Hedge funds not so risky for the banks

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The central bankers meeting yesterday at the Bank for International Settlements in Basle were duly discussing the role and dangers of hedge funds - if only because this was what was expected of them by the world's media. Hedge funds were puffed up initially as the great new innovation in finance of the early 1990s; more recently, with the break in international bond prices, they have been billed a serious threat to the stability of world financial markets.

The reality is more modest. The first thing to be clear about is that the term hedge fund is a misnomer - as the Independent on Sunday pointed out in a thoughtful survey of the breed at the weekend. The normal use of the word 'hedge', both in ordinary conversation (as in 'hedge one's bets') and in the financial markets, is to lay off risk.

Typically this involves paying some kind of premium, or entering into some kind of contract, to ensure that if markets move in such a way as to give one a loss, all or part of that loss will be recouped.

Hedge funds, however, do the opposite. They speculate on financial markets, using money put into them by investors, plus further borrowed funds to gear up the scale of their speculation.

This use of a word to mean something 180 degrees away from its usual meaning is similar to the use of the word 'arbitrageur' to describe the speculators in the middle and late 1980s who bought shares in potential takeover victims in the hope that another purchaser would buy their shares at a profit. This is completely different from the accepted meaning of arbitrage - the risk-free activity of taking advantage of the very small differences in prices of the same item on different markets by buying on one and selling on another.

Hedge funds would break the investor protection regulation of most countries, so they are deliberately constructed in such a way as to avoid it. There are two main ways in which this can be done. They can be formed as private partnerships, with people buying into them as partners rather than investors. Or they can be based offshore, typically in the Netherlands Antilles, where national regulations do not apply.

The people marketing these investments manage to turn this lack of regulation into a selling point. Potential 'partners' in the enterprise are usually charged a premium for the privilege of joining such a select group, while the offshore funds (which generally also charge a premium) make a point of saying that the issue cannot be advertised in the US. The unstated message is: 'This issue is so special that we can only sell it to sophisticated high-net-worth individuals such as yourself.'

The product investors are buying is a geared investment in whatever markets the managers expect the greatest investment profit. When markets are performing well, as they have for much of the past six years, the gearing means these funds are liable to generate very high returns. But when they are performing badly, as the bond markets in particular have for the past six or so weeks, these funds are liable to generate equally large losses. Typically, they have lost a quarter of their value this year.

Does this matter? It is disagreeable for the high-net-worth individuals who have lost money, but it should have always been clear that these were risky ventures. We need not worry about them. It might matter, however, in two ways to central bankers, and these are the two issues the bankers were considering - pretty briefly by all accounts - in Basle yesterday.

The first is whether the amounts of money being chucked at the markets by hedge funds are destabilising. The answer to that is, yes, but not very. These funds must to some extent have influenced the markets in recent weeks and it may well be that the break in bond prices was greater than it otherwise would have been.

However, the hedge funds are by no means the only players and the fact they had to bale out of markets very sharply may have created profitable opportunities for the banks and the various investment institutions.

The second issue is whether the amount that these hedge funds borrow from the banks is dangerous to the system as a whole: whether, in the event of a large hedge fund going bust, the loans to it from banks would threaten a run on the banks themselves.

The answer to that is there is always a small danger of a collapse of the banking system, but unless the banks have been exceptionally stupid, they will not have lent so much as to threaten their own stability.