The global economy will face a huge liquidity risk under the next downturn as over-exposed hedge funds seek to unwind their positions causing defaults and severe declines in asset prices, according to a new Fitch report. “In a market downturn, the potential for a forced unwind of credit assets cannot be discounted... any such forced selling of assets would be magnified by the effects of leverage”. Hedge funds now account for nearly 60% of the trading volumes in the $30 trillion credit default swap market.
Germany has tried to make tighter regulation of hedge funds a core priority of its G8 and European Union presidency and has pushed for a voluntary code of conduct wary of the huge expansion of the industry. But the plan has been virtually shelved with the G8 ministers today simply stating in their communiqué: “Given the strong growth of the hedge-fund industry and the increasing complexity of the instruments they trade, we reaffirm the need to be vigilant.”
At the end of 2006, around 9,400 hedge funds operated worldwide, with assets of $1.4 trillion. The assets of Asia-focused hedge funds have grown more than six times from around $20 billion in 2002 to over $130 billion by the end of 2006.
Hedge funds provide significant capital flows to all areas of the cash credit markets, particularly more levered, subordinated risk exposures in pursuit of higher returns, driving risk premiums to record lows, said the report. Eileen Fahey, Managing Director, Financial Institutions at Fitch and report co-author explained that abundant capital and the search for yield has give even the most distressed issuers easy access to fund and refinance maturing debt. Fahey told Emerging Markets that any change in risk appetite poses particular problems for emerging markets: “hedge funds will be affected by the psychological contagion and could easily leave if there was a crisis”. But that “at the same time other funds would come in for the distressed debt and the larger hedge funds, contrary to popular belief, are largely there for the longer term”.
At the Institute of International Finance spring meeting, Lucas Papademos, vice-president of the European Central Bank argued there were severe dangers that liquidity risk was under-priced and a change in market conditions could lead to strong risk aversion causing havoc on world markets. But Axel Weber, president of Deutsche Bundesbank argued that these funds should submit to regulation now to prevent tougher oversight when the economic conditions are less benign: “current times provide a good window of opportunity for hedge funds to submit to regulation”.
Philippe Costeletos, a partner at the U.S. buyout firm Texas Pacific Group, also at the meeting argued that firms were now seeking increasingly diverse portfolios so penetrating into emerging markets. But he conceded that the resilience of the valuations, the depth of liquidity and risk management techniques have not been tested: “A lot of people say risk is diversified among many players. I think there is a lot of system risk which few can quantify, we need to be careful.''
Hedge funds have had a controversial foray into emerging markets. Their highly leveraged positions in Asia’s currency markets led to accusations that they caused the region’s financial crisis in 1997 by destabilizing currencies in small and open markets.