Executive summary - Udo Bullmann

One year earlier the British Financial Service Authorities (FSA) took a similar stance arguingthat “significant distress of a large and highly exposed hedge fund – or, with greater probability, acluster of medium sized hedge funds with significant and concentrated exposures – could causeserious market disruption.” This is particularly likely to be the case in markets where hedge fundshave taken large positions or when markets are relatively illiquid. The FSA furthermoreemphasised that a crisis “… could also erode confidence in the financial strength of other hedgefunds or of firms which are counterparties to hedge funds.” 26The concerns of the ECB and the FSA stand in contrast to the relaxed attitude of theInternational Monetary Fund (IMF) and the Bank of England, both of which have stressed thepositive effects of hedge funds while recognising minor dangers. Among the potentially positiveeffects mentioned are liquidity provision and the removal of perceived market inefficiencies byarbitraging away price differences for the same risk across markets. 27In its recent report the Alternative Investment Expert Group of the European Commissionseems even more relaxed than the IMF and the Bank of England. Thus, the report devoted justone short paragraph to the issue of hedge funds and financial stability. In this paragraph it isstated that “there is little evidence to suggest that hedge funds threaten financial stability”.Moreover, the Expert Group claims – with strikingly few references to empirical evidence – thatthe LTCM crisis has “prompted the tightening up of controls as investment banks havesignificantly improved the way in which they manage their exposures to hedge funds.” 28Who is right? In the following we will argue that the crisis of LTCM and other hedge funds hasproved to be only a temporary setback for the long-term growth of the hedge fund industry. Inaddition, several of the factors that played a central role in the LTCM crisis remain. Last but notleast, regulators still find themselves in a situation with an enormous lack of transparency andreliable data on which to base informed decisions about threats. Consequently, it is difficult totake proportionate regulatory action to prevent or counter such treats. For these reasons, we sidewith those who believe that hedge funds have created substantial threats to global financialstability, threats for which there are currently too few remedies.We will return to the remedies, i.e. recommendations for voluntary and regulatory action in PartIII. Thus the focus of this chapter – and our fifth and last major concern – is on the threats thathedge funds pose to financial stability. To structure the analysis, it seems useful to distinguishbetween six factors explaining why hedge funds may pose threats to financial stability. Thesefactors are often related, meaning that a financial crisis may be escalated through mutual linksamong several factors. For instance, market risk, liquidity risks and leverage may interact.Ideally, a risk assessment ought to analyse such potential patterns of interaction. Yet, this isbeyond the scope of this chapter. Here we will have to deal with the factors separately. Thefactors that we will deal with are:1. Risk taking in the context of growing competition and high performance fees2. Growing assets under management3. Short selling26 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).27E.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)28European Commission (2006): Report of the Alternative Investment Expert Group: Managing, Servicing and Marketing Hedge funds in Europe,http://ec.europa.eu/internal_market/securities/docs/ucits/reports/hedgefunds_en.pdf, p. 12 (08.11.2006).