This report explores the extent to which hedge funds create or contribute to systemic risk, the role they played in the financial crisis, and whether and how the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addresses the potential systemic risks posed by hedge funds.

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Hedge Funds and Systemic Risk

by Lloyd Dixon, Noreen Clancy, Krishna B. Kumar

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Research Questions

  1. What is the nature of hedge funds?
  2. Did hedge funds contribute to systemic risk through the credit channel and thereby aggravate the recent financial crisis?
  3. Did hedge funds contribute to systemic risk through the market channel and thereby aggravate the recent financial crisis?
  4. How might hedge funds contribute to systemic risk in the future?
  5. To what extent does the Dodd-Frank Wall Street Reform and Consumer Protection Act address the potential systemic risks posed by hedge funds?

Hedge funds are a dynamic part of the global financial system. Their managers engage in innovative investment strategies that can improve the performance of financial markets and facilitate the flow of capital from savers to users. Although hedge funds play a useful role in the financial system, there is concern that they can contribute to financial instability. The collapse of Long-Term Capital Management (LTCM) in 1998 raised awareness that hedge funds could be a source of risk to the entire financial system. Hedge funds also invested heavily in many of the financial instruments at the heart of the financial crisis of 2007–2008, and it is appropriate to ask whether they contributed to the crisis. This report explores the extent to which hedge funds create or contribute to systemic risk (that is, the risk of a major and rapid disruption in one or more of the core functions of the financial system caused by the initial failure of one or more financial firms or a segment of the financial system) and the role hedge funds played in the financial crisis, the consequences of the 1998 failure of LTCM, and whether and how the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addresses the potential systemic risks posed by hedge funds.

Key Findings

Hedge Funds Did Not Aggravate the Recent Financial Crisis Through the Credit Channel

  • There is little indication that hedge fund losses led to significant losses at prime brokers and other creditors.

Hedge Funds Did Not Did Not Play a Pivotal Role in the Financial Crisis Through the Market Channel

  • No strong case can be made that hedge funds significantly contributed to the financial crisis through the buildup of the housing bubble, deleveraging, or short selling.
  • Hedge fund withdrawals arguably weakened some prime brokers and their parent organizations.

Regulation Addresses Many Potential Systemic Risks

  • Dodd-Frank aggressively addresses gaps in the information available to regulators on hedge fund operations, investment strategies, and investment positions.
  • Dodd-Frank aggressively addresses gaps in the information available to regulators on hedge fund operations, investment strategies, and investment positions.Had the derivative trades been centrally cleared by an organization that enforced appropriate margin requirements, some failures might never have occurred.
  • Dodd-Frank overhauls the derivative market, giving regulators the authority to impose margin and other requirements that will cover the risk of default.
  • Dodd-Frank contains provisions that protect the margin that hedge funds post with prime brokers on their derivative positions.
  • The U.S. Securities and Exchange Commission reinstated a modified version of the uptick rule to curb short selling.
  • Dodd-Frank limits bank investments in hedge funds.
  • It is not clear that the recent financial reforms will do much prevent the buildup of highly leveraged, illiquid hedge fund portfolios and massive hedge fund deleveraging when prime brokers or investors withdraw credit and capital in response to a financial shock.
  • Some Dodd-Frank provisions might be undermined by the absence of global coordination of financial regulations.

Recommendations

  • Policymakers and regulators should monitor hedge fund leverage and collect data on and monitor the liquidity of hedge fund portfolios. However, in doing so, they should consider the trade-off between increased financial stability and the possible reduction in hedge funds' ability to take risks in markets in which other financial institutions do not provide capital intermediation.
  • Although they should focus on the largest funds, they should also pay attention to risk posed by the large number of small or medium-sized funds pursuing similar strategies.
  • They should be on the lookout for important classes of derivatives that continue to trade outside the regulatory structure set up by Dodd-Frank.
  • They should continue to pursue coordination of regulations across national jurisdictions.

Table of Contents

  • Chapter One

    Introduction

  • Chapter Two

    Background on the Hedge Fund Industry

  • Chapter Three

    The Collapse of Long-Term Capital Management

  • Chapter Four

    Hedge Funds and the Financial Crisis of 2007-2008

  • Chapter Five

    Potential Hedge Fund Threats to Financial Stability and Reforms to Address Them

  • Chapter Six

    Conclusion

  • Appendix

    Regulatory Reforms That Address Potential Systemic Risks Posed by Hedge Funds

The research described in this report was supported by a contribution by Christopher D. Petitt, principal of Blue Haystack, a financial research and consulting firm, and by the RAND Center for Corporate Ethics and Governance.

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