Hedge funds and systemic risk

A hedge fund is a privately offered investment vehicle that pools the contributions of investors in order to invest in a variety of assets, such as securities, futures, options, bonds and currencies. Hedge funds have attracted growing attention from policy makers, financial market participants and the general public due to their rapid growth and substantial scale, their importance to banks as clients and the impact of their trading activity on global capital markets. Because of their rapid growth and the market disruptions caused by Long-Term Capital Management (LTCM) in 1998, some analysts believe that hedge funds pose systemic risks. However, this is unlikely. A thorough review of the avenues through which hedge funds could cause systemic problems indicates that, although a major disruption emanating from the hedge fund sector is possible, it would be diffi cult for the sector to be highly disruptive to fi nancial markets. Post-LTCM, regulatory authorities have encouraged banks to monitor their hedge fund clients through constraints on their leverage. This has thus far proven effective, as the recent failure of Amaranth demonstrates. That failure, the largest yet, caused hardly a ripple in the wider financial markets. Hedge funds support the robustness of markets in many ways. They provide attractive investment alternatives and improve economy-wide risk sharing. In addition, they promote fi nancial market stability by assuming risks that other market participants are unwilling or unable to bear; by providing liquidity; and by placing trades that move mispriced assets toward their “fundamental” values. Of course, hedge funds could raise problems through their dominant role in some markets, active trading strategies, use of leverage and relative lack of transparency. Counterparties must therefore be cognizant of the risks they bear from hedge funds. Also, regulators must continue to promote better hedge fund risk management and transparency through their regulation of counterparties while remaining vigilant about potential systemic risks emanating from the sector. On balance, however, hedge funds enhance market stability and are unlikely to be the source of a systemic failure.