Hedge Funds and the Financial System

Jesper Ulriksen Thuesen, Financial Markets

INTRODUCTION AND SUMMARY

Recent years' experience has shown that even problems and losses of large hedge funds have not generated systemic crises in the international financial markets. Neither can the turmoil in the financial markets that began in the summer of 2007 be attributed to hedge-fund activities. Furthermore, in 2007 hedge funds have to date generated decent overall yields, despite the financial turmoil.

The development has spurred international discussions on both the need for and the feasibility of regulating hedge funds. These discussions have resulted in an indirect and market-based approach to regulation of hedge funds is still being applied.

The best protection against financial instability caused by hedge funds is competent risk management in the financial enterprises that are hedge-fund counterparties.

INTERNATIONAL HEDGE-FUND DEVELOPMENTS

The increasing role of hedge funds has been a key structural trend in the international financial markets in recent years. The current number of hedge funds is estimated to be around 10,000 globally, with AUM (assets under management) totalling 1,500-2,000 billion dollars. The uncertain estimate can be attributed to incomplete statistical coverage of hedge funds and their activities in national and international financial markets. This is partly due to the absence of a clear and generally accepted definition of a hedge fund^[1], partly to the fact that a considerable number of hedge funds do not report data systematically to authorities or international databases.

The hedge funds' AUM have been on the increase since 1990, and the development has accelerated especially in the last five years, as illustrated in Chart 1.

The growth in hedge funds has taken place even though yields reported since 2003 have not been systematically higher than those on e.g. shares-only portfolios, cf. Table 1 and Box 1. The relatively more modest yields can be viewed as a result of the maturing and broadening of the sector.

In addition to actual hedge-fund activities, similar investment strategies^[2] are being pursued from managed accounts with considerable funds at their disposal, i.e. portfolios managed by hedge-fund managers on behalf of private or institutional investors. For managed accounts, the investors typically have direct ownership of the managed assets, which ensures the investors almost full transparency as to the composition of the portfolio and the trading activity. Furthermore, the investors can realise their portfolios at very short notice. The extent of managed accounts is difficult to estimate. However, it is estimated that around one quarter of the existing hedge funds operate managed accounts, and that private managed accounts alone amounted to more than 300 billion dollars at the end of June 2005.^[3]

Furthermore, strategies similar to those pursued by hedge funds are increasingly being applied by the proprietary trading desks of major international banks.^[4] In addition, strategies that might be applied by hedge funds have been indirectly applied by some banks through the establishment of conduits and SIVs.^[5]

Changing geographical spread of the activity
Until 10 years ago, hedge funds were almost exclusively a US phenomenon. The USA still accounts for the largest share by far of hedge-fund activity, but in recent years hedge funds have also gained ground rapidly elsewhere, especially in the UK. Chart 2 illustrates the geographical spread measured in terms of AUM and the number of hedge funds.

Hedge funds in Denmark and the other Nordic countries
It is estimated that around 120 hedge funds are managed from the Nordic countries, with AUM totalling approximately 18 billion euro^[6]. For comparison’s sake, the Danish investment associations manage assets amounting to more than 130 billion euro. Most of the Nordic hedge funds are found in Sweden, primarily focusing on various share-portfolio strategies. There are just over 20 hedge funds in Denmark^[7]. As opposed to Swedish funds, most of these are funds of hedge funds (FoHF), i.e. hedge funds investing in hedge funds, and fixed-income hedge funds. This may explain recent years' relatively lower yields in Danish hedge funds compared to Swedish hedge funds and Nordic hedge funds overall, cf. Table 2.

Key role in trading and price formation in the securities markets
Despite the growth in recent years, the portfolios managed by the hedge funds are still modest compared to the estimated amount of approximately 18,000 billion dollars managed globally by conventional investment funds, in Denmark by investment associations. In most countries, AUM for hedge funds account for less than 10 per cent of AUM for investment funds. In Sweden, Austria and the USA, the figure is approximately 10 per cent, while Switzerland and the UK are notable exceptions with approximately 20 per cent and almost 60 per cent, respectively.^[8] Many hedge funds tend to trade their portfolios more often than other portfolio managers. Consequently, hedge funds now account for a considerable share of total turnover in many major securities markets. This is illustrated by US data in Table 3. Hedge funds therefore play a key role in liquidity and price formation in the international securities markets.

