The failure of Long-Term Capital Management provides a rich lode from which to mine a better understanding of risk taking. In the aftermath of this failure, the dreaded "R" word -- regulation -- is being raised. New regulation may have a place after the Long-Term debacle. However, before regulation can be seriously considered, the nature of risk-taking needs to be refined.
It is generally assumed by the financial community that all uncertainty involves risk. This is not the case; all uncertain situations are not risky. Some are dangerous. Dangerous situations should be avoided. Situations that can be controlled with skill, knowledge and experience are risky and should be managed for the rewards they offer. The distinction between risk and danger is an important one that needs to be made explicit.*
DANGER VS. RISK
The first step in understanding this distinction is to recognize that one man's risk is another man's danger. It is risky for Al Unser Jr. to drive 215 miles per hour in a metal box with wheels; it is dangerous for the author to do so. But, it is also dangerous for Al Unser Jr. to drive 215 mph anywhere but a racetrack set up to accommodate such speeds.
This little example points out one of the key features of the risk-taking enterprise. The environment in which risk-taking occurs must be properly designed. This translates directly into the requirements for a non-intrusive system regulating hedge funds that supports risk-taking. The criteria for such a system are:
* It promotes risk-taking and precludes danger; and
* It includes mechanisms for eliminating danger, when it arises.
The details of such a system are well beyond the scope of this essay. Their development is, in reality, the prerogative of the participants and others who have a stake in the success of hedge fund transactions.
THE REGULATOR'S ROLE
Nevertheless, the distinction between risk and danger brings the role of the regulator into focus.
Part of any risk-taking enterprise is a regulator. Together, participants, stakeholders and regulators create a setting which is manageable -- i.e., risky but not dangerous. Once this setting is established, a function of the regulator is to step in when a situation has changed from risky to dangerous.
For example, in an automobile race, if race officials decide that a driver or his car is creating a hazard, like spilling oil on the track or reckless driving, that driver will be taken out of the race -- "black flagged" -- until his equipment is fixed, or he will be warned to change his ways.
If the officials decide a condition has occurred that is hazardous to the entire field, like an accident or debris on the track, out comes the yellow "caution" flag and the field is slowed until the hazard is removed.
If the hazard is beyond the officials' control, like heavy rain, the race is stopped until the conditions are gone. Once the hazards are removed, it's back to "green flag" racing.
The primary role of a regulator is not to control the participants' race strategy or car setup; nor is it to control the results of the race. Rather, it is to maintain a risky setting in which participants can operate safely, avoid danger and take risks they judge will provide adequate reward. Such a regulator would have prevented the Long-Term Capital failure without unduly interfering with hedge fund operations.
Long-Term Capital executives made one of the most fatal mistakes that can be made when dealing with uncertainty. They thought they were taking risks but were, in reality, living dangerously. This can happen to anyone caught up in the heat of the moment.
The job of the regulator is to catch such errors; not to punish, unless it is a frequent and flagrant offender, but to prevent a dangerous situation from developing.
'BLACK FLAG' FOR HEDGE FUND
How does this apply to Long-Term Capital? Had there been a regulator with a different perspective on the condition of Russian banks and the positions of other participants, Long-Term Capital could have been "black flagged" for its own protection and the protection of others. A dangerous situation would have been avoided.
Ultimately, the proper role of a hedge fund regulator will be far more extensive than discussed here. However, the critical distinction between risk and danger establishes two threshold questions a regulator should ask of participants in the hedge fund "game."
* What are you doing to manage your risks?
* What are you doing to avoid dangerous situations?
Accidents are part of racing -- just as losses are part of investing.
After every racing accident, especially serious ones, there is a discussion of whether this was a "racing accident" -- that is, one that could not have been avoided because the events surrounding it are inherent in the nature of racing -- or if it could have been avoided, had the participants been more responsible and/or the officials enforced the rules better.
Sometimes, it takes a bad accident to call participants' attention to the fact that the rules need changing to account for new technology that has made racing dangerous.
It is now appropriate to ask:
Was the LTCM failure a 'racing accident', or has new technology made hedge fund investing dangerous and, therefore, subject to new regulation?