Hedge funds and Private Equity - PES

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5. Stability of financial markets
The near-collapse of the hedge fund Long-Term Capital Management (LTCM) in 1998 raised
concerns that the rapid growth of hedge fund business could have negative effects on the
stability of financial markets (see box 1). Even though the collapse was prevented at the last
minute, there was a significant reduction of 10-year government bond yields in many developed
countries and a huge increase of the spreads between the 30-year and the 10-year maturities.
In addition to this instability in the more liquid markets the crisis had extremely negative effects
on emerging markets securities’ prices, where the trading ranges, as far as equity markets were
concerned, reached a width of almost 50% throughout 1998.
Financial instability and the related effects on counterparties and financial market confidence are
important for many reasons. From a macro economic and social point of view two are particularly
important. First, research has shown that financial instability is likely to slow down economic
growth for several years after a crisis has occurred. Second, instability often has significant distributional
consequences. This is especially the case in developing countries. Yet, even in the EU
member-states lower income households are likely to bear a disproportional burden in terms of
increasing unemployment and/or falling real-wages 56 .
So far LTCM remains exceptional. Nonetheless, a number of more recent, smaller crises have
prompted similar concerns about financial stability. This was for instance the case during the
crisis of the hedge fund Amaranth (see box 2). Against this background, a Wall Street Journal
survey among 50 renowned economists asked if “hedge funds pose a risk to the stability of financial
markets?”, 57% of the experts said yes 57 . Since June 2006 the European Central Bank
(ECB) Financial Stability Review contains a special section on hedge funds. In a clear hint of
rising concerns with the growing hedge fund business, the first of these sections described a
number of significant threats to financial stability that “warrant close monitoring”. In addition, the
ECB stressed “the essential lack of any possible remedies” to deal with the threats 58 .
One year earlier the British Financial Service Authorities (FSA) took a similar stance arguing that
“significant distress of a large and highly exposed hedge fund – or, with greater probability, a
cluster of medium sized hedge funds with significant and concentrated exposures – could cause
serious market disruption.” This is particularly likely to be the case in markets where hedge funds
have taken large positions or when markets are relatively illiquid. The FSA furthermore emphasised
that a crisis “… could also erode confidence in the financial strength of other hedge funds
or of firms which are counterparties to hedge funds.” 59
The concerns of the ECB and the FSA stand in contrast to the relaxed attitude of the International
Monetary Fund (IMF) and the Bank of England, both of which have stressed the positive
effects of hedge funds while recognising minor dangers. Among the potentially positive effects
mentioned are liquidity provision and the removal of perceived market inefficiencies by arbitraging
away price differences for the same risk across markets. 60
In its recent report the Alternative Investment Expert Group of the European Commission seems
even more relaxed than the IMF and the Bank of England. Thus, the report devoted just one short
paragraph to the issue of hedge funds and financial stability. In this paragraph it is stated that
“there is little evidence to suggest that hedge funds threaten financial stability”. Moreover, the
56 Stiglitz, J. (2000): Capital market liberalization, economic growth, and instability, in World Development, Vol. 28, No. 6, pp. 1075-1086.
57 Wall Street Journal (Phil Izzo) (2006, Oct. 13): Economic forecasting survey. Getting a grip on hedge fund risk,
http://online.wsj.com/public/article/SB116058289284889490-P5gz1td28WJajNheo7gAUEzUtkY_20071012.html?mod=rss_free
(16.11.2006).
58 ECB (2006): Financial Stability Review, http://www.ecb.int/pub/pdf/other/financialstabilityreview200606en.pdf, p. 142 (12.11.2006)
59 FSA (2005): Hedge funds: A discussion of risk and regulatory engagement,
http://www.fsa.gov.uk/pages/library/policy/dp/2005/05_04.shtml, item 3.2/p. 19 (06.11.2006).
60 E.g. speech by Sir John Gieve (Deputy Governor, Bank of England) at the 2006 Hedge Conference,
http://www.bankofengland.co.uk/publications/speeches/2006/speech285.pdf (13.11.2006)