Hedge funds

In the business of credit, credit derivatives, CDOs and securitisation, hedge funds were, of late, occupying quite a crucial position. In the CDO and credit derivatives business, as suppliers of equity, and in securitisation business, as buyers of subordinated tranches, hedge funds

In the credit derivatives business, hedge funds came into limelight recently (May 2005 and thereabouts) when, pursuant to downgrades of US auto majors, there were reports that several hedge funds had lost substantial money. See, for some of these reports, Vinod Kothari's Credit Derivatives site, here .

Folllowing these reported upheavals in hedge fund profitability, several reports have gone into the possible shocks to the system that could be faced by a potential shake out in the hedge fund industry. Market participants remind themselves of the Long Term Capital Management fiasco of 1998.

It is common knowledge that both the SEC, USA and the FSA UK have been making overtures for coming out with some express regulation of hedge funds. The UK FSA recently released a discussion paper on regulatory engagement of hedge funds - linked in the box on top above.

Fitch Ratings also recently came out with a special report titled Hedge Funds: An Emerging Force in Global Credit Markets. Hedge funds have always been known as arbitragers and traders in derivatives and currencies - but they have slowly built a significant position in the global credit market by selling protection on credit derivatives, basket swaps and CDOs. Hence, they have emerged as suppliers of equity to the market in transfer of credit risk. A shakeout in the hedge fund industry might mean several CDOs will be forced to wind up or square up positions, which will lead to exacerbation of adverse credit events.

So hedge funds are seen as having much more significant influence on the entire financial marketplace today than ever in the past - possibly much more than at the time of the LTCM saga.

One of the strongest and most notable reports to come of late is that of the Counterparty Risk Management Policy Group (CRMPG). The CRMPG is a group of senior bankers - representing most of the top US investment banks, leading law firms etc. The CRMPG held held its first meeting after the 1999 failure of LTCM, and thereafter, met in early 2005 and submitted its report on 27th July 2005. The report goes by way of a letter to the CEOs of all leading US banks.

The report says that while the financial system today is highly interconnected (a point well established as there are far more linkages today than ever in the past - the insurers buy banking risks and the bankers buy insurance risks, and capital markets buy all sorts of risks), the market has shown remarkable resilience in the face of major shocks over the last few years. The technology bubble bursting, major corporate bankruptcies and accounting scandals, 9-11, mild recession, and so on. However, in the face of the increased complexity of the financial system and the speed with which shocks in one segment of the system get transmitted all over has assumed alarming proportion.

The report covers several issues in the oversight of the financial system, with counterparty risk being in focus.

Specifically on Hedge fund regulation, the Report recommends a deliberate and voluntary self regulation of the hedge fund industry, while apprehending that an indirect regulation of the industry might shortly be in hand. It recommends adoption of the 2005 guidelines of the Managed Funds Association.

More basic reading

What are hedge funds

Difficult to define, but think of unregulated, collective investment boutiques with restricted membership and broad mandates, which allow the managers to follow a broad spectrum of strategies to fetch exaggerated returns. The term "hedge" may be a misnomer, as many of the hedge funds are not fully hedged. Hedge funds are better understood by what they do than what they are, and what they do is a function of the strategy that a particular fund follows.

There are approximately 8000 funds with assets under management close to USD 1 trillion.

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