Hedge Funds, Financial Stability and Market Integrity 2. Why Something Needs to be Done

There are three possible reasons for a public-policy response to the emergence of hedge funds as major players in financial markets. These are:

• the protection of investors;
• the need to maintain the stability of the financial system; and
• the need to maintain the integrity of markets.

2.1 Investor Protection

The case for regulation of hedge funds on investor protection grounds is weak, and this is the major reason why hedge funds have been subject to minimal regulation in the past. Typically, investors in hedge funds are both sophisticated and wealthy, and have the resources to monitor and assess risk (although recent events suggest that they have not always done this effectively). In the absence of other considerations, such investors should be able to manage their investments without government regulation. If investors are dissatisfied with the amount of information they are receiving, they should either put pressure on the fund manager to provide more information, or they can place their funds elsewhere.

2.2 Financial Stability

The need to enhance the stability of the financial system is the second possible reason for a public-policy response. Until recently, this was not considered a strong reason, but this situation changed last year when the US Federal Reserve organised a rescue for Long-Term Capital Management (LTCM). In explaining the Federal Reserve's actions, Dr Greenspan said before the US Congress (Greenspan (1998), page 1046):

Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own’ [emphasis added].

Clearly, in the Federal Reserve's judgement, the activities of LTCM posed a threat to the stability of the financial system, and ultimately, to the health of the world economy. This was a remarkable assessment given the conventional view that hedge funds did not pose such risks. This conventional view was well summarised in the IMF's Report, Hedge Funds and Financial Market Dynamics, which was released less than six months before the LTCM problems. The Report concluded that (page 12):

‘… regulators seem generally satisfied that they [hedge funds] pose no special problems of systemic risk.

If the Federal Reserve's judgement was right, then the conventional view was mistaken and the existing arrangements are deficient. The health of the world economy was put at risk by the actions of a few investors managing a private portfolio. When private investment decisions pose such risks, there is a strong and legitimate case for some form of public response to reduce and contain those risks.

The emergence of hedge funds as systemically important institutions arises largely from the fact that their activities can result in damaging fire-sales of financial assets. In turn, this possibility stems from the large market positions that some hedge funds have been able to obtain, and is increased when those positions are highly leveraged. Such positions are not only risky for investors in the fund, but also for the system as a whole. When prices move adversely, liquidity problems can arise as institutions attempt to meet margin calls, with solvency becoming an issue if the positions are highly leveraged. These problems can force the rapid fire-sale of financial assets by the troubled institution, triggering a wave of selling in other markets through a cascading process of liquidation of positions. The difficulties are compounded when financial institutions have large credit exposures to hedge funds and exposures to the markets in which the fire-sales are occurring. The end result could be a seizing up of even the largest financial markets.

The need for public policy to prevent, or at least reduce the probability of, damaging fire-sales of assets is a long-standing one. It was an important consideration in the early development of central banks' lender of last resort operations (and later, bank regulation). The idea was that if a bank was forced to sell its loans at distressed prices, solvent banks could quickly become insolvent and the process of financial intermediation could be disrupted. In a world in which much intermediation is conducted through markets, the bigger threat to the stability of the system arises from the fire-sale of financial instruments, not the fire-sale of bank loans. If institutions are forced to sell these instruments at distressed prices, solvent institutions can quickly become insolvent, undermining financial intermediation through both markets and institutions.

While the activities of hedge funds have the potential to cause these types of problems, it is important to recognise that only some types of funds pose such risks. Many funds do not have extremely large positions and are not highly leveraged, and many restrict their activities to equity markets, attempting to take advantage of small anomalies in market prices (see Appendix 1). In many cases, this type of trading adds depth to, and improves the efficiency of, the relevant markets. The recent threats to financial stability have come from a relatively small number of large funds.

It is also worth noting that hedge funds are not the only institutions whose activities can cause cascading fire-sales of financial assets. Other large financial institutions could cause similar problems if they were forced to rapidly liquidate positions in a period of financial stress. These other institutions are, however, subject to some form of regulatory oversight. Large hedge funds stand out as the only currently systemically important institution not subject to some form of regulation.

2.3 Market Integrity

The need to protect the integrity of markets is the third possible rationale for a public-policy response to the emergence of hedge funds as major players in financial markets. The previous section has explained how large, highly leveraged, position taking can lead to increased volatility in asset prices without any market participant setting out to achieve that result. This section looks at increased volatility that can result from a conscious decision to achieve that result.

If financial markets are to perform the important tasks of efficiently allocating resources and transferring risk, not only does the financial system need to be stable, but no single institution should be able to affect the market price. In addition, the activities of speculators should be stabilising in the sense that they contribute to prices moving towards values supported by underlying economic fundamentals.

These conditions have not been met in a number of markets. Some large hedge funds have been able to affect the market price, either through the sheer size of their positions, or by employing trading strategies that affect the behaviour of other market participants. By manipulating market prices, they have prejudiced the integrity of some markets. In addition, the hedge funds' trading strategies have amplified movements in market prices, as have their actions in rapidly unwinding large positions in stressed market conditions.

A variety of strategies have been used by hedge funds. Some of these strategies have been designed not just to take advantage of expected price movements, but to cause price movements. The strategies might start with a fund quietly establishing a position in a particular market, say a short position in a given currency. Having established the position, the fund makes it clear to other market participants that it intends to aggressively sell the currency. This ‘public announcement’ of its intentions leads to a widespread expectation of a depreciation, with the market becoming one-sided as other market participants withdraw. In other cases, hedge funds have placed a succession of large orders in a short period of time during periods when market activity is particularly light. In doing so, they have been able to use their market power to generate price movements that enhance the profitability of their underlying positions. In addition, these strategies, by contributing to the development of ‘one-way’ sentiment in markets, have led to exaggerated movements in prices.

