Hedge Funds' Use Of Illiquid Assets Poses Risk To Financial Stability, Says FSA

by Phillip Morton, Investors Offshore.com

26 January 2006

While the risk posed by hedge funds to the overall stability of the financial system is low, their growing holdings of illiquid assets may nevertheless present a danger that markets could be destabilised at a time of future crisis, according the UK's financial regulator, the Financial Services Authority.

In its Financial Risk Outlook report for 2006, the FSA noted that although there are now several large multi-billion hedge funds, none of these comes to close to the size of Long Term Capital Management, which imploded spectacularly in 1998 sparking fears of a collapse in the US banking system.

Nonetheless, the FSA went on to observe that hedge funds appear to be increasing their investments in a range of asset classes which are "inherently less liquid than conventional assets, or whose liquidity is more likely to be reduced in times of market stress".

This could contribute to further volatility in times of an economic shock or other events causing panic in the markets, the FSA warned.

The authority also cautioned that conflicts of interest may arise when hedge fund managers are trying to value particularly complex instruments, leading to a temptation to over-state the value of assets, especially as assets under management are one of the key criteria governing fund managers' performance fees.

In general, the FSA foresees over the next twelve to eighteen months as a continuation of the "benign" economic and financial climate of 2005, which saw strong world economic growth and low volatility in the markets. However, the FSA warned that there are certain risks and uncertainties that will need to receive greater attention in 2006. It also stated that it is "easy" to identify an increasing number of severe risks which, although of low probability, would have high impact if they were to materialise.

The UK financial services regulator identified three main threats to financial stability that, if they were to occur in a "rapid or disorderly manner," would pose risks to both providers and users of financial services.

These are:

• A significant and sustained rise in oil prices;
• A slow-down in global consumption; and
• A large and disorderly depreciation of the US dollar.
  

The FSA also identified a number of other risks that may impair its ability to regulate the financial system and also upset the equilibrium of the markets, including:

• The reaction of firms to an extreme event such as a major corporate bankruptcy or global pandemic;
• The threat terrorism poses to the financial system;
• The level of outstanding credit-derivative trade confirmations;
• The growing risk of financial fraud;
• The volume of international regulatory reform;
• High levels of consumer borrowing;
• The increasingly complex nature financial decisions; and
• The pension funding crisis.

"In these circumstances it is important that senior managers in financial services firms do not rely on the continuation of the low volatilities and stability of recent years, but instead identify, analyse and test the impact on their firms of differing assumptions, by carrying out effective stress tests, and learning from them," urged Callum McCarthy, Chairman of the FSA.

Recommended