Countries should monitor hedge funds' leverage and interconnections, IMF says
I'm LongbridgeAI, I can summarize articles.The IMF warns that hedge funds, with gross notional exposure of ~$40T, can amplify market stress through high leverage and interconnectedness. As the sector grows to $13T in assets, risks from margin calls and redemption pressures may spread to banks and across borders. The IMF recommends enhanced monitoring of leverage, derivatives, and prime broker relationships, alongside system-wide stress tests to prevent systemic risks.
Hedge funds' ability to borrow with relatively few regulatory constraints allows them to support liquidity, price discovery, and risk-sharing in normal times. But they can also amplify shocks when markets deteriorate, the International Monetary Fund said in its Global Financial Stability report on Tuesday.
The role of hedge funds becomes more prominent as the sector has tripled since 2013 to $13T in gross assets under management. Adding in on- and off-balance-sheet positions, their gross notional exposure comes to ~$40T. In sovereign bond markets, hedge funds held ~9% of US Treasuries last year, the IMF said.
"Whether hedge funds support markets or worsen stress depends on the vulnerabilities that can manifest in their balance sheets—notably, leverage, crowded positions, and redemption pressures," the organization said in a blog post.
Many hedge fund strategies rely on borrowed funds, including short-term financing against securities through repurchase agreements, prime broker credit, and derivatives, to leverage their returns. "When volatility rises or financing conditions tighten, hedge funds may face margin calls, requiring them to reduce exposures or unwind positions," the IMF said. "In these circumstances, hedge funds can shift from acting as liquidity providers to amplifiers of market stress."
Stress in hedge funds can spread to banks' prime broker divisions, which provide financing and trading services to the firms. That can reduce the banks' ability to lend when markets are already stressed. Shocks can also transmit across borders.
Better reporting of such information as leverage, derivatives exposures, prime broker relationships, and cross-border relationships is critical to effective surveillance, the IMF said. "Policy measures should be calibrated to the source of risk," the blog said.
Among the IMF's recommendations is ensuring that prime brokers maintain strong counterparty risk management and monitor exposures to highly leveraged hedge funds.
"System-wide stress tests can show how hedge funds and their counterparties would respond to shocks and how pressures could propagate across financial institutions and markets," it said. "Identifying such vulnerabilities early can help prevent them from becoming systemic risks."