Leverage puts hedge funds in the systemic-risk spotlight

In April, the US Financial Stability Oversight Council (FSOC) published a 27-page update on systemic risk in the asset management industry, without once mentioning systemic risk designations for individual firms.

The omission reflects a wider change of focus from regulators internationally as they have switched attention towards the risk of buy-side firms collectively rather than the risk from single firms acting alone. It's a shift that has led them to focus more closely on the chance of buy-side fire sales, and the role of liquidity and leverage in exacerbating market panic.

Leverage gets an eight-page section in the FSOC's report and hedge funds, in particular, are an area of focus. The council is working with imperfect data, so can only make approximations. But it says the top 10 hedge funds by net asset value seemingly account for nearly half the total derivatives notional across the industry.

The council is setting up an interagency working group to look both at the possible risks posed by highly leveraged hedge funds and to ask what data is needed to monitor and mitigate any such risk in future.

Academics say one way regulators might target hedge fund leverage is through reducing its provision at source, a squeeze many funds are already experiencing thanks to Basel III constraints on lending and repo.

Interestingly, the FSOC also talks about tracking hedge fund behaviour through prime brokers, but says doing so has got harder as bank regulation forces funds to increase the number of prime brokers they work with. Because many prime brokers operate under different national watchdogs "no single regulator has a complete window into the risk profile of hedge funds", states the update.

Efforts to establish such a window seem likely to be only a first step towards closer monitoring of hedge fund leverage in the future.

Theory and action

For mutual funds, regulators are concerned more about liquidity than leverage, with the US Securities and Exchange Commission ahead of other supervisors in its proposals to address such worries. Many in the industry point to the absence of historical examples of buy-side fire sales leading to liquidity issues, but academic studies support the view such scenarios are possible.

Academics are sceptical about certain of the regulator's ideas, though. Some think cash buffers and the close management of liquidity in mutual funds might add to panic in a crisis. They say the protection of cash buffers can be illusory because funds need to replenish the buffer once used, forcing the quick sale of less liquid assets anyway.

Meanwhile, greater transparency about liquidity risk might make investors more likely to ditch a fund that seems to be heading for trouble.

The apparent logical step would be to put gates or other limitations on fund redemptions, but such measures are hard to implement even if some in the industry privately agree they would be helpful – a situation that leads one former member of the Federal Reserve Board of Governors to lament that another crisis might be needed to achieve meaningful change.