Hedge Funds, Financial Stability and Market Integrity 1. Introduction

Over the 1990s hedge funds have emerged as major players in financial markets. These funds have taken very large positions in particular markets, with some funds apparently being prepared to use high leverage to do so. This has led to concerns that hedge funds are contributing to financial instability and impairing the efficient operation of markets, although, on the other hand, there are also those who point to the greater depth of markets that has resulted from the higher turnover that hedge funds generate. Criticisms of the undue influence that hedge funds can have on markets have been around for some time, but the recent event which brought the issue to centre stage was the threatened collapse of Long-Term Capital Management. This incident not only seemingly led the US Federal Reserve to widen the ‘too important to fail’ test to include a hedge fund, but brought home to the authorities the risks that some funds posed to the stability of the financial system.

Developments in 1998 have also led to renewed concerns that some hedge funds are able to use their market power to manipulate prices to their advantage. In addition, there are concerns that the trading strategies used by some hedge funds have led markets to overshoot, and that the rapid building-up and liquidating of large positions by some funds has added to market volatility. These concerns have tended to be most pronounced in medium-sized, relatively liquid, currency markets.

The emergence of hedge funds as major players in financial markets has raised the question of whether some form of public-policy response is required. This question is examined below. The central conclusions are that:

1. a strong ‘in principle’ argument exists for the regulation of some types of hedge funds on the grounds that they pose a risk to the stability of the financial system and to the integrity of financial markets;
2. the ‘in principle’ case for hedge-fund specific regulation is weakened by the likelihood of other institutions, with similar risk profiles, developing outside an expanded regulatory framework;
3. in view of the above, the most effective approach would involve three elements: improving standards of disclosure; improving the risk monitoring practices of institutions that ultimately provide hedge funds with the ability to generate large positions; and removing distortions in the Basle capital framework; and finally
4. standards of disclosure could be improved by the application of higher capital charges to banks' exposures to institutions that do not meet specified minimum disclosure standards.

For improvements in disclosure and risk management to be fully effective, international coordination and agreement is important. In a number of areas this is already happening. The Basle Committee on Banking Supervision has developed a set of sound practices for banks' interactions with highly leveraged institutions and the BIS Committee on the Global Financial System is studying how disclosure standards can be improved. However, notwithstanding the need for a coordinated approach, regulators in individual countries, particularly those in the United States, have scope for unilateral action. By improving their own disclosure requirements and supervision practices, they would not only contribute to improving the stability of the United States financial system, but would also make a contribution to improving the stability of financial systems in other countries.

This paper is divided into two main sections. The first examines the case for a public-sector response, and the second discusses what form a response might take. Three appendices to the paper set out, respectively: some basic facts about hedge funds; examples of how leverage is used in financial markets; and the Basle capital standards as they currently apply to financial market activities.