It is worth noting that any abuse of market power by hedge funds occurs only periodically. It is not the case that hedge funds have the ability to consistently manipulate prices to their own advantage. Rather, their use of market power has been restricted to certain episodes, particularly periods in which markets are already under strain for other reasons. During such periods, market participants are unusually uncertain about the immediate outlook and liquidity may be less than normal. In this environment, aggressive trading strategies can have a significant effect on market prices.

It is also important to recognise that, just as not all hedge funds pose systemic risks, not all hedge funds are able to use market power in this way. Indeed, most funds are not large enough to move the prices in the markets in which they are transacting. It is primarily the large global macro funds that have been able to obtain and use market power.

The ability of these funds to periodically manipulate markets stems largely from the strong reputations that they built up over the 1990s, particularly following the role that they played in the Bank of England's decision to float the pound in 1992. The reputations were reinforced by a sequence of high-return years and by the hiring of staff with extremely strong market reputations.

The strong reputations of hedge funds gave them the ability to influence the activities of other market participants. Some participants sought to copy the positions of the funds, hoping to emulate their success, while others, who would normally have been on the other side of the market, withdrew and awaited more advantageous prices. The strong reputations also led to a dilution of normal credit assessment standards by counterparties. Hedge funds were able to generate extremely favourable margining requirements and generous trading lines on the basis of their reputations and the market insights that came from knowledge of their trading activities. Moreover, banks were keen to conduct business with hedge funds, for as the recent OECD Report (1999, page 7) states, ‘the global-macro funds … tend to trade enormous volumes in order to maintain returns, and in so doing, are a key source of commission business for bankers’. The banks desire to conduct large volumes of business with hedge funds contributed to the lax credit standards and made it easier for the funds to attain very large market positions.

While the issue of market power is relevant to all financial markets, it is particularly acute for liquid, medium-sized markets. It is these markets that offer the right combination of liquidity and opportunity. They are sufficiently liquid that in normal times positions can be established and closed without affecting prices, but, if the intention is to affect prices, they are not so large as to make this impractical.

Perhaps surprisingly, the abuse of market power tends to be less severe in small markets, for while a large player can push prices in its favour, it can also move prices against itself when it closes out positions. In contrast, in a large deep market, like the United States, positions can generally be closed out without affecting the market price, but a single institution, or a few institutions acting together, are unlikely to have enough market power to move market prices, even in unsettled market conditions. The currency markets in Australia, South Africa and Hong Kong all fall, to some extent, into the medium-sized liquid category, and over the past year, all three markets have seen highly leveraged hedge funds have some success in moving market prices.

While other institutions, such as investment banks, securities firms and corporate treasuries, can also take extremely large positions, they have not, in general, employed the same type of trading strategies used by hedge funds. Typically, investment banks have on-going multi-dimensional relationships with market participants and government authorities. These other relationships reduce the incentive to undertake trading strategies that violate standard market conventions, for such strategies undermine other (more important) aspects of the relationships. In contrast, hedge funds typically have a single-product business with the sole focus of maximising returns from trading in financial markets, and as such are subject to fewer constraints than other institutions. Hedge funds are also able to have more concentrated portfolios than other institutions, so that for a given portfolio size, they are able to obtain larger positions in individual markets, and to change those positions more quickly. The result is that they can be completely opportunistic when it suits them.

The use of leverage

The threats that macro global hedge funds pose to financial stability and market integrity have their roots in the large market positions that these funds have been able to obtain. Market participants regularly attribute these large positions to the extensive use of leverage. Unfortunately, it is difficult to determine with any precision the use of leverage by hedge funds because comprehensive figures are not available, largely as the result of the general inadequacy of disclosure arrangements for hedge funds.^[1]

Some publications by industry consulting bodies do report leverage ratios for hedge funds, but their reliability is well below what would normally be required of official statistics. The publications leave the definition of leverage up to the reporting hedge funds, which can choose whatever definition or time period suits them. Some of the better-known macro hedge fund managers also only report for a sub-set of the funds they manage.

Perhaps the biggest shortcoming is the handling of off-balance sheet exposures through the use of derivatives. Derivatives have allowed hedge funds to take on much larger exposures to market movements than would be possible using on-balance sheet transactions. As the OECD Report (1999, pp. 10–11) states ‘The leverage provided for hedge funds … typically is created through repurchase agreements (repos) and swaps, though options, futures and other structured products are also used. …. Depending upon the size of the haircut, traders could easily establish a $1 billion position in a given security with only $10 million in capital’. Similarly, the absence of an up-front funding requirement on foreign currency swaps has allowed very large and leveraged positions to be generated in the foreign exchange market. If these positions had to be funded through on-balance sheet financing, rather than through derivatives, they would imply much higher leverage than the commonly quoted figures.

Given the risks identified above there is clearly a need for better information on the use of leverage by hedge funds.

Footnote

For example, the Brockmeijer Report (Basle Committee on Banking Supervision, 1999) estimated that at the start of 1998, LTCM's ratio of balance-sheet assets to equity was about 25:1, but concluded that this was ‘only a very incomplete measure of leverage’ and that ‘it is not clear how large LTCM's true leverage was’. While LTCM was much more leveraged than most hedge funds, the lack of relevant data makes it difficult to build up a comprehensive picture of the true risks being taken by hedge funds. [1]