Wider spread on more hedge-fund strategies
Many hedge funds try to identify and exploit market imperfections. As the number of hedge funds increases, and in step with the growing complexity of the financial markets, hedge funds are increasingly specialising, and the pattern of investment strategies shows greater dispersion. This means that the traditional long/short strategies^[9] are less dominant than previously, although they are still estimated to make up almost one third in terms of AUM.

Less clearcut interfaces to other investment types and financial players
In step with the increasing prevalence of hedge funds, the traditional distinction between hedge funds and other investment types and financial players has in some cases become blurred. A case in point is the distinction between hedge funds and private equity funds. The latter are characterised by investing in individual business enterprises in order to obtain a controlling influence on the enterprises' strategies and operations, i.e. "governance activism". In contrast, conventional hedge funds operate with portfolio investments only, among other characteristics. However, recent years have seen several examples of large hedge funds playing an active role in e.g. negotiations on consolidation of banks or operators of securities markets.

Changed composition of investors
Traditional investors in hedge funds are private individuals with very substantial wealth. Part of the growth in hedge funds can be attributed to the higher number of such people globally. In recent years, institutional investors, including a number of pension companies, have placed an increasing share of their assets in hedge funds. Furthermore, there has been a tendency for increased investment in hedge funds by private individuals who do not fall into the category of very affluent. These investments are primarily indirect investments via FoHF.^[10]

The structural shift in the investor base, especially the tendency towards more retail investors, has given rise to an international debate concerning whether the authorities should introduce consumer protection rules in relation to hedge funds similar to the rules applying to traditional investment products offered to retail investors.

HEDGE FUNDS AND FINANCIAL STABILITY

Many international analyses of hedge funds are carried out by central banks as an element of their financial stability effort.^[11]

Many analyses indicate that hedge funds have generally had a positive impact on financial stability e.g. by contributing to better price formation and spreading of risk in the global financial markets.^[12]

This can be attributed to the following direct and indirect factors, among others:

• Hedge funds' strategies and methods of analysis are often based on identifying and exploiting even very small market imperfections, thereby contributing to more efficient price formation.
• Through considerable trading activity and position-taking, hedge funds contribute liquidity to the financial markets
• Hedge funds often possess financial expertise and risk appetite that can benefit the development of new markets. An example is the development of the credit derivatives markets, which has gained momentum in recent years.
• Hedge funds may contribute to limiting market volatility. Since they often aim at absolute yields, they might be less inclined to buy in a rising market and sell in a falling market.^[13]
• Hedge-fund investors cannot usually withdraw their deposits at short notice. This contributes to dampening the hedge funds' need for rapid realisation of assets, which could result in an unintentional negative impact on already falling markets. In this respect, hedge funds are different from e.g. conduits and SIVs, whose financing structure has contributed strongly to the turmoil in the financial markets in recent months.
• Yields on investments in hedge funds have proved to be significantly less correlated with yields in the share and bond markets than e.g. yields in the share and bond markets with each other. Inclusion of hedge funds in portfolios therefore increases investors' possibilities of diversifying their portfolios.

However, the increasing importance of hedge funds is also associated with a number of potential risks. The risks that are most often pointed out are as follows:

• Probably the largest risks associated with hedge funds are "crowded trades", i.e. a situation with most of the hedge funds trading in the same direction in a falling market, thereby reinforcing downturns in the international securities markets. Since hedge funds account for a large share of trading in many securities markets, they play a key role in price formation, as mentioned above. This can be amplified by the fact that the proprietary trading desks of large investment banks may pursue trading strategies similar to those of hedge funds.
• Due to the increasing hedge-fund activity, prime brokerage^[14] has become a substantial business area for some of the large international investment banks. For these banks, there are risks associated with the further development of the hedge-fund sector and potential shifts in the terms of competition between the existing and any new providers of prime brokerage.
• Losses on hedge funds had no significant implications for financial stability as long as the investors were mainly very affluent individuals. As more and more banks and institutional investors have increased their direct or indirect positions in hedge funds, the potential risks associated with hedge funds have risen. It is essential that the financial institutions that are, in one way or another, counterparties of hedge funds have the necessary risk management tools and information at their disposal to be able to manage portfolios that include hedge funds. The risk management of financial institutions is generally found to have improved significantly in recent years.

These potential risks, among other factors, have given rise to the debate on hedge funds in recent years. A central policy issue in the debate has been whether it is expedient – and possible – to launch international initiatives to strengthen the regulation of hedge funds.

