Hedge funds still pose risk FSA says

The UK’s Financial Services Authority says hedge funds pose “limited” systemic risks presently, but any forced selling in stressed periods or in markets whose liquidity they fuel could “impact market liquidity and efficient pricing”.

Hedge funds represent less than 1.5% of activity in eight major asset classes.

However, they play prominent roles in convertible bonds (8% of total outstanding), interest rate derivatives (4%) and commodity derivatives markets (3.7%), according to a poll the FSA conducted in September of 50 hedge fund managers running $380bn.

“Individually most surveyed hedge funds do not account for a significant proportion of trade volumes. As a group, however, they are considered to be more significant in providing market liquidity in normal conditions.

“Some risks to hedge funds remain, particularly if they are unable to manage a sudden withdrawal of liabilities during a crisis period,” according to the semi-annual study, published today.

The watchdog says managers had improved their portfolio liquidity over six months, and can now sell 55% of holdings inside a working week, while having to meet 10% financing liabilities over the same period.

The watchdog added the financial system is more resilient to funds defaulting since banks tightened margin requirements from 29% before Lehman Brothers’ collapse, to 38% by October.

“Firms and supervisors will need to make sure that margins do not fall to unsustainably low levels if exuberant market conditions return,” the report cautioned.

In a separate study of bank financiers of hedge funds, the watchdog said funds had increased the number of counterparties they use since Lehman Brothers collapsed.

But it cautioned: “Counterparty exposures…remain fairly concentrated with just five banks accounting for over 60% of aggregate net credit counterparty exposure”.

The maximum credit exposure any one bank surveyed has to any hedge fund is under $500m, with the average being sub-$50m.

Some 11% of industry assets remain impaired, the FSA added, and 90% of funds reserve the right to curb restrictions when necessary.

The FSA also noted a dramatic decrease in assets not earning performance fees, down from 43% to just 5% now.

The FSA will carry out its next industry survey in March.

David Walker

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