Central banks' warnings about hedge funds

By Neil Behrmann

London :- Central banks believe that market participants should introduce innovative risk controls, now that hedge funds have become so influential in global financial trading.

At a conference convened by the Hong Kong Monetary Authority, Timothy F. Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York said that banks should institute flexible but tighter risk controls and higher margins to control hedge fund dealings.  These "challenges" would help prevent a vicious circle of hedge fund failures, further market volatility and losses and an ultimate financial crisis.

The global financial system's resilience to shocks in recent years "is not just good luck", said Mr Geithner. "It is the consequence of efforts by regulatory, supervisory and private financial institutions to address previous sources of systemic instability.

"We should focus more attention on parts of the risk-management process where uncertainty is greatest.... It means more attention on assessing potential exposure in extreme events that lie outside past experience, not just those outside of the recent past."

At the same conference incoming Reserve Bank of Australia governor Glenn Stevens added that in normal markets hedge funds improve liquidity in markets.  During times of unexpected sharp market movements, however, they can disrupt dealings and aggravate financial stress by simultaneously dumping securities or derivatives. The hedge fund crowd can also get carried away in bull markets, helping create bubbles that ultimately lead to a market crash.

Activity of some 8,500 hedge funds, estimated to control US$1300 billion to US$1700 billion is not exaggerated according to independent surveys in the market. By placing small margins or deposits on securities and deposits and by borrowing, leverage can boost the amount that global hedge funds control to around $3 trillion. Greenwich Associates' 2006 Fixed-Income Investors Study estimates that hedge funds now generate 45 per cent of annual trading volume in emerging market bonds, 47 per cent of annual volume in distressed debt, about one-third in leveraged loans and one-quarter of the dealings in high-yield bonds.  The influence is particularly evident in credit derivatives because of the leverage of these instruments, according to Greenwich . In the past year, hedge funds accounted for more than 55 per cent of all credit derivatives trading, the firm estimates.  Greenwich also believes that hedge funds account for almost a third of brokers' equity commissions in the US and a rising proportion in Europe and Asia .

"The surge in trading in derivatives and other fixed-income products, mean that in certain instruments hedge funds have become the market," contends Peter D'Amario. a consultant at Greenwich Associates. Investment banks are making significant changes in research and trading divisions to cater for hedge fund clients.  Greenwich cautions that there is potential for conflict of interest. "Sell-side firms (brokers) want to cover hedge funds more actively, but at the same time some dealers are looking and acting more like hedge funds themselves," by carrying out proprietary i.e. in house speculative trading.

The surge in speculative trading means that market participants should use a mix of different analytical tools and scenarios to help gauge the dimensions of uncertainty and potential losses, Mr Geithner of the New York Fed believes. The efficacy of "stress testing and scenario analysis" should be viewed not only as tools for monitoring risks but would cover the broader distress that a hedge fund failure might cause in the market.

As leverage increases and as hedge funds grow in importance, "the overall level of margin held against positions can provide an important cushion against the type of adverse market dynamics and general run on liquidity we saw in 1998.", Mr Geithner added.  Margin levels should be set at limits that are "sustainable over the cycle."

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