The recent history of major hedge-fund crises
In connection with the most well-known collapse of a hedge fund, Long-Term Capital Management, LTCM, in the autumn of 1998, the Federal Reserve actively encouraged a solution in view of the potential negative impact on the financial markets of compulsory liquidation. LTCM was thus subsequently acquired by other private financial enterprises.^[15]

However, recent years' experience shows that problems and losses for even large hedge funds have not since given rise to systemic crises in the international financial markets. Table 4 provides an overview of the largest hedge-fund crises since LTCM.

It is estimated that well in excess of 2,000 hedge funds closed down in the period 1999-2005^[16]. None of these events gave rise to systemic crises in the financial markets.

ECB analyses indicate that around 5 per cent of the hedge funds go into liquidation during a year.^[17] The liquidation can be voluntary, i.e. initiated by the hedge-fund manager, or involuntary if it is no longer possible to obtain sufficient AUM volume. Many liquidations are attributable to the latter reason either because the hedge funds are unable to attract a sufficient number of new investors, or because the investors execute their right to withdraw their investments from the hedge funds.

Hedge funds and the turmoil in the international financial markets in 2007
As apparent from Table 5, hedge funds have year-to-date in 2007 generated reasonable yields despite the turmoil in the financial markets, which began in the summer of 2007. Several hedge-fund strategies generated positive yields in July, when the turmoil began, while most, but not all, strategies generated – relatively modest – negative returns in August, when the turmoil really took off. In September virtually all strategies again generated positive yields.

So far, the financial turmoil has not had a significant impact on the hedge-fund sector as a whole. Part of the explanation is the heterogeneous nature of the sector in terms of chosen strategies and risk level. Consequently, the hedge funds are affected in different ways by sudden shifts in market conditions, and they also have different response patterns. In its latest Financial Stability Report^[18], the Bank of England concludes that although a few hedge funds have had to close down, the recent financial turmoil has seen few examples of hedge funds being forced to sell their assets or having to refuse investors who wanted to withdraw their investments, in order to avoid forced sale of the their assets. In other cases, hedge funds have apparently contributed to stability by buying assets in falling markets. The ECB is also noticing these trends:

"It does not seem that selling pressure coming from hedge funds was a major factor behind the recent turbulence, since problems in interbank, ABCP and other credit markets, as well as losses experienced by some banks, were far more important for the smooth functioning of the global financial system."^[19]

In addition, the Bank of England points out a trend in the hedge-fund sector towards reallocation of funds between various hedge-fund strategies, while the financial turmoil has not led to any decrease in total AUM.

APPROACHES TO REGULATION OF HEDGE FUNDS

Traditionally, special regulation of financial institutions has been governed by two primary considerations, i.e. consumer protection and limiting systemic risks. The latter is the risk that problems in one part of the financial sector will spread to the rest of the sector, resulting in a financial crisis.

The consumer protection issue has so far not been relevant to hedge funds, as the funds' investors have traditionally been private individuals with very substantial wealth and subsequently also institutional investors and other professional investors. These investors are able to assess the risks on their investments and to bear any losses without any significant impact on the economy as a whole.

As described above, the systemic risk issue has become relevant as the total activities of the hedge funds have reached a level that can have a considerable impact on the rest of the financial system.

As regards regulation of hedge funds, an overall distinction can be made between direct, indirect and market-based regulation.^[20]

Direct regulation of hedge funds can be associated with a number of problems. One objective of establishing a hedge fund has been to implement investment strategies that could not have been implemented under the regulatory framework for traditional financial institutions such as banks and investment associations. Any need to regulate hedge funds' portfolio management should therefore be considered in relation to the potential drawbacks of regulation. It would be just as difficult to regulate hedge funds on the basis of risk-based requirements for capital adequacy and risk management systems, along the lines of the regulatory framework applying to other financial institutions. One reason is that the rapid restructuring of the hedge funds' often very complex portfolios would require frequent, resource-intensive inspections by the supervisory authorities.

On the liabilities side it may be somewhat easier for the authorities to limit investor access, in practice blocking retail investors' access to invest in hedge funds, which would minimise consumer protection concerns. However, this raises the fundamental issue of whether only already very affluent individuals should have access, as private investors, to the potentially higher yields that can be achieved by including hedge funds in the portfolio. The Danish Act on Hedge Associations, which entered into force on 1 July 2005, provides a solution that does not limit the associations' investment strategies, while accommodating consumer information needs by imposing information requirements on the hedge associations as regards investment strategies and risk profile.

In addition, there is the perhaps most important and practical problem in relation to direct regulation, i.e. that many hedge funds are registered in offshore financial centres^[21], or can easily move to offshore financial centres if new regulatory requirements are imposed.

