Hedge funds will face direct regulation unless they sign up to proposed new voluntary codes to prevent a repeat of the financial scares of the Asia crisis, the head of the United Kingdom's chief financial watchdog warned yesterday.
Howard Davies, chairman of the Financial Services Authority (FSA), said speculative investors would not be allowed to use their might to undermine the world's small economies.
Mr Davies was speaking in his role as chairman of a working group of the international Financial Stability Forum that is investigating the role of hedge funds.
"If you cannot give smaller open economies some kind of assurance that they will not be subject to repeated speculative attacks, then there is a clear risk that they will close up and that would be in nobody's interest," he said.
Mr Davies called on the hedge funds - known as highly-leveraged institutions (HLIs) - to show they were prepared to accept the FSF's recent recommendations.
"If not, and particularly if there is another market destabilising collapse, then we might find ourselves developing a closer and more formal relationship with the hedge fund industry," he said.
In a speech to the Morgan Stanley European hedge fund forum, Mr Davies said his working group had considered whether hedge funds should be subject to "prudential oversight" by regulators if their actions threatened the collapse of the whole financial system.
The FSF was set up by the finance ministers of the seven richest nations in the wake of the near-collapse of Long Term Capital Management.
LTCM, a Connecticut-based hedge fund, lost very heavily in the 1998 Russian crisis, and at one point threatened to trigger a financial panic on Wall Street.
Mr Davies said there was also concern about the unregulated actions of hedge funds, which in 1997 launched speculative attacks on the currencies and markets of Australia and Hong Kong.
"It is clear to me that if we cannot offer these economies some kind of comfort about the trading practices that major institutions will adopt, then we cannot be surprised if the calls to restrict access get louder," Mr Davies said.
The FSF working group last month called for improved risk management by institutions that lent to HLIs, greater disclosure and transparency, and an agreed set of guidelines for trading practices that can apply to smaller economies.
The G7 finance ministers strongly backed the working group's proposals at the organisation's spring meeting in Washington last month, saying it would see whether "additional steps" were necessary.