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
Save to active project

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.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Hedge Funds, Financial Intermediation, and Systemic Risk
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.