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Defaulting hedge funds do not pose systemic risk, says FSA

Date: Friday, July 29, 2011
Author: Charles Gubert, COO Connect

Hedge funds do not pose a systemic risk to the financial system, according to the UK Financial Services Authority’s (FSA) latest hedge fund survey - thereby reinforcing again what most industry experts have said since 2008.

“Counterparty credit exposures to hedge funds remain concentrated amongst a small number of banks. Aside from the apparent extension of average maturities, banks appear to have tightened financing terms for hedge funds post-crisis increasing their resilience to hedge fund defaults,” read the report.

Robert Mirsky, head of hedge funds at KPMG, welcomed the findings. “The report is fairly consistent vis a vis the hedge fund industry in the sense that it states hedge funds do not pose a systemic risk to the markets in the event of a default. The banks have reduced their exposures by increasing margin requirements,” he said.

Politicians, particularly in the European Union, have repeatedly stated defaulting hedge funds pose a systemic risk to the marketplace despite the industry being continually absolved of this by both the FSA and European Commission. These fears are misguided – unlike the major investment banks, hedge funds are almost “too small to fail.” Hedge funds manage approximately $2 trillion globally, according to data from Hedge Fund Research – a number smaller than some individual bank’s balance sheets. “Hedge funds are an easy scapegoat to blame for market woes,” stressed Mirsky.

The report said: “When examining the potential systemic impact of hedge funds, it is particularly important to consider the size of hedge funds’ footprints relative to the size of the global markets they trade in. When measured by the gross value of their exposures relative to the size of the markets, the footprint of hedge funds is generally low suggesting these hedge funds are not the biggest category of players in most markets.”

However, it acknowledged hedge funds could be systemically important in the convertible bond, interest rate and commodity derivatives markets. The survey estimated hedge funds hold in aggregate roughly 7% of the outstanding value of the global convertible bond market and approximately 4% and 6% of the much larger and systemically important interest rate and commodity derivatives markets. “I do not think that is an issue,” said Mirsky. “Even if a hedge fund is overexposed to these derivatives, it poses more of a risk to the hedge fund itself rather than the broader markets,” he added.

Furthermore, hedge funds could pose a potential risk during distressed markets, said the report. “Hedge funds appear to have extended the term of their financing recently. Nevertheless, the risk of a sudden withdrawal of liabilities during stressed markets (particularly a withdrawal of financing) is likely to remain with an associated risk of fire sale of assets. This can potentially occur on all forms of liabilities,” it read.

The survey polled 50 investment managers with $390 billion in assets.