Hedge funds, private equity and a retiring politician's bete noire - short selling.

As the politicians pick up the task of repairing the worlds financial system, one opinion that hasn't seemed to have filtered through is the idea that hedge funds and private equity firms have an important role to play. I guess in the current environment, it simply isn't good politics to voice support for an industry incorrectly held to blame for many of the problems we have seen.

Let me fly in the face of popular opinion - hedge funds and private equity firms are crucial to the future of the finance system if we want an efficient fair system. And I think I speak for everyone when I say, not only do we want an efficient and fair finance system, we desperately need one. However, hedge funds do need appropriate control and regulation, which has been lacking in recent years. This is all the more surprising when you think that LTCM's blow up over 10years ago almost brought the financial system to its knees - you'd have thought we'd have learnt some lessons from that debacle, but clearly not.

Perhaps the LTCM disaster was actually the point at which Gordon Brown felt that 'boom and bust' had finally ended and hence he stuck with his light touch regulation despite the evidence suggesting this wasn't the best of strategies? However, that's a blog topic for another day. So why are hedge funds so crucial and how should hedge funds be regulated without stifling innovation and liquidity and chasing them into offshore havens?

Pools of private capital willing to take risks more conservative investors shy away from, or expose flaws in the financial system, or help deflate asset bubbles to fair levels, are crucial to creating efficient liquid markets. Markets typically are far from efficient. Efficient markets should trade at levels considered by the market to reflect fair value. To do this they need a variety of investors who analyse assets in different ways, who innovate new valuation tools, and who are able to gamble on stock prices either rising or falling. If you restrict short selling, or indeed ban it altogether, you limit the scope for investors to force assets back to their fair value if they start to 'bubble'. This isn't so bad for stocks, as hedge fund investors can short names by buying CDS protection, or buying equity puts, but it can cause problems in markets like housing for example.

The straw that broke the US housing markets back, and most importantly destroyed value in subprime CDO's was the introduction of the ABX CDS product. This product effectively brought the first efficient method of shorting subprime mortgage pools in large size. Up until then, the financial markets didn't have the ability to efficiently short the subprime market. As a result, with a market only populated with buyers combined with a hopeless misunderstanding of CDO technology, the US subprime market started to bubble with no wily old hedge funds to bring asset levels back down to more realistic levels.

And then along came the ABX CDS product and give or take six months or so, the rest is history - the US housing market, particularly in subprime areas, collapsed. Had the ABX CDS product been launched 10 years earlier, the US housing market bubble arguably would never have happened or at the least been much smaller.

Hedge funds are the investors who have their fingers on the pulse of new innovations in markets and it is these innovations which help bring effeciency and fair valuation to assets.

Furthermore, hedgefunds and private equity firms also bring liquidity to projects which otherwise wouldn't see the light of day. This is key to encouraging a dynamic thriving economy. People need to find the innovation frontier in the economy in order to drive the discovery of new products and new markets. The only way to do this is in taking risk through entrepreneurs. So not only are hedge funds key for ensuring assets trade at fair prices, but they also help the economy grow and reinvent itself.

Hedge funds, and investors in general, should be given the whole range of products to trade all kinds of risks. The issue then becomes, ensuring the size of these risks remains appropriate for what the risk is.

For hedge funds to access liquid markets, they must typically do this through an investment bank or prime broker. Hedge funds need to be forced into having a prime broker so regulators can come to one investment bank and survey a hedge fund's entire assets. If the hedge fund has assets at multiple brokers, the regulators can't do this so easily. From here, the regulators need to decide appropriate sizes for risks at any one hedge fund. This also isn't an easy thing to do, but your goal is to ensure a hedge fund can default and be liquidated into the market without melting it. Fortunately there are now many examples of a hedge fund being liquidated to help guide this solution.

If you get the regulation right, and you help set up a virtuous circle which encourages investors and encourages an efficient financial system, you'll also make great strides in reducing systemic risk in the economic system. As the financial systems approaches some level of improved or 'peak' efficiency, you'll find that hedge funds strategies will get more varied and more and more diverse - this is the sign of a healthy financial system.

If hedge funds are all betting in the same direction in a particular market, you can bet your last dollar that they have probably all spotted a major inefficiency and they're simply waiting for the levee walls to breach.

I know some of these hedge fund managers who court publicity can be somewhat unpalatable. And the flaunting of their money too can be unpalatable. However, the more efficient the system gets, the less these people will get paid. Surely that's reason enough for encouraging them? And as for the politicians who want to ban short selling. If you look at the key people behind the drive, they are mostly at the end of their careers and at retirement age. They perhaps think, incorrectly, that a quick ban on short selling will save their pensions. Well, they're 10 years too late for that. They are, to some degree, reaping what they have sown.

Happy hunting,
Andy Shaw