FSA Survey Results Downplay the Threat of Systematic Risk Posed by the Hedge Fund Industry

The results of the Hedge Fund Survey and Hedge Fund Counterparty Survey published on 21 August by the FSA show that the hedge fund industry poses a minimal risk to the financial stability in the United Kingdom. The two hedge fund surveys use a sample of FSA regulated hedge fund managers and banks providing counterparty services to hedge funds in order assess the overall systematic risk as well as counterparty risk arising from the hedge fund sector.

According to the FSA, there are two separate ‘channels’ through which hedge funds could potentially affect financial stability:‘Credit Channel’ which essentially means failing hedge funds causing losses to their counterparties such as banks; and ‘Market Channel’ which refers to market dislocations causing disruptions to liquidity and pricing.

The results show that hedge funds have a limited chance of transmitting systematic risk across the market channel as the ‘footprint’ of the hedge funds in the grand scheme of the financial markets remains relatively modest. However, as pointed out by the FSA, the survey does not show the overall footprint of the global hedge fund industry, as it covers only a limited sample of FSA regulated hedge fund managers.

Banks more secure – what about hedge funds?
The Hedge Fund Counterparty Survey shows that 14 FSA regulated banks taking part in the survey have further reduced their exposure to the hedge funds in an effort to insulate themselves from hedge fund risk. However, more alarmingly for hedge funds, the survey shows that the funds participating in the survey have their exposures highly concentrated in five large banks, which cover close to 65% of the counterparty exposures for the participating hedge funds. This remains a worrying statistic after the most recent financial crisis.

Borrowing a remote risk
The FSA concludes that hedge fund borrowing is still mainly done via repo (47%). Borrowing on an unsecured basis continues to be negligible. The FSA noted that the risks of hedge fund borrowing are remote due to the small footprint of hedge funds. However, the regulator also identified that if finance to hedge funds is withdrawn quickly, forced sales of assets could have an impact on market liquidity during periods of already stressed market conditions. Therefore the risk of borrowing affecting market liquidity is mainly a source of risk in an existing market crisis.

Jerome Lussan, CEO of Laven Partners comments “These annual FSA Hedge Fund Surveys serve an important function in both monitoring the potential systematic risk from within the hedge fund sector as well as in debunking some of the common myths of hedge funds as a source of financial instability.

Lussan continues: “The fact that large banks have become less exposed to hedge fund defaults is a healthy sign, but it is still very worrying – from the funds’ point of view – that the counterparty exposure of hedge funds is heavily concentrated. For fund managers, these studies will highlight the importance of addressing counterparty risk re banks.

50 FSA-authorised investment managers participated in the survey with an aggregate AUM of approximately US$380bn

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