Hedge funds bring benefits but also risks to financial markets. Is regulating their counterparties enough to manage the risks?
To talk about the role of hedge funds in financial markets would have been highly controversial back in 1997, when Asia was hit by a very severe financial crisis, which was widely believed to have been triggered by a group of aggressive hedge funds. Although a decade has passed during which the hedge fund industry has evolved a lot, there remain concerns about hedge fund activities in the region.
In fact, hedge funds continue to be controversial as seen in the market concerns over the collapse of Amaranth last year and the near failure of two Bear Stearns hedge funds more recently. Hedge funds can bring significant benefits to financial markets, but they also bring with them the possibility of systemic risks. On the positive side, hedge funds help provide additional liquidity to financial markets and improve market efficiency by taking risks to exploit arbitrage opportunities. They also facilitate financial innovation by participating actively in developing and trading complex and innovative financial products, such as credit derivatives. The greater risk appetite of hedge funds increases the overall risk-taking capacity of the global financial system, while their "contrarian" investment style tends to stabilise financial markets by maintaining liquidity during sharp declines in asset prices.
But, despite all these benefits, hedge funds also raise concerns about significant systemic risk, and these concerns are growing along with the increasing asset size of hedge funds and their share of turnover in various markets. There are now around 10,000 hedge funds around the world managing about US$1.6 trillion of assets, with increasing retail and institutional interests. Hedge funds now account for roughly 40% of the turnover of major stock exchanges, a quarter of credit derivatives turnover, and around one-quarter of high-yield bond holdings.
Systemic risk is most likely to arise from the failure of a systemically important hedge fund that has large exposures to other financial institutions. The failure itself, and any panic sell-off afterwards, could push up the risk premium, causing a sharp decline in asset prices that might eventually drain the market of liquidity. It might also trigger herding behaviour among some less sophisticated hedge funds. Some people argue that the increasing correlation between the returns of hedge funds and the performance of stock markets suggests that some hedge funds are taking more beta risk than the market expects. Too many one-way bets could create excessively concentrated positions, which would make the financial system more vulnerable to sudden market shocks and disorderly exits.
The potential systemic risk from hedge funds is further amplified by their unstable capital base, which is likely to shrink quickly in times of stress either because of redemption by the investors or the funds' leverage ratio being too high. The latter problem is becoming more acute, because it is difficult to accurately measure the embedded leverage in complex structured products.
Hedge funds also present new and unique challenges to regulators. The majority of hedge funds fall outside any regulatory regime. It is very difficult to bring them under proper regulation because they can easily relocate to a jurisdiction with lesser regulatory requirements. What makes the oversight of hedge funds so difficult is that care needs to be taken to avoid stifling the creativity and innovation in financial products they bring about. The goal is to harness the benefits of having the hedge funds in financial markets while building sufficient safeguards to address the systemic risk they create. This is no easy task.
Hedge funds also create fundamental changes to the structure of the international financial system. As Governor Noyer of Banque de France put it, market dynamics are now increasingly disassociated from banking intermediation. We have seen large-scale transfer of credit risk from the banking sector to hedge funds through securitisation and the use of credit derivatives. The fact that banks no longer need to bear the ultimate credit risk may weaken their incentives to lend money more prudently, sometimes leading to an erosion of credit standards. But the hedge funds, which are the ultimate risk bearers, may not have sufficient information about the underlying credit risk of the structured instruments they have bought. These issues are accentuated by the recent failure of the two hedge funds run by Bear Stearns that specialise in investing in collateralised debt obligations with sub-prime mortgage loans as underlying collateral. While credit rating agencies may be able to fill this information gap, credit risk may still be mis-priced.
In facing these challenges, most regulators choose to manage the systemic risk of hedge funds through the regulation of their counterparties, mostly banks and securities firms. This indirect oversight approach is desirable because it preserves the incentive for hedge funds to promote financial innovations. It is also a more pragmatic approach given how hard it is to subject hedge funds to direct regulation.
Nonetheless, there are still some questions about whether the current approach of indirect oversight is adequate to address the systemic risk of hedge funds. I will discuss this in more detail, and offer my thoughts on what the best regulatory approaches might be next time.
Joseph Yam
5 July 2007
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