Executive summary - Udo Bullmann

But the rapid growth of the hedge fund industry also raises important questions about thepossible negative implications for financial stability and other risks. As we see it, we cansummarise the risks in the following points:• The systemic risks, ie. the risk of destabilisation of financial markets. Hedge fundscan cause financial instability through their potential impact on financial markets and banks.The near collapse of LTCM in September 1998 provides the most vivid example of howhedge funds have the potential to disrupt the functioning of global financial markets.• Market abuse i.e. potential market price manipulation and insider trading. The highpressure on production of extreme growth yields by managers and the use of out-performancecommissions can create pressure on hedge funds to test the limits of certain rules of themarket. The impact of such market abuse will be substantial in a market environment wherespeculative funds represent between one third and one half of the arbitrating volumes.• The misbehaviour in shareholder activism. We are seeing too many examples ofhedge funds exerting excessive influence on the strategy of some listed companies with apotential negative impact on all stakeholders. This is clearly because hedge fund activitiesfavour a short-term approach of the target company strategy. The short-term approach is indirect contradiction to the long-term needs of companies to compete on investments in theglobal economy.• Insufficient supervision of operational risks and insufficient internal control. This isthe question of inadequate validation of illiquid and complex assets held by hedge funds.• Mis-selling of the sale of inappropriate alternative projects to insufficiently informedclients.Hedge funds have shown very impressive growth over recent years and have developedinto a very important alternative investment instrument - for good and sadly also for the lessgood. The international character of the hedge fund industry and its unregulated nature,challenges our societies and authorities.The possible implications of hedge funds for the stability of the financial systems are notonly a problem for the hedge funds - the far-reaching consequences in case of a risk beingrealised will hit corporate industries, employment, and investments as well as pensioners’savings.All in all, there is a central argument for reducing risks associated with the increasing roleof hedge funds in the financial system. Given the case for regulating banks and investmentbanks and other financial actors - we must ask why should hedge funds and private equity beany exception? Given the readiness to reforms labour markets in all European macroeconomies as well as our goods markets - why should the new developments of the financialmarkets around hedge funds and private equity be exempted? We can summarise this part ofour analysis by saying there is a strong case for demanding transparency and disclosure - anda strong case for some sort of incentives/regulations to ensure against systemic risks, marketabuse, risk to the governance of listed companies, risk of poor asset evaluation, andprotecting insufficiently informed investors.35