Hedge funds: a central bank perspective

The international financial system is undergoing a sustained process of structural change characterised by features such as the rapid growth of the hedge fund industry and credit risk transfer markets. In general, this development should generate positive effects for the efficiency of the financial markets. As the financial system is becoming more complex and less transparent, however, it is becoming a growing challenge for central banks to make an adequate assessment of the potential risks to financial stability. From a monetary policy perspective, hedge funds are likely to infl uence the transmission mechanism as well as the international linkages between interest rates and exchange rates. However, it has proved difficult up to now to track these effects empirically. The main concern with regard to financial stability is that failures of one or more larger hedge funds might jeopardise the stability of major complex financial institutions and/or create market liquidity crises. Probably the most important line of defence in containing potential risks to stability is adequate market discipline, which, in turn, requires hedge funds to be sufficiently transparent. There are doubts as to whether the purely market-driven process of recent years has produced sufficient progress in this respect. Therefore, given the key importance of market discipline exercised by the hedge funds’ prime brokers, the recommendations of the Counterparty Risk Management Policy Group II (Corrigan Group) should, as a matter of principle, be implemented in full. These recommendations contain proposals on hedge funds’ disclosure vis-à-vis counterparties. Especially prime brokers should aim at tailoring credit terms, especially collateral and margin requirements, to the transparency and the risk profi le of their respective hedge fund counterparties. The increasing investments of institutional investors such as pension funds, foundations, and insurance corporations are, on the whole, likely to help improve the quality of hedge funds’ risk management and disclosure. Nevertheless, there are evidently still considerable differences in disclosure practices and the current recommendations of the hedge fund industry associations fall somewhat short of earlier international recommendations. Against this backdrop, it would be desirable if the hedge fund industry were to define more demanding sound practices of disclosure to investors. It would also be useful if such best practices were to be incorporated into a voluntary code of conduct. Finally, it might be worthwhile examining whether the current indirect approach to monitoring regulated financial institutions’ substantial risk exposures to hedge funds should be further improved, for example, by strengthening the international cooperation among prudential authorities. Central banks are committed to not impeding an efficiency-enhancing process of structural transformation that can be observed within the financial system. At the same time, however, a suitable framework needs to be put in place so as to ensure adequate market discipline and the appropriate degree of transparency. This would constitute a key safeguard against significantly increased macroprudential stability risks in the wake of any market adjustments in the hedge fund industry in a less favourable economic setting.