Donaldson told the country’s lawmakers that through the use of leverage and the deployment of rapid trading strategies, hedge funds can have a disproportionate impact on both large and small investors.

On Wednesday, Paul Roye, the director of the SEC’s division of investment management, said the industry is at about $850 billion, and both he and Donaldson predicted a rapid ascent towards $1 trillion.

Roye said that over the past five years, there have been 46 cases of fraud in the hedge fund industry, resulting in investor losses in excess of $1 billion. "As if these cases were not sufficiently troubling, we now know that a number of hedge funds played a prominent role in the late-trading and market-timing scandals involving mutual funds," Roye said.

Average investors are increasingly becoming more exposed to the product through their investments in both "public and private pension funds, as well as universities, endowments, foundations and other charitable organizations," as well as through funds-of-hedge funds, some of which have investment minimums as low as $25,000, Roye said.

But aside from the impact the vehicle may have on individual investors, Donaldson noted concern of hedge funds’ impact on the overall market. Citing a recently published article, Donaldson said that during certain times, a single hedge fund has been responsible for 5% of the daily trading volume on the New York Stock Exchange.

Plus, the agency wants to get a better picture of hedge funds’ impact on other investment products, as well as be able to anticipate problems before they occur in the industry. Previously, the SEC was relegated to cleaning up the mess and bringing charges against fraudulent hedge fund managers only after a blowup and investor losses were unrecoverable.

"The SEC has the primary regulatory responsibility for protecting investors and the integrity of our securities markets," Donaldson said. "In an increasingly complex environment, we simply cannot afford to ignore this vital sector of our markets."

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