Executive summary - Udo Bullmann

implications associated with the liquidation of Amaranth’s assets. It is, however not at all certain,that such mechanisms would have worked if a number of hedge funds had experienceddifficulties at the same time.Sources:- Banque de France, Financial Stability Review, No. 9, December 2006, p. 23. (Main source).- Herald Tribune International (2006): Anatomy of a hedge funds $6.6 billion. Failure, December7.- Handelsblatt (2006): Milliardenverluste des Hedge-Fonds Amaranth schüren die Angst voreiner Finanzkrise, Oktober 20.5.5 Concentration on less liquid marketsIn addition to increasing correlations, the ECB has stressed that the liquidity of many hedgefund investments may be decreasing, “… as recently hedge funds have reportedly been acquiringless liquid assets.” In this connection the ECB argues that “most strategies involving liquid assetshave come under pressure due to higher competition and lower profitable trading opportunitiesacross common strategies. Hence, more funds have been turning to increasingly exotic strategiesand less liquid markets in order to earn the associated liquidity premium.” 38The latter in turn increases the vulnerability to redemption risks in the advent of a crisis. Thus,in stressed times, a squeeze can arise especially in less liquid markets. When several hedge funds,that are pursuing the same strategies, rush for cover, liquidity evaporates suddenly in thosemarket segments. Instead of bringing in liquidity, hedge funds generate major liquidity risks. Themix of credit and liquidity risks in investment styles using short selling-come-leverage can makehedge funds the weak links initiating a systemic event. If hedge funds are induced to withdrawtogether from the same markets under the constraint of a higher cost of financing or margin calls,the forced selling of assets could trigger the same behaviour among more traditional institutionalinvestors. This could in turn spark a financial crisis.From a geographic perspective, Asia currently seems to be a major growth area of hedge funds.In this area markets often tend to be less liquid 39 . The taking of positions in relatively illiquidOTC derivatives and the adoption of private equity-style investing are further examples of a trendtowards decreasing liquidity. In addition to this, moves into illiquid assets have beencomplemented by changes in macro economic policies affecting the liquidity of existingpositions. One example of this was when – in early 2006 – Japan ended its seemingly endlessmonetary easing policy, thereby taking around €190 billion out of the global financial markets.5.6 High leverage and concentration in complex derivative productsA key characteristic of many hedge funds is a very high degree of leverage compared totraditional funds. In the aftermath of the LTCM crisis, the US President’s Working Group on38 ECB (2006): ibid., p. 137.39FSA (2005): ibid., item 3.21.