SHADY organisations ruthlessly manipulating complex strategies. Highly paid operatives striving to locate and deploy powerful weapons with the potential to wreak havoc.

It sounds like the latest spy thriller — or the scary picture drawn by a government’s dossiers in the build-up to the war on Iraq.

In fact, this is a description of the burgeoning operations of hedge funds — operations that may now pose a threat greater than Saddam Hussein and his elusive weapons of mass destruction.

The growth of the largely unregulated hedge-fund industry has been phenomenal and has elevated its importance to the preservation of financial stability. In 1999 there were about 6,200 hedge funds managing assets worth $480 billion. By the end of this year the International Monetary Fund expects the number of funds to have reached almost 9,000 and the assets involved to have more than doubled to about $1,000 billion (£555 billion). In the first quarter of this year, another $38 billion flowed into hedge funds — half the increase for the whole of last year.

The speed and scale of this expansion has, unsurprisingly, caught the attention of regulators. Tomorrow America’s Securities and Exchange Commission will take a decision on whether to compel hedge-fund managers to register and it looks likely to bring their activities under its umbrella.

The SEC’s move, proposed in the summer, has been opposed by the industry, which has won powerful support — not least from Alan Greenspan, the Federal Reserve Chairman. The industry and Mr Greenspan have voiced concern that the SEC’s limited plan for registration and a modest degree of increased disclosure will end up as the thin end of a thick wedge of extra regulation. Mr Greenspan rightly argues that hedge funds have played an important role in fostering deeper and more liquid capital markets worldwide.

These reservations fail to confront the escalating potential dangers to financial stability being fomented by hedge funds as a consequence of three factors: the exploding scale of the industry; its increasing use of leverage; and the growing prevalence of herd behaviour in a desperate pursuit of high returns.

The expansion of the hedge-fund sector has two consequences. As the industry balloons, its increased weight means that it can no longer be regarded as a fringe element of limited importance. More crucially, as it mutates from the esoteric instrument of the wealthy to a mainstream tool employed by pension funds and other key institutions, the sector’s players are being compelled to take bigger risks.

The outsize returns that make these funds attractive depend on their use of innovative strategies not available in the rest of the market; by definition, hedge funds must be contrarian and innovative. Yet securing this distinctiveness becomes more difficult as the number of funds, and the money they manage, multiply.

Leverage — in other words, making bets with borrowed money — adds to the scale and the risks.

Hedge funds have always borrowed money to back their trading strategies, but it was the scale of leverage used by the LTCM fund that led to its near-collapse and a global financial crisis in 1998. But the amount of other people’s cash in play has been ratcheted upwards by the creation of so-called funds of funds. In theory, these allow cautious institutions to play the hedge game in safety by putting their money into a range of funds.

However, the benefits of this diversification may be wiped out as the funds of funds try to bolster their performance by borrowing extra money to invest. If some of the initial investors have also borrowed part of their stake, then debt is being used to finance debt and a house of cards is being built.

The twin problems of scale and leverage are now coalescing with herd behaviour by competing hedge funds to create a lethal brew.

Weak returns on conventional investments and the flood of cash into hedge funds are driving the sector’s managers into a scramble for ever more innovative strategies and ever more exotic instruments. No sooner is a new technique or investment discovered by one group than it is copied by competing funds. Thus a fresh search for higher returns on the fringes of the financial world begins. And, like lemmings, the funds dash closer to the cliff.

The result is that an escalating amount of money is being bet on the same extreme positions. And since funds rely on similar models to gauge the scale of their gambles, the fear is that some unexpected development could cause a simultaneous dash for the exit, with disastrous consequences.

Little wonder that the SEC feels it needs to shed some light into these muddy ponds.

The commission can only be right to conclude that it is long past time to clip the more exotic branches of the hedge-fund industry.

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