Leading article: The nemesis of the hedge funds – and a lesson to us all

We urgently need to regulate the shadow banking sector

There are some delicious ironies in the latest remarkable twist in the international financial markets. That so many hedge funds have met their nemesis in Germany, the country which has always been most suspicious of their activities, is one. That the car manufacturer, Porsche, the traditional choice of high-flying financiers, should have been the vehicle of their ruin, is another.

It might also be noted that the whizz-kids of global finance and their super-wealthy clients have inadvertently ended up enriching the conservative investors in German pension funds and the citizens of Lower Saxony. No wonder schadenfreude is a German word.

But now the hedge funds which have taken an almighty pasting are crying foul. They are complaining of a lack of transparency in German stock markets, arguing that they could not see what was coming because Porsche had built up its stake in VW through derivative contracts, rather than straightforward share purchases.

The hypocrisy of this is immense. No players in financial markets are less transparent than hedge funds, which never reveal their holdings and which lobby against greater regulatory oversight with an almost religious zeal. But more importantly, what Porsche did is not illegal.

British stock market regulators require investors to disclose derivative positions if they confer a controlling share of more than 1 per cent of a company, but the German authorities do not. This is significant. For years, the hedge funds themselves lived by the maxim that what is not outlawed is permissible. Now they find themselves on the receiving end of that philosophy.

Yet to concentrate on the question of transparency in German markets is to miss the larger point. The bigger story in global markets is the massive contraction of the shadow banking sector (of which hedge funds are a major part) and the risk this poses to the global financial system.

The crucial point about hedge funds is that their way of doing business is incredibly risky. They make colossal bets on movements in markets, often with borrowed money. If the bets pay off, they reap a fat profit. But if they go wrong, as was the case with their short-selling of Volkswagen's stock, it can be disastrous. Normally, this would be a case of caveat emptor. But the risk of hedge fund bets going wrong and the consequent need of the funds to dump assets is borne not only by their clients but the rest of us too. This was pointed out in the Bank of England's financial stability report this week.

The US and British governments were so alarmed by the rampant short-selling of banking shares by hedge funds earlier this year that they temporarily banned the practice. This was probably futile. The banks were so weak that the markets would have sold them off anyway. But it gives a good indication of the power of hedge funds to move markets on their own. We are seeing this effect in other areas. As hedge funds unwind their positions, they are helping to destabilise the currencies of emerging economies and pushing up the value of the Japanese yen to painful heights.

Some argue that the hedge fund model is finished; that it was reliant on cheap borrowing from the investment banks, which will no longer be forthcoming in the new era of tighter credit. Perhaps that is so. The sector is certainly shrinking rapidly, but we cannot afford complacency. We can never again allow an unsupervised and inherently unstable shadow banking system to jeopardise the health of the global economy. Better regulation and closer scrutiny is essential.