Central bankers have never had a comfortable relationship with hedge funds, and valuable lessons have been learned over the years with risk systems improved and controls tightened, according to an editorial by Andrew Rozanov, senior manager at State Street Global Advisors in the Wall Street Journal . However, the number of hedge funds and the amount of assets they control have risen significantly while the strategies they employ have become more complex and dynamic.

Arguably, the pace of hedge fund growth and innovation has outstripped the ability of central banks and regulators to keep up.

A typical reaction is to propose more regulation, but that route may do more harm than good. While they may help protect individual investors from unscrupulous operators, they would hardly be protective against low-probability, high-impact systemic risks. And these are the risks that central bankers and policy makers increasingly flag as a concern.

However, there may be a better way for monetary authorities to get back on top of the hedge fund game. Many central banks have amassed enormous foreign-exchange reserves, arguably well beyond what they need for traditional policy purposes. It might be prudent to now concentrate less on the amount of reserves and more on how efficiently they are being used.

Investing a portion of reserves in a broadly diversified portfolio of hedge funds could also improve the ability of monetary authorities to monitor, pre-empt and deal with future systemic crises. It would allow central bankers to extract better information and more timely market intelligence.

In an atmosphere where policy makers in the U.S. and Europe are pressing for tighter legislation to regulate the hedge fund industry, there is a great need for central banks to carefully review all the options available and consider more innovate ways of understanding and dealing with the hedge-fund industry. A more active involvement from the investment side may be a very effective way to supplement their more formal regulatory and financial stability oversight.

 The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries. 

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