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Central banks express mixed views on hedge funds

The Bank of England, the European Central Bank and Germany's Bundesbank expressed varying opinions this week over HF issues including leverage.

The Bank of England warned hedge fund managers that they need to increase investors' lock-in periods if they are moving into less liquid asset classes.

In its latest Financial Stability Review (FSR), the Bank, referring especially to those hedge funds relying on funds of hedge funds for capital, said that "a combination of leverage, relatively illiquid assets and, in many cases, model-based approaches to trading and valuation may, in the event of material asset price shifts, exacerbate stressed conditions."

At a time when hedge funds have in excess USD I trillion under management, the Bank of England says that leverage does not appear to be at 1998 levels, when Long Term Capital Management, brought the international banking system to its knees when it was caught short by a Russian sovereign debt default. LTCM relied on huge levels of leverage supplied by banks to make money on very fine margins.

The current report says that potential "economic" leverage surrounding hedge funds appears to have been rising in recent years.

Alongside its concerns of hedge funds moving into stickier markets, the Bank notes greatly increased issuance of debt by companies in emerging market economies, particularly Russia.

It warns that investors generally need to be aware of the lower levels of transparency and higher levels of risk associated with these instruments.

European Central Bank gives clean bill of health to hedge funds
The European Central Bank has given hedge funds a generally clean bill of health, saying the possible dangers to financial markets are "much less worrisome" than even a few years ago.

Publishing a "financial stability review" for the first time yesterday, the eurozone central bank said hedge funds improved the efficiency of financial markets and thus boosted social welfare.

But the ECB expressed some concern about the risks posed by the large US current account deficit, warning that a "disorderly rebalancing" would exert "severe downward pressure on the US dollar".

The ECB's comments contrast with a more cautious tone struck by the Bundesbank, the German central bank, which last week warned that the lack of transparency involved with hedge funds required greater surveillance.

Presenting yesterday's report, Jean-Claude Trichet, ECB president, agreed there was a debate about the degree of regulation required for hedge funds and said: "The question of transparency is crucial."

The near-collapse of the Long-Term Capital Management hedge fund in 1998 sent shock waves through the financial system and focused attention on the regulation of such vehicles. The first hedge funds concentrated on buying and short-selling equities, but the ECB notes that today hedge funds use a wide variety of investment strategies, with few restrictions.

Although admitting there was "no conclusive evidence" about the impact of hedge funds on financial markets, the ECB report said: "The available information points to a situation which is much less worrisome than at the time of the LTCM crisis." Trichet pointed out that the "scrupulous scrutiny" of commercial banks was in itself a way of controlling hedge funds.

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