Hedge Funds, Financial Intermediation, and Systemic Risk

By Kambhu, John; Schuermann, Til et al. | Federal Reserve Bank of New York Economic Policy Review, December 2007 | Go to article overview
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Hedge Funds, Financial Intermediation, and Systemic Risk

Kambhu, John, Schuermann, Til, Stiroh, Kevin J., Federal Reserve Bank of New York Economic Policy Review

* An important channel through which largely unregulated hedge funds interact with regulated institutions is prime brokerage relationships.

* Central to these relationships is the extension of credit to hedge funds, which exposes banks to counterparty credit risk.

* Counterparty credit risk management (CCRM) practices, used to assess credit risk and limit counterparty exposure, are banks' first line of defense against market disruptions with potential systemic consequences.

* Hedge funds' unrestricted trading strategies, liberal use of leverage, opacity to outsiders, and convex compensation structure make CCRM more difficult, as they exacerbate potential market failures.

* While past market failures suggest that CCRM is not perfect, it remains the best initial safeguard against systemic risk; thus, the current emphasis on CCRM as the primary check on hedge fund risk-taking is appropriate.

1. Introduction

Financial economists and policymakers have historically focused on banks as prospective channels of systemic distress through, for instance, bank runs and the concomitant reduction in the supply of credit. This "special" attribute of banks has been behind the classic policy rationale for regulating them. The ongoing move toward financial markets, arm's-length transactions, and active trading, however, has shifted focus to the potential impact of a hedge-fund-led disruption on financial institutions, markets, and the broader economy. (1)

Financial intermediaries, of course, have many ways to reduce their exposure and mitigate the impact of financial market shocks. The first line of defense is the intermediary's counterparty credit risk management (CCRM) system. Banks establish limits; implement risk reporting infrastructures; and define haircut, margining, and collateral policies--all designed to assess credit risk and limit their counterparty exposure. Effective CCRM is obviously needed for any counterparty, but hedge funds differ in important ways, such as in their use of complex trading strategies and instruments, leverage, opacity, and convex compensation structures, all of which increase the challenges to effective CCRM.

This article examines how the nature and characteristics of hedge funds may generate "market failures" that make CCRM for exposures to hedge funds intrinsically more difficult to manage, both for the individual firm and for policymakers concerned with systemic risk. We put forward no specific new policy proposals, however, because we believe CCRM remains the appropriate starting point for limiting the potential for hedge funds to generate systemic disruptions. (2) By laying out the issues and highlighting the specific linkages from hedge funds to systemic risk, we hope to highlight areas for further research on when and how markets may fail to yield a desirable outcome.

2. Hedge Funds 101

We begin by describing the difference between a hedge fund and other asset management vehicles such as mutual or pension funds, then discuss the traditional role of counterparty credit risk management, and present some stylized facts about the hedge fund industry.

2.1 What Is a Hedge Fund?

Hedge funds, in short, are largely unregulated, private pools of capital. Hedge fund managers can invest in a broad array of assets and pursue many investment strategies, such as global macro, market neutral equity, convertible arbitrage, or event-driven. (3) While strategies and individual hedge funds are quite heterogeneous, it is useful to focus on four broad characteristics that distinguish hedge funds from other types of money management funds.

First, hedge funds are not restricted by the type of trading strategies and financial instruments they may use. In particular, hedge funds can and do make use of short-selling, derivatives, and options, all of which are complex and potentially nonlinear in payoffs.

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