Indirect regulation of hedge funds may take prime brokers as the starting point. Prime brokers are typically already regulated and subject to financial supervision. By imposing the right requirements on prime brokers, the authorities can contribute to curbing the risk that problems in the hedge-fund sector spread to the core of the financial system. Such requirements could encompass the size and quality of collateral for loans and securities lending, the size of margins on derivatives contracts, capital requirements for exposure to hedge funds and the quality of risk management systems.

In principle, the objective of, and approach to, indirect regulation of hedge funds is no different from the regulation applying to prime brokers and other traditional financial enterprises to ensure appropriate risk management and capital adequacy in these enterprises. However, having hedge funds with complex investment strategies as counterparties may present special challenges. An important advantage of indirect regulation is that it is feasible in practice, which makes it the most frequently recommended approach to hedge funds in recent years' international reports.^[22] There is no need for direct regulation of hedge funds in so far as prime brokers apply appropriate risk management. Basically, losses in hedge funds and for their investors do not represent a problem to the financial system or the economy as a whole. However, it should be noted that indirect regulation does not necessarily prevent problems in one or more hedge funds from causing problems in the financial markets as a result of crowded trades and sudden liquidity shortages, as described above.

Proposals for market-based regulation of hedge funds are based on the assumption that if all market participants are sufficiently well informed, they can take the relevant risks into account.^[23] This also applies to the risks associated with e.g. crowded trades. A considerable degree of market transparency is therefore a precondition for well-functioning market-based regulation.

Prime brokers and financial investors in hedge funds are qualified counterparties that should only do business on an informed basis. The hedge funds are therefore effectively under substantial pressure to provide information to the counterparties, although not necessarily to the general public. Nevertheless, there may still be a need to increase the transparency of hedge funds with a view to monitoring by both market participants and authorities of the potential risks that hedge funds may represent to the financial system overall. For example, how will the compulsory liquidation of a large hedge fund affect the financial system, and what are the potential risks associated with crowded trades? However, even if a documented need for increased transparency exists, it is not always clear how the right information can be provided in practice. For example, in many cases the balance sheet of a hedge fund does not provide a true and fair view of its risk profile since exposure management is also conducted on an off-balance-sheet basis, including widespread use of credit derivatives. Another example is the risk associated with crowded trades. Here, a snapshot of a hedge-fund portfolio may become obsolete very quickly due to frequent portfolio restructuring by the hedge funds.

THE LATEST INTERNATIONAL DISCUSSIONS AND INITIATIVES

Recent years have seen intensification of the international discussions relating to the need for regulation, and opportunities to regulate hedge funds amongst others under the auspices of the EU and G8. A number of initiatives have been taken. The overall result of the discussions has been that the approach to regulation of hedge funds at the international level is still indirect and market-based, and that the authorities as well as the financial sector will continue to focus on the development.

In February 2007, the G7^[24] Ministers of Finance and central-bank governors concluded that hedge funds make a significant contribution to the efficiency of the financial system, but that the development should be closely monitored in view of their increasing importance and complexity. In this connection, Financial Stability Forum, FSF,^[25] was asked to update a previous report from 2000 on highly leveraged institutions. The FSF report was published in May 2007^[26] after a series of meetings with e.g. high-level representatives of the hedge funds. The report contains recommendations aimed at supervisory authorities, prime brokers, investors and hedge-fund managers in order to limit the potential systemic risks associated with hedge funds and other highly leveraged financial institutions. In line with the previous FSF report, direct regulation of hedge funds is not recommended, and the report does not concern itself with consumer protection issues. The following recommendations are made:

• Supervisory authorities and prime brokers should work to strengthen the latter's risk management and resilience to drops in market liquidity.
• Prime brokers and investors should seek to strengthen market discipline, including requiring accurate and timely information from the hedge funds on their portfolios and risk management.
• Supervisory authorities should initiate work to clarify the extent to which more systematic and consistent data collection on prime brokers' consolidated exposures to hedge funds might strengthen the existing supervisory regime.
• Finally, the hedge-fund sector should review and strengthen the existing best practice benchmarks for hedge-fund managers in the light of expectations to this effect from the rest of the private sector and from the authorities.

Subsequently the G8 leaders discussed hedge funds in June 2007 and supported the recommendations in the FSF report and thus an approach based on indirect regulation/supervision and market discipline.

