Hedge Funds, Financial Stability and Market Integrity 4. Conclusion

There is a strong ‘in principle’ case in terms of financial stability and market integrity for a public-policy response to the emergence of hedge funds as major players in financial markets. Any response, however, needs to be mindful of the possibility that specific controls on hedge funds could simply lead to the development of a different set of institutions which pose much the same risks. Effective responses need to address the sources of the problems, not just their manifestation. This means addressing the factors that allowed hedge funds to obtain large positions in some markets.

There is no single solution, with the most effective responses involving a combination of changes to supervisory practices, changes to the Basle capital arrangements and improvements in disclosure.

Bank supervisors need to work with supervised institutions to improve internal credit assessment procedures. Particularly important is the need to develop stronger collateralisation arrangements. A set of sound practices will help in this regard. The effectiveness of these sound practices is likely to be enhanced if a mechanism is developed through which institutions are required to disclose their compliance with these practices.

The current capital arrangements also need reviewing. In a number of important areas the capital charges for exposures generated in financial markets do not bear a close relationship to the risks being incurred. This had led to the financial institutions mispricing risk and paying to too little attention to the size of their exposures.

There is also a need for additional disclosure of information that is useful in assessing market concentration, credit risk and the health of markets. In each of these areas, the private market has not delivered adequate information, and a public-sector response is needed. While there are a number of ways forward, one approach is for regulators to specify a minimum set of information that should be publicly disclosed by all active participants in financial markets. This set of information might include details of large positions relative to the market, various measures of VaR, stress tests and measure of the performance of the VaR models. To encourage compliance, regulated institutions could be required to hold additional capital against exposures to any institution that did not meet these minimum standards.

In each of these areas, the most effective results are to be obtained through international cooperation. However, if agreement cannot be reached, unilateral action, particularly by countries with developed financial markets and in which hedge funds have major operations, will need to be considered.