Editor's Note: The following originally appeared on September 29, 2003 and, in light of current events, has been reprinted here for the benefit of the Minyanville community.

As the SEC progresses toward rules to regulate hedge funds, I thought it a good time to talk about their history and development, as well as their current and future role in the investment world.

As these funds become a more and more integral part of the investment process, it's important to understand where the media and other laypeople are misinformed about how they operate and how they affect the financial system. This is a history, and not the history, because it is my history - and my opinion.

I started at Morgan Stanley (MS) in 1983 as a trader in derivatives. We made markets in both listed and over-the-counter options for large institutional clients. As a consequence of facilitating their trades (creating a position on our books opposite the position on their books), we ran a multi-billion dollar portfolio of derivatives, the size of which would make any dealer today chuckle.

We didn't have the computing power available today, either, so our thinking skills had to be pretty sharp. When we agreed to execute a customer order at a certain price, we took the order down to the floor of one of a number of option exchanges.

There we negotiated the price and quantity of each trade with the floor market makers, 10% of which were brilliant and 90% of which followed the other “Ten”. The Ten found that they could make a lot more money if they were in many places at once, participating in many such “institutional” trades.

Is there another Bear Stearns out there?
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I can remember a conversation I had with Jeff Yass about this. We agreed that he would leave the floor for an upstairs office, and I would call him on the phone with a trade we were pricing. He would participate in the trade as normal, but now I would execute his side of the trade as well as the customer’s for a small fee. This worked so well that he expanded his business several fold, growing his firm, called Susquahana, into one of the premier “upstairs” market making firms in the country.

There were other individuals, like Irv Kessler (Irv went on to form Deephaven in Minneapolis, one of the largest and most successful multi-strategy hedge funds in the world), Dan Asher, and Marc Kelner, all brilliant traders that likewise banded together and raised significant amounts of capital to start similar trading firms specializing in options. There were others already organized as firms, like O’Connor Securities and Chicago Research and Trading, that grew exponentially as option volume and liquidity expanded.

All these became a “blueprint” for what I consider to be the first “hedge” funds.

Before going any further, note that the firms that developed into hedge funds were predicated on providing liquidity: Selling derivatives to buyers and buying them from sellers. When you provide liquidity, you reduce rather than increasing volatility (the more liquid something is, the less volatile it tends to be).

One of the primary criticisms of hedge funds (forwarded by people like William Safire) is that they increase volatility. There are certainly hedge funds that do so in certain situations -- because they use too much leverage and have too highly concentrated positions -- but in general, it's my opinion that it's a wash at the end of the day.