The arrest on charges of insider trading of Raj Rajaratnam, the billionaire founder of the Galleon hedge fund, heralds laudable prosecutorial zeal to enforce criminal law in the financial sector. But this effort must not be confused with what the regulations governing hedge funds ought to be.
Court documents allege that Mr Rajaratnam and his associates illegally used information from corporate insiders to place trades before market-sensitive announcements. If the claims are true, the scheme’s reach into the cathedrals of corporate capitalism was nothing short of spectacular: a McKinsey director and an IBM senior vice-president are among those charged. The investigation will, if nothing else, have the salutary effect of reminding everyone that no one is above suspicion.
Insider trading is no victimless crime: there is always another side that loses out. Large gains from putting one’s own money at stake are legitimate; those from illegally rigging the deck in one’s favour are not. That in itself is a reason to welcome strong law enforcement.
Another benefit is that, in a sector where knowledge is money, the investigation will help clarify what information hedge funds may trade on, and alert managers that they are being watched. Both strengthen incentives for self-regulation. Most investors worry about their money skirting the law; they will worry more the surer they are that lawbreaking is punished. Moreover, since insider trading is often rumoured but hard to prove, prosecutors were right to tap suspects’ phones – how else can such wrongdoing be uncovered?
Investors do not lack for suspicions that some funds’ handsome profits were due to more than skill. One would expect rogue financiers to congregate disproportionately in lightly regulated areas of finance. But that does not indict hedge funds in general: it is a useful and legitimate industry.
While it is worth asking whether hedge funds must be regulated differently, some efforts under way seem to presume that they were responsible for the financial crisis. They were not; and the undeniable benefit of prosecuting hedge funds that break the law has no bearing on whether they should face stricter rules – which must depend on how likely they are to become vehicles for harmful risk-taking.
This bears emphasising, since it is, as a hedge fund manager told the FT, “the hedge funds that get targeted because we’re seen as fair game”. Administer the law rigorously to hedge funds; but do not run them out of town.