Hedge Funds and Financial Stability: The State of the Debate

The authors review the state of the debate on hedge funds and the potential threat that hedge funds pose to financial stability. The collapse of a hedge fund or a group of hedge funds might pose a systemic risk directly by damaging systematically important financial institutions, or indirectly by increasing market volatility and generating a liquidity shock in key markets. Both the hedge fund sector and the prime brokerage industry supporting them are highly concentrated, with a small number of dominant players that have a complex business relationship. Therefore, while the potential for a systemic risk from the hedge fund sector is considered small, the potential for <em>damage</em> from such shocks may have increased due to the increased spread, complexity, and tighter linkages of the global financial system. Going forward, the relationship between large complex financial institutions and hedge funds must be monitored closely. In terms of policy, direct regulation that increases transparency - whether of counterparty exposures or trading positions - does not appear feasible, may create a moral-hazard problem, and may reduce overall market efficiency. Indirect regulation via prime brokers, market discipline, and improved riskmanagement practices are the most promising approaches for addressing potential risks from the hedge fund sector.