Hedge Funds and Systemic Risk

The FSA conducts surveys on a six monthly basis (‘Hedge Fund Survey’ *HFS+ and ‘Hedge Fund as Counterparty Survey’ *HFACS+) in order to assess the systemic risk posed by hedge funds (see Regulatory Roundup 27 for a review of the previous analysis).

Systemic risk in the context of the surveys is a risk which, if it happened without any intervention by the authorities, would mean a high likelihood of major and rapid disruption to the effective operation of a core function of the financial system and so leading to a wider economic impact. The results of the survey have been published in the form of a report.

In the eyes of the FSA the potential risks that could arise from hedge funds could be market dislocations that disrupt liquidity and pricing and/or losses in hedge funds leading to losses by banking and other counterparties.

The HFS (which is voluntary) captured around 50 investment managers with more than 100 ‘Qualifying Funds’ (being hedge funds with a NAV of $500m+) representing approximately $390bn. The FSA estimate that the HFS captures around 20% of global hedge fund industry net AUM.

The HFACS (which is also voluntary) covers ’14 large FSA-authorised banks’.

The funds in the survey showed an average return of 7% for the six months to end of March 2011 (the previous report showed 2% for the six months to September 2010) with 90% of funds reporting positive returns (contrasted with 75% in the previous survey).

Counterparty exposures remain concentrated with five banks accounting for 60% of aggregate net credit counterparty exposure. Having said that, the average potential exposure of any one bankis less than $50m – but it is revealed that there are two hedge funds for which the potential exposure by banksis $500m+.

The report advises that current risks to financial stability seem limited and, as many clients will know, counterparties have increased margining requirements.