Hedge Funds Pose Only ‘Limited’ Risk to System, Says FSA

Terry Flanagan

The U.K.’s financial regulator has called into question impending European Union hedge fund regulation after results from an industry survey by the Financial Services Authority (FSA) revealed that hedge funds pose only a “limited” risk to the stability of the financial system despite their use of leverage.

“The aggregate footprint of surveyed funds remains modest in most markets and leverage is largely unchanged for most funds,” the FSA said in a report published on its website this week. “Most cash (or on-balance sheet) leverage comes from repo borrowing, which must be continually rolled. Funds continue to report a strong ability to manage the liquidity of their assets and liabilities in aggregate.”

Hedge funds and private equity firms were partly blamed by regulators and politicians for exacerbating the economic turmoil that followed the collapse of U.S. investment bank Lehman Brothers in September 2008, and steps have since been put in place to govern Europe’s alternative investment firms.

The Alternative Investment Fund Managers Directive (AIFMD), which is set to be implemented from next year, is the first attempt by Brussels to oversee hedge funds and private equity by harmonizing regulatory standards across the EU.

The FSA report, which was conducted in March and April of 50 FSA-authorized funds controlling assets worth $380 billion, said the reduction in risk posed by hedge funds is in part to down to “counterparties increasing margining requirements and tightening other conditions on their exposures to hedge funds since the financial crisis—this suggests an increase in banks’ resilience to hedge fund defaults”.

Hedge funds, the report added, have also reduced their reliance on short-term, or repo, borrowings from 57% in its September 2011 survey to 47% in the latest survey. Although the FSA was still concerned about the reliance on this type of borrowing. “Repo borrowing may be a particular risk as it has to be continually rolled, and this may be difficult for hedge funds to achieve during stressed market conditions,” said the FSA.

The FSA did not, however, say that hedge funds were without risk and added that the “reports are based on self-assessment [by hedge fund managers] and it is difficult to gauge whether these measures would hold during stressed market periods”.

Old problems, though, still persist. “Risks to hedge funds remain from a sudden withdrawal of funding (such as financing from prime brokers and margin calls on derivatives trading), resulting in forced asset sales,” said the FSA. “This is of particular concern if funds have significant footprints.

“If a sudden withdrawal of funding was to occur in one highly leveraged fund or across a number of funds, this may result in forced asset sales that exacerbate pressure on market liquidity and efficient pricing.”

In the past, hedge funds have threatened the stability of the financial system. In 1998, U.S. hedge fund Long-Term Capital Management collapsed, having lost $4.6 billion in less than four months. This implosion forced U.S. authorities—who feared a wider collapse of the financial system—to organize a bailout of the stricken hedge fund by major investment banks to abate the crisis.

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