In the EU, hedge funds were discussed at the informal Ecofin meeting in April 2007, and in May the Ecofin Council adopted Council conclusions on hedge funds. The conclusions acknowledge that the existing approach with indirect regulation/supervision has so far strengthened the resilience to systemic risks, and the Council encourages market participants and authorities to remain alert as to potential risks. However, at the same time the Council points out the need for better understanding of the significance of hedge funds to financial stability. Finally, the Council conclusions refer to the concerns expressed by some member states regarding retail investors' investments in hedge funds. The European Commission has been asked to investigate the need for EU regulation of the investment funds that are currently subject to national legislation and are on offer to the general public. These might include some funds of hedge funds.

In March 2007, IOSCO^[27] issued a consultation report^[28] on the principles for the valuation of hedge-fund portfolios and issues that arise in connection with the valuation of illiquid or complex financial products. The purpose is to lay down a set of overall principles to ensure consistent, independent and transparent valuation of hedge funds. Besides the immediate challenges of valuing illiquid and complex portfolios, a special characteristic of hedge funds is that the hedge-fund manager's remuneration is to a high degree directly linked to the calculation of the hedge fund's yields. IOSCO issued another consultation report in April 2007^[29] to provide input for the discussion of which issues IOSCO should concentrate on in future in relation to FoHF for retail investors. The consultation periods for the two reports expired during the summer, and IOSCO is now continuing the work on specific initiatives.

The strong political focus has put pressure on the hedge-fund sector to be more willing than previously to engage in a dialogue with the authorities on the potential risks associated with hedge funds. One result has been that in the summer of 2007, a working group of 14 of the largest European hedge funds invited other European hedge funds to cooperate on formulating a code of conduct for hedge funds. In October the group issued an extensive consultation report^[30] with a total of 15 draft standards, in the first instance primarily about more information on hedge funds and issues related to the significance of hedge funds to financial stability. The issues include valuation of complex financial products, efficient risk management, governance structures to handle potential conflicts of interest, and rules on exerting influence on companies. The report suggests application of the "comply or explain" principle, i.e. that each hedge fund should comply with the future standards, or alternatively explain to the public why it has chosen not to do so. The consultation period expires on 14 December. The final report with a code of conduct is expected in January 2008.

LITERATURE

Alternative Investment Expert Group (2007), Report of the Alternative Investment Expert Group, European Commission, July.

Bank of England (2007), Financial Stability Report, Issue No. 22, October.

Barth, James R., M. Bertus, T. Li and T. Phumiwasana (2007), Hedge Funds: A Global perspective on Strategies and Risks, Prepared for the Joint Meeting of the Shadow Financial Regulatory Committees of Europe, Japan, Latin America and the United States, Copenhagen, Denmark, September.

Cole, Roger T., G. Feldberg and D. Lynch (2007), Hedge funds, credit risk transfer and financial stability, Financial Stability Review, Banque de France, April.

Crockett, Andrew (2007), The evolution and regulation of hedge funds, Financial Stability Review, Banque de France, April.

ECB (2004), Financial Stability Review, December.

ECB (2005), Hedge Funds and their Implications for financial Stability, Occasional Paper Series, August.

ECB (2007:1), The Transparency of Hedge Funds, Contribution to the Financial Stability Table, March.

ECB (2007:2), Financial Stability Review, June.

ECB (2007:3), Financial Stability Review, December.

Ferguson, R., og D. Laster (2007), Hedge funds and systemic risks, Financial Stability Review, Banque de France, April.

Financial Stability Forum (2007), Update on the FSF Report on Highly Leveraged Institutions, May.

Greenwich Alternative Investments, www.greenwichai.com

G8 (2007), Chair's Summary. Heiligendam, 8 June.

Hedge Fund Working Group (2007), Hedge Fund Standards, Consultation Paper, October.

HedgeNordic, www.hedgenordic.com

IOSCO (2007:1), Consultation Report. Principles for the valuations of hedge fund portfolios, March.

IOSCO (2007:2), Consultation Report. Call for views on issues that could be addressed by IOSCO on funds of hedge funds.

OECD (2007:1), Recent market developments, the boom in private equity and the rise of hedge funds, OECD Financial Roundtable Meeting, May.

OECD (2007:2), An overview of hedge funds and structured products. Issues in leverage and risk, OECD May.

OECD (2007:3), Selected questions regarding hedge funds. Result from the CMF questionnaire and previous CMF discussions, OECD May.

Thuesen, Jesper U. (2005), Hedge Funds in Denmark and Internationally, Danmarks Nationalbank, Monetary Review, 1st Quarter.