FRANKFURT, Germany (HedgeWorld.com)--In separate reports this month, both the European Central Bank and the Bank of England highlighted the risks, but also the benefits, of hedge funds with respect to financial markets.
Leverage, lack of transparency and concentrated trading positions were among the potential concerns, while liquidity and the stabilizing effect contrarian trading, like that done by some hedge funds can have on markets, were among the benefits, according to year-end financial stability reviews from both banks.
Bank of England officials seemed most pessimistic in their analysis, emphasizing that the growing use of leverage likely would enhance volatility should markets experience a significant shock or shocks. "A combination of leverage, relatively illiquid assets and, in many cases, model-based approaches to trading and valuation may, in the event of material asset price shifts, exacerbate stressed conditions," bank officials wrote.
This essentially was a toned-down version of the concerns the bank expressed in a decidedly "glass-is-half-empty" analysis it published in June.
Still, the bank pointed to what it called "crude proxies" that show funded leverage is on the rise. Although still not as high as in 1998, "given strong growth and the apparent increase in 'economic leverage,' it seems plausible to believe that potential leverage in the hedge fund sector may have been increasing in recent years," bank officials wrote.
Additionally, hedge funds pose risks to other financial institutions such as U.K.-owned banks and so-called large complex financial institutions, or LCFIs, via those institutions' exposure to either hedge funds directly--through lending or prime brokerage arrangements--or indirectly via the effect hedge funds can have on global financial markets.
While U.K.-owned banks' direct exposure to hedge funds is limited, according to the Bank of England report, hedge funds increasingly are linked to non-bank entities such as securities dealers, which provide prime brokerage, and to life insurance and pension funds, which increasingly are investing in hedge funds.
For Bank of England officials, it all comes back to leverage. "?? 1/2 hedge funds' leverage ?? 1/2 allows them to take positions that are far larger than their capital subscriptions," according to the report. "They also usually trade more actively than other asset managers, so they typically account for a much greater proportion of market activity than their assets under management suggest."
Finally, hedge funds tend to take similar positions, bank officials wrote, which can lead to problems if many try to exit those positions at the same time in response to some market disturbance.
That was a concern shared by European Central Bank officials, as well, along with growing use of leverage as returns flatten because the influx of capital into hedge funds recently has caused more managers to chase the same number of or fewer opportunities. "The so-called crowding of positions ?? 1/2 could have a destabilizing impact on both rising and, especially, falling markets."
Specifically Central Bank officials said there was evidence that hedge fund strategies like convertible arbitrage have reached capacity and may be seeing managers piling on the same positions. But this appears to be an isolated problem, at least for now, according to the bank report. Overall, concentration of positions in the hedge fund industry appears to be low, particularly with no super funds like Long-Term Capital Management operating today. That doesn't eliminate the possibility that with more capital flowing into hedge funds such crowding might pose a problem down the road.
Hedge funds' primary threat to overall financial stability comes from leverage, and the counterparty exposure that leverage creates among other financial institutions, according to the Central Bank report.
Of particular concern to Central Bankers was the potential for a domino effect should U.S. Treasury markets see rising yields as a result of foreign investors either selling or halting their purchases of U.S. government bonds. "Global over-the-counter (OTC) interest-rate derivative markets--markets that are known to be highly concentrated--would face strains from dynamic hedging activity," according to the Central Bank report. "The concentration in these markets, where several large euro area financial institutions have counterparty exposures, can raise the vulnerability of the global financial system to financial disruption. Moreover, risks could spill over through other channels of contagion to the euro area financial system."
The bankers complained that a lack of transparency has led to a dearth of data, which makes it difficult to estimate the effect hedge funds have on financial markets.
Central Bankers, however, saw more good in hedge funds than their counterparts at the Bank of England. Hedge funds contribute to market liquidity, are important in aiding price discovery, help eliminate market inefficiencies and have diversification benefits, they wrote.
"Under normal conditions, hedge funds contribute to the liquidity and efficient functioning of financial markets, but in certain cases, especially in small or medium-sized markets, their actions can be destabilizing," according to the Central Bank report.
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