Where is the risk in global financial markets?

UK Weekly, Jul 13, 2007

Much recent attention has focused on the role of hedge funds as a potential source of systemic risk. Certainly hedge funds have grown dramatically in recent years - they now control around US$1.5 trillion in assets and are believed to account for more than 50% of trading volume in equity and corporate bond markets. But this growth in itself is not a reason for concern - it has improved financial market liquidity, and may also have contributed to a more efficient distribution of risk within financial markets.

The main worry has been that hedge funds might suffer major losses due to following high-risk and highly correlated strategies, leading to a draining of market liquidity and significant counterparty losses - in the latter context it is important to note the growing exposure to hedge funds of major investment banks and pension funds. The fear is that a rerun of the 1998 LTCM collapse could be on the cards, a collapse which required not only an expensive recapitalisation but also emergency Fed action to preserve financial market stability. The relatively limited degree of regulation of most hedge funds increases these kind of concerns, as does their extensive use of derivative instruments - many of which are traded outside organised exchanges (i.e. on an OTC basis).

There are a number of reasons why we think these fears may be overdone. Firstly, the "death" rate of hedge funds is already relatively high, but this has not led to financial market disturbances. About 7% of hedge funds failed last year and around 30% never see their fourth birthday. Most of these funds are quite small, with failed funds having median assets around US$6 million, but there have been large scale failures too - most recently the Amaranth fund which lost its investors US$6 billion through speculation in gas derivatives.

Secondly despite warnings from some official bodies, there is limited evidence that hedge funds are crowded into the same high-risk trades. Over the few years, major hedge fund indices have shown a pattern of returns if anything slightly less volatile than for example major equity indices. In addition, recent research from the New York Fed shows that while the returns of hedge funds appear highly correlated - implying a concentration of risk similar to 1998 - this is misleading. The recent rise in correlations is due to the drop in financial market volatility (and is thus a statistical artefact) rather than high covariances of returns. Covariances are in fact only around average levels.

The available evidence on derivatives markets also shows only limited evidence that the increased use of these instruments has heightened systemic risks. While the turnover of derivative instruments has risen sharply in recent years, the BIS estimates that the gross market value (a better measure of risk than notional amounts) of OTC FX, interest rate and equity derivatives was little changed in 2006 against 2005. The gross market value of credit default swaps rose sharply but these remain a small part (around 5%) of the overall derivatives market.