The bankers have set up an informal working party to examine whether the banks they regulate have a dangerous level of exposure to hedge funds - and, if so, whether there is any way of preventing the large falls in securities prices that follow big sell orders from hedge funds. Among the measures they are considering are: regulation; making it prohibitively expensive for banks to lend; and compulsory disclosure.
'They do not know what their policy is, but they are concerned about avoiding a risk that could lead to the collapse of the financial system. They feel that if they do not look at this issue, there may be a chance of a surprise collapse in a financial institution, which they do not want to be embarrassed by,' said a senior source at one bank.
This move follows two weeks of almost unprecedented volatility and near panic in the European bond markets. The villains of the piece are widely held to be the hedge funds. They have been forced to liquidate much of their bond portfolios to stem potentially crippling losses.
The effect on long-dated gilts is that a year's bull market has been wiped out in little more than a month. Some hedge funds have taken big hits as, according to rumour, have some big investment banks.
This has served as a chilling reminder to central banks that the firms they supervise are exposed to these leveraged funds. Trouble at a hedge fund might conceivably lead to it not being able to meet its obligations to a bank. At worst, it could lead to financial meltdown. The fear of such an outcome has grown in intensity as derivatives - highly volatile swaps, futures and options contracts derived from the price movements of individual securities and indices - have become increasingly popular.
According to the International Swap Dealers Association, the total amount of interest rate and currency swaps written during the last six months of 1993 was dollars 2,100bn ( pounds 1,400bn), an increase of 27 per cent on the first half of the year.
In a co-ordinated attempt to regulate the derivative markets, leading central banks want to introduce capital requirements governing market risk. A working group for the regulators also expects to report in the next few months on how statistical information might be collected to measure market size and large risks.
The danger is that big hedge funds make considerable use of derivatives to flit in and out of markets in a largely unregulated way. Caribbean tax havens are ideally suited to the requirements of the millionaires who are typical hedge fund investors. But this makes it hard for regulators to get a grip on the total exposure of these funds to markets.
By no means all hedge funds inspire these sorts of fears; many are essentially 'market neutral' in that they are largely unaffected by market movements, while others invest in 'distressed securities', which belong to companies in serious trouble.
According to Republic New York Securities Corporation, there are more than 800 hedge funds, containing dollars 35bn-dollars 40bn.
Around dollars 15bn of this is run by the big US hedge fund managers - George Soros, Michael Steinhardt of Steinhardt Partners, and Julian Robertson of Tiger Management. Perhaps dollars 5bn is run by a new group of managers that has sprung up in London, among them the one run by Crispin Odey. But as all these funds might be borrowing up to five times their asset base, there could be as much as dollars 225bn of hot money on the loose. That is about dollars 55bn more than the London gilts market, so these funds have plenty of muscle to drive markets.
One London hedge fund manager says the effect of this capacity becomes more pronounced when the big hedge managers all follow each other. He adds that they do this often, most recently in the European bond market, where hedge funds have started to sell.
The problem is that once markets start falling, the hedge funds have to sell a disproportionate amount to cover losses on bond futures contracts that have been leveraged through loans with banks.
Leverage means that if a market doubles, investors make a much bigger profit. But if the market halves, they have to come up with more money from elsewhere to cover losses. Hedge funds have been forced to do this by the falling markets. As a result, they have accentuated the falls.
But one broker who introduces rich individuals to hedge funds says they are not alone in taking big directional bets in the European bond markets. The banks have also had big positions on their own accounts and may have been among those forced to sell at a loss.
Others say that the big falls in markets have triggered sales by other investors, such as mutual and pension funds, that have set stop-loss levels - at which point they automatically sell to limit their losses.
These events have focused the minds of the Bank of England and its US counterpart, the Federal Reserve Board. Both institutions have been conducting research into what kind of dealings banks have with leveraged funds, and how banks assess the creditworthiness of hedge funds. They also want to know the aggregate exposure to different hedge funds of different parts of banks; how much collateral the banks require for their loans; and at what point they require more if markets are falling.
Ultimately, the Bank and the Fed are asking how responsible hedge fund sales have been for the fall in European bond markets.
This is a relatively new issue for central banks because the hedge fund business has grown tremendously in the past year. In this country alone, the number of hedge fund management companies has probably doubled. At least part of the appeal is the huge potential earnings available from annual management fees of up to 2 per cent and incentive fees of up to 25 per cent of any gain. Mr Soros is reported to have made dollars 650m last year, and this country's two leading hedge fund managers earned well over dollars 15m each in their first year.
One thing seems clear: the results this year are unlikely to be on the same scale as 1993, when some funds returned profits of more than 50 per cent of capital. Whether the use of derivatives by hedge funds plays a part in a market crash of the future, they should not be made the scapegoats for the recent market weakness. Other leveraged investors are, by all accounts, also to blame.
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