Monitoring hedge funds: a fi nancial stability perspective

Investor inflows into hedge funds have been significant in recent years and they have continued unabated. As a result, the presence and role of these investment funds in global capital markets have become increasingly important, and to a much greater extent than the amount of capital they manage would suggest. This is because hedge funds can, and often do, leverage their investment positions. Indeed, their leveraged assets are sometimes comparable with the assets of large banks. The growing and active participation of hedge funds in a large number of financial markets implies that the functioning of these markets could be seriously affected if the hedge fund sector came under stress. The positive contribution of hedge funds to the efficiency and liquidity of global financial markets is widely recognised, but there are also concerns that in times of stress their activities may create risks to financial stability. The lack of transparency and limited publicly available information about their balance sheets and activities poses significant challenges for financial stability analysis. While it is possible to base such an analysis on a multitude of information sources on hedge fund activities – including dedicated financial media, commercial hedge fund databases, quarterly industry reports, hedge fund return indices, academic studies, some supervisory data and market surveillance – these sources are not sufficient for an adequate monitoring and robust evaluation of hedge fund activities from a financial stability perspective. Three groups of indicators could be important for financial stability analysis, namely those which shed light on banks’ exposures to hedge funds, provide yardsticks of the crowding of hedge fund trades, and facilitate the gauging of endogenous hedge fund vulnerabilities. The latter group would include the measures of funding liquidity risk, leverage and exposures to market risk factors. The construction of all these indicators would be greatly facilitated if basic information on hedge fund balance sheets were available. Since this is not the case, various indirect estimation methods have to be relied upon. A “desirable vs. available” analysis reveals the most important information gaps, but it does not aim at providing recommendations on how to enhance hedge fund transparency in practice. Instead, it proposes three elements which a transparency framework would ideally include: fi rst, more aggregate information to all market participants; second, a highly standardised reporting template that would make disclosures more effective; fi nally, adequate information for a joint analysis of the aggregate activities of banks, hedge funds and other highly leveraged institutions in order to have a comprehensive picture of risks to the smooth functioning of financial markets.