The rapid growth of the hedge fund industry and the leverage that hedge funds employ in their trading strategies poses a risk, albeit low, to the future stability of the financial system, according to a report by Standard & Poor's.
According to S&P, hedge funds have "obvious liquidity benefits" for the financial markets and provide a useful mechanism for the transfer of risk. However, on the other side of the coin, hedge funds may be tempted to take more risky positions in the market place in an effort to boost returns after one of the leanest periods for the industry, and this has the potential to destabilise markets when "unexpected events" occur.
”Although hedge funds provide liquidity and facilitate risk transfer in the global capital markets, a sudden liquidation of leveraged positions due to margin calls could destabilize certain markets, particularly if collective redemptions of similar positions trigger a downward spiral of market prices outside of modeled expectations," said the report.
”The liquidation of positions to meet a margin call into a weak market can further depress prices. In extreme cases, a race to liquidity can ensue, resulting in widespread trading losses, not only for the hedge funds, but also for the trading desks of securities brokers. As a result, financial institutions’ links to the hedge fund sector go well beyond the direct losses a prime broker can incur from a failed hedge fund client," S&P warned.
However, the report also played down the chances of another Long Term Capital Management-stlye scenario, the hedge fund which went bust in 1998 and required bailing out by the US government, noting that banks have become more responsible in their lending to hedge funds, and also pointing out the the hedge fund industry has matured over the last three decades.
”The systemic risks are real, but this does not necessarily imply a bad ending," S&P's report observed.
A comprehensive report in our Intelligence Report series examining offshore investment, offshore stock exchanges, and hedge funds is available in the Lowtax Library at http://www.lowtaxlibrary.com/asp/subs_reports.asp and a description of the report can be seen at http://www.lowtaxlibrary.com/asp/description_report9.asp
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