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Administration's Plan to Expand Financial Oversight Could Add New Risks

But some who closely track the industry warn that may encourage more investors to put their money into hedge funds without actually protecting against fraud and risky investment practices.

"The government is going to be more hands-on, and that's going to imply to people the government is vetting the risks relevant to a hedge fund," said Jason Scharfman, managing director of Corgentum, a firm that evaluates whether hedge funds have proper safe internal procedures. "It exposes investors to a false sense of security that they don't need to perform adequate due diligence on the hedge funds they're investing with."

The SEC and other agencies may not have the manpower to adequately oversee new markets.

In recent months, the SEC has disclosed that the number of agency staffers available to police the market has stagnated even as the size and complexity of the market has grown far greater. For instance, only one in 10 investment advisers -- the designation under which most hedge funds register -- is examined every year by the SEC.

Meanwhile, the special inspector general overseeing the Treasury Department's financial recovery plan has just 30 employees. The inspector general's chief of staff recently said that his operation would need an agency the size of the FBI -- which has nearly 30,000 employees -- "to truly cover this by ourselves."

In his testimony on the future of regulation, Geithner also said that most derivatives should be regulated. Of particular concern are credit-default swaps, which are essentially insurance contracts between two parties to cover losses should a bond default. These swaps were behind the near-collapse of American International Group. And because trillions of dollars of swap agreements were made over recent years, it was difficult for the government to determine the extent to which they posed a threat to the entire financial system when the crisis escalated last fall.

Geithner proposed that swaps be traded through a central clearinghouse, allowing regulators to keep an eye on the derivatives market and give investors more confidence that their partners are legitimate. This would apply to standard swaps -- for instance, one to protect against a General Electric bond going bad.

But others would be exempt. This would include nonstandard swaps, such as one to protect against the default of a multilayered security composed of residential and commercial mortgages.

Several experts cautioned that leaving any room for exemptions could be devastating.

"It could give incentives for parties to issue less standardized or very customized contracts which would not be required to be cleared," said Houman Shadab, senior research fellow at the Mercatus Center at George Mason University.

There could be a rush to use nonstandard swaps if there's an opportunity to get around a clearinghouse, which would impose additional costs.

Michael Greenberg, a University of Maryland law professor and former top official at the Commodity Futures Trading Commission, said "any fissure in this regulatory structure will lead to a race to the bottom."

The Obama administration's initiative also poses a risk that financial firms will move their activities offshore to avoid heightened regulation. Last week big industrial nations met in London to work on international regulatory reform, and some European countries want even tighter regulation than does the United States. But that doesn't solve the problem of lightly regulated island regimes such as the Cayman Islands or Netherlands Antilles, or developing financial centers in Asia and the Middle East.

"More regulation here will undoubtedly lead to more money flowing to places with a less heavy regulatory framework, in an effort to keep costs down," Andrew P. Morriss, a professor who studies regulation at the University of Illinois at Urbana-Champaign, said in an e-mail.

Morriss warned that money currently flowing into the United States from international investors could go elsewhere, such as China, "if we try to make it hard to come here."


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