The Federal Reserve does not believe any one hedge fund can topple the financial system and therefore the private pools of capital may escape direct supervision by the central bank, an industry source familiar with the Fed's position said.

The newly created Financial Stability Oversight Council, which includes the Treasury secretary and 14 U.S. supervisors, including the Fed, are in the early stages of determining which non-bank firms pose a threat to the financial system.

Firms labeled as systemically important will be subject to rigorous oversight by the Fed but will also have access to the central bank's emergency lending facilities.

The indication that hedge funds might escape this designation is sure to send a huge sigh of relief through the $1.7 trillion industry, which has long avoided the tighter controls imposed on mutual funds, for example.

In exchange for looser regulations, hedge fund firms promise to allow only wealthy and sophisticated investors like pension funds and endowments into their portfolios.

The Fed's view will carry considerable weight among the Financial Stability Oversight Council, which was created by the Dodd-Frank legislation to monitor risks to the financial system in the aftermath of the 2007-2009 credit crisis.

The source said the Fed does not think any one hedge fund can be systemically important but believes that information about the funds' positions could give the council insight into potential risks. The source requested anonymity while discussing talks held with the Fed.

The Fed did not immediately return a call seeking comment.

INDUSTRY SAYS NO

Already a number of financial industry firms, ranging from insurers to mutual funds, are trying to convince regulators they are do not pose a threat.

Mutual funds tend to manage much more money than hedge funds. The world's biggest mutual fund, Pimco Total Return Fund, managed by Bill Gross, oversees $250 billion. By comparison, John Paulson's hedge fund firm Paulson & Co, ranked among the world's largest hedge funds, oversees about $30 billion.

The Managed Funds Association, which lobbies for the hedge fund industry, argues that individual funds do not pose a systemic risk.

It told regulators that the industry made risk management changes after the 1998 collapse of Long-Term Capital Management roiled financial markets and prompted a bailout by other industry players at the urging of the Clinton administration.

The resulting changes may be one of the reasons that hedge funds were not the focus of the recent global financial crisis, the group said in a November 5 letter to Treasury Secretary Timothy Geithner, who chairs the Financial Stability Oversight Council.

The council, which also includes the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corp, is seeking input on what criteria to use to decide which non-bank firms and clearinghouses should be considered systemically important. It is unclear when they will start designating firms.

NEW RULES FOR HEDGE FUNDS ANYWAY

Even if hedge funds are not labeled systemically important, they will still face increased supervision and forced to be more transparent because of the Dodd-Frank legislation and recent SEC actions.

They have been able to exploit inefficiencies in the marketplace, by mining information that is not readily known to others, said Daniel Crowley, a partner at law firm K&L Gates, who represents financial services firms including hedge funds.

Their job will become harder when they have to register. Their trading strategies will become public, he said.

The SEC now has the power to regulate the trillion-dollar industry. Many of the world's largest hedge funds have already registered with the SEC, agreeing to divulge certain details about how they run their businesses and how much money they oversee.

The funds' activities have also been curtailed with the SEC's recently adopted short sale rule, which restricts short selling in a company's stock if the stock falls more than 10 percent. Hedge funds, unlike mutual funds, have long relied on short selling, or betting that a stock price will fall, to make money even in down markets.

Under Dodd-Frank, hedge funds, banks and others that deal in the estimated $600 trillion over-the-counter derivatives market will be forced to set aside extra funds to trade the financial instruments.

The Commodity Futures Trading Commission's plan to limit speculation in energy and metals will also impact certain funds' activities.

(Additional reporting by Svea Herbst-Bayliss in Boston; Editing by Leslie Adler)

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