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The Dodd financial reform bill currently making its way through the banking committee has a number of shortcomings, including the proposed regulation of hedge funds, which should trouble pro-market types and the left wing.

In the summary (pdf) of the bill, Dodd suggests that one of the benefits of the measure is that it

Closes Loopholes in Regulation: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Two of these items stand out as somewhat unrelated to our recent financial crisis: payday lenders and hedge funds. Payday loans are a separate conversation. But the attack on hedge funds is mostly spurious.

A hedge fund is neither the product of a loophole nor an "abusive practice." The Investment Company Act of 1940 made the exception that a fund investing on behalf of fewer than 100 clients -- hedge funds -- need not face the same regulations as a bank that serves huge numbers of small depositors, which seems eminently reasonable. And hedge funds are widely acknowledged as having managed risk and abuse better than heavily-regulated banks in the financial panic.

So why single out hedge funds, among many other kinds of financial entities, for increased regulation?

The answer seems to be pure populism. In the popular imagination, hedge funds=greed, so they're getting heavier regulations. Senate Democrats are throwing their base a bone (it's worth mentioning that similar, more restrictive provisions were in the House version of the bill and in the administration's plan).

The Democratic base should throw that bone right back at Dodd, though, because the bill is written to avoid having the advertised effect. That is, it's written up to include loopholes to allow hedge funds to continue whatever risky or abusive practices they've engaged in previously. The key loophole is that there is no real common definition of a hedge fund. The only concrete distinguishing feature of a hedge fund is that it has under 100 owners. Usually a hedge fund entails some combination of a long/short strategy and leverage, but not necessarily. There is no bright line dividing what are referred to as hedge funds, private equity funds, and venture capital funds -- they are legally similar firms distinguished mostly by different business models . Yet Dodd would attempt to "close loopholes" on hedge funds without affecting private equity or venture capital firms. How? From the text (pages 377-378, pdf):

Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘venture capital fund' for purposes of this subsection....   Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules... to define the term ‘private equity fund' for purposes of this subsection.'

In other words, the Democrats would pass the bill, satisfying the left-wing's resentment of Wall Street fat cats, and then give hedge fund managers six months either to lobby for very wide definitions of venture capital and private equity or to make whatever small organizational changes are necessary to get away with calling their firms venture capital or private equity instead of hedge funds.