Greenspan: Hot Institutional Money in Hedge Funds Could Strain Markets

Date: Thursday, May 5, 2005
Author: By Chidem Kurdas, New York Bureau Chief

By Chidem Kurdas, New York Bureau Chief
Thursday, May 05, 2005 12:21:03 PM ET

NEW YORK (—Federal Reserve Board Chairman Alan Greenspan told a Federal Reserve Bank of Chicago conference Thursday that there are legitimate concerns about the possible adverse effects of hedge funds on derivatives markets and the financial system generally, although hedge funds are increasingly valuable in correcting mispricings and providing liquidity.

Mr. Greenspan pointed in particular to the risk of institutional investors negotiating much shorter redemption periods than was the case previously, possibly forcing hedge funds to suddenly liquidate underlying assets.

"If institutional money proves to be ‘hot money,' hedge funds could become subject to funding pressures that would impair their ability to supply liquidity to markets and might cause them to add to demands on market liquidity," Mr. Greenspan said, according to the written transcript of his speech, delivered by satellite from Washington to the Chicago conference.

Hedge fund leverage is also a concern for the Fed chief. Since the Long-Term Capital Management episode, banks have strengthened their risk management practices, but there are still weaknesses, he said. Some fund managers do not give banks full information about their portfolios and banks do not always aggregate across hedge fund counterparties to assess exposures in volatile and illiquid markets.

Mr. Greenspan expressed even greater concern that in highly liquid markets, such as those for interest rate swaps, competitive pressures may be eroding the margins that banks require from hedge funds.

He does not believe government regulation can contain these risks. "Ensuring sound credit-risk management by hedge funds' counterparties remains the most promising approach," he said.