How important are hedge funds to a newly regulated Wall Street?

Sabastian Mallaby on hedge funds and financial regulatory reform:

It is not enough to prevent risk from building in the wrong places. Congress should also take a view on where the risk should go. Lawmakers should be asking themselves what type of financial vehicle survived the stress test of the recent crisis. Then they should encourage that type of firm.

What firms am I talking about? Hedge funds. In 2007, when the mortgage market imploded, hedge funds were almost unique in avoiding disastrous losses; as a group that year, they were up 10 percent. In 2008, when the Lehman collapse caused a seizure in the payments system, hedge funds lost money -- but far less than everybody else.

This wasn't just luck. Because of their design, hedge funds are the best risk managers in the world. Unlike the too-big-to-fail banks and investment banks, which are encouraged to be reckless by their government backstop, hedge funds have the great virtue of being small enough to fail. Over the past decade, about 5,000 went under, none of which required a taxpayer bailout.

Traders at big banks gamble with OPM -- Wall Street's contemptuous term for "other people's money." Again, the incentives at hedge funds are better. Hedge fund managers risk their personal savings alongside those of their investors, so they have good reason to avoid gambling too hard.

If hedge funds have healthy incentives, is Congress doing what it should? Unfortunately, it isn't. The bills under consideration require hedge funds with more than a paltry $100 million in assets to register with the Securities and Exchange Commission, and they threaten other burdens that will be especially onerous for smaller funds lacking armies of lawyers. This is an absurdity. Congress is creating obstacles for entrepreneurial boutique financiers -- precisely the players who must absorb the risks that were appallingly mishandled by too-big-to-fail behemoths.