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Politicians love to grouse about regulating hedge funds. They have yet to explain exactly how they intend to do it. One idea is to force hedge funds to register with the authorities. That might protect investors. But it does nothing to protect against system-wide risks. Another is to require funds to disclose their trading positions.

But even if regulators could craft a system capable of analysing the millions of trades by the world’s 9,000 hedge funds each day, it is unclear how they might use it to spot and defuse risky bets. A better approach, according to a forthcoming article in the Journal of Financial Stability, might be to focus on prime brokers. While there are thousands of hedge funds, only a handful of companies provide most hedge funds’ clearing, custody and collateral needs.

The 10 biggest prime brokers service 84 per cent of hedge fund assets, according to Institutional Investor. Because they act as both a clearing house and lender, prime brokers have an excellent view into the risks being run by their hedge fund clients. By demanding more collateral to fund risky trades, they provide a natural brake on leverage.

Such oversight was lacking in 1998, when the demise of Long Term Capital Management sparked fears of financial collapse. Amaranth, by contrast, barely caused a ripple when it went under in 2006. Collateral demanded by its prime broker ensured that counterparties got paid.

There are limits to self-discipline, however. During the credit boom, there were signs that some prime brokers had begun to reduce collateral requirements to win new business. That is dangerous, and suggests a need for greater scrutiny. As they move beyond a reliance on the self-interest of counterparties to police the financial system, regulators should work smarter, not harder. Imposing minimum collateral requirements and increasing monitoring of prime brokers would be a good place to start.

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