HKMA Chief Worried About Risks Posed By Hedge Funds

by Mary Swire, Tax-News.com, Hong Kong

09 July 2007

Hong Kong Monetary Authority chief Joseph Yam has said that while hedge funds bring benefits to the financial markets, the current regulatory framework may not be robust enough to remove systemic risks to the global financial system posed by hedge fund activities.

Writing in his latest 'Viewpoint' column, Yam warned that although the hedge fund industry has evolved over the past decade since the Asian financial crisis, which he said was triggered by "a group of aggressive hedge funds", there remain concerns about hedge fund activities in the region.

"Hedge funds can bring significant benefits to financial markets, but they also bring with them the possibility of systemic risks," he observed. "On the positive side, hedge funds help provide additional liquidity to financial markets and improve market efficiency by taking risks to exploit arbitrage opportunities. They also facilitate financial innovation by participating actively in developing and trading complex and innovative financial products, such as credit derivatives. The greater risk appetite of hedge funds increases the overall risk-taking capacity of the global financial system, while their "contrarian" investment style tends to stabilise financial markets by maintaining liquidity during sharp declines in asset prices."

However, Yam went on to caution that: "Despite all these benefits, hedge funds also raise concerns about significant systemic risk, and these concerns are growing along with the increasing asset size of hedge funds and their share of turnover in various markets. Hedge funds now account for roughly 40% of the turnover of major stock exchanges, a quarter of credit derivatives turnover, and around one-quarter of high-yield bond holdings."

Yam believes that systemic risk is most likely to arise from the failure of a significant hedge fund that has large exposures to other financial institutions.

"The failure itself, and any panic sell-off afterwards, could push up the risk premium, causing a sharp decline in asset prices that might eventually drain the market of liquidity. It might also trigger herding behaviour among some less sophisticated hedge funds," he wrote. "Too many one-way bets could create excessively concentrated positions, which would make the financial system more vulnerable to sudden market shocks and disorderly exits."

Yam added:

"The potential systemic risk from hedge funds is further amplified by their unstable capital base, which is likely to shrink quickly in times of stress either because of redemption by the investors or the funds’ leverage ratio being too high. The latter problem is becoming more acute, because it is difficult to accurately measure the embedded leverage in complex structured products."

The HKMA chief noted that hedge funds also present new challenges to regulators, since most hedge funds fall outside of national regulatory regimes.

"It is very difficult to bring them under proper regulation because they can easily relocate to a jurisdiction with lesser regulatory requirements. What makes the oversight of hedge funds so difficult is that care needs to be taken to avoid stifling the creativity and innovation in financial products they bring about. The goal is to harness the benefits of having the hedge funds in financial markets while building sufficient safeguards to address the systemic risk they create. This is no easy task," Yam observed.

Hedge funds are also fundamentally changing the structure of the international financial system, suggested Yam. "As Governor Noyer of Banque de France put it, market dynamics are now increasingly disassociated from banking intermediation."

"We have seen large-scale transfer of credit risk from the banking sector to hedge funds through securitisation and the use of credit derivatives. The fact that banks no longer need to bear the ultimate credit risk may weaken their incentives to lend money more prudently, sometimes leading to an erosion of credit standards. But the hedge funds, which are the ultimate risk bearers, may not have sufficient information about the underlying credit risk of the structured instruments they have bought," Yam wrote.

This issue has been highlighted by the recent failure of the two hedge funds run by Bear Stearns which specialised in investing in collateralised debt obligations with sub-prime mortgage loans as underlying collateral, according to the HKMA chief.

"While credit rating agencies may be able to fill this information gap, credit risk may still be mis-priced," he wrote, continuing: "In facing these challenges, most regulators choose to manage the systemic risk of hedge funds through the regulation of their counterparties, mostly banks and securities firms. This indirect oversight approach is desirable because it preserves the incentive for hedge funds to promote financial innovations. It is also a more pragmatic approach given how hard it is to subject hedge funds to direct regulation."

He concluded: "Nonetheless, there are still some questions about whether the current approach of indirect oversight is adequate to address the systemic risk of hedge funds."

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