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The Growing Hedge Fund Trend That's Fueling Systemic Risk (May 24, 2007)

Location: New York
Author: Lenny Broytman
Date: Thursday, May 24, 2007

It's certainly no secret that hedge funds have become a major component of the financial world over the past few years. Experts are saying that since the Financial Stability Forum (FSF) first reported on their effects on systemic financial risk in 2000, they have become even more influential in today's market.

The latest report, which was published on May 19, came at the request of G-7 finance ministers and central bank governors after their meeting in Essen, Germany in February. Although the report did not delve into any investor protection issues, it did focus on issues of systemic and financial stability, which are often posed by hedge funds.

According to an article posted on, the latest report found that competition for hedge fund business has become a contributing factor to increasing risk. According to the FSF's findings, declining initial margins are a sign that counterparty discipline is being relaxed.

"These complement other signs of complacency about risks in markets, such as the weakening of covenants in credit contracts, as well as the possible under-pricing of credit, market and liquidity risks," reports the FSF paper. "The materialization of these risks could pose serious challenges for market participants."

The organization maintains that systemic risk can take shape in two different ways. A direct risk can often stem from a counterparty's credit exposure to a hedge fund while an indirect example could be a hedge fund's forced liquidation of a position causing rapid deterioration of market liquidity and prices.

Furthermore, a lot of the aforementioned is often complicated by standardized risk measures and methodologies and the difficulties of aggregating and comparing risk exposures.

The original report, which focused primarily on the effects a potential hedge funds collapse could have on the market as well as other institutions, published several recommendations for investors.

The recommendations (taken from the FSF's website) are as follows:

  • Supervisors should act so that core intermediaries continue to strengthen their counterparty risk management practices.
  • Supervisors should work with core intermediaries to further improve their robustness to the potential erosion of market liquidity.
  • Supervisors should explore and evaluate the extent to which developing more systematic and consistent data on core intermediaries' consolidated counterparty exposures to hedge funds would be an effective complement to existing supervisory efforts.
  • Counterparties and investors should act to strengthen the effectiveness of market discipline, including by obtaining accurate and timely portfolio valuations and risk information.
  • The global hedge fund industry should review and enhance existing sound practice benchmarks for hedge fund managers in the light of expectations for improved practices set out by the official and private sectors.

While the bulk of the report's recommendations mention market supervisors, the FSF still maintains that it favors a principles-based approach to the issue.

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