FSF warns of hedge fund risks

The growth of the hedge fund industry is hindering risk management and valuation processes and is putting margins under pressure, says a report by the Financial Stability Forum (FSF), issued on Friday (May 18).

The report warns that firms could be exposed to a liquidity crunch, if hedge funds pull out. Although indirect risk is difficult to estimate, the FSF says that investors should improve stress tests to estimate their exposure to a drop in market liquidity and asset prices, and calls for improvements in financial infrastructure to strengthen the resilience of the system against sudden liquidity shocks.

The FSF also warns that competition is putting margins under pressure, and that the absence of concentration limits is leading to increased concentration of market-making in certain sectors. It adds that many new and complex products remain untested under stress conditions.

The report, issued at the request of G7 finance ministers and central bank governors, is an update of the forum’s 2000 report on highly leveraged institutions. The forum consists of central bankers, regulators and international bankers from around the world, and is supported by the Bank of International Settlements in Basel.