Hedge Funds, Financial Intermediation, and Systemic Risk

Abstract

Hedge funds are significant players in the U.S. capital markets, but differ from other market participants in important ways such their use of a wide range of complex trading strategies and instruments, leverage, opacity to outsiders, and their compensation structure. The traditional bulwark against financial market disruptions with potential systemic consequences has been the set of counterparty credit risk management (CCRM) practices by the core of regulated institutions. The characteristics of hedge funds make CCRM more difficult as they exacerbate market failures linked to agency problems, externalities, and moral hazard. Nonetheless, we conclude that CCRM remains the best line of defense against systemic risk and that direct regulation of hedge funds is not desirable.

Keywords: banks, counterparty credit risk management, liquidity

JEL Classification: G12, G21