I Overview

Anne Jansen, Donald Mathieson, Barry Eichengreen, Laura Kodres, Bankim Chadha, and Sunil Sharma
Published Date:
May 1998
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Barry Eichengreen and Donald Mathieson

Hedge funds are collective investment vehicles, often organized as private partnerships and resident offshore for tax and regulatory purposes. Their legal status places few restrictions on their portfolios and transactions, leaving their managers free to use short sales, derivative securities, and leverage to raise returns and cushion risk. This occasional paper considers the role of hedge funds in financial market dynamics, with particular reference to the Asian crisis.

While hedge funds are large in absolute terms, they are dwarfed by other institutional investors (banks, pension funds, mutual funds), some of whom engage in many of the same activities as hedge funds. This points against the conclusion that hedge funds play a singular role in precipitating crises. Hedge funds did have large positions against the Thai baht in the summer of 1997, but so did other investors, and most hedge funds were relatively late to take those positions. That is, they were at the rear, not the front, of the financial “herd.” And there is scant evidence that hedge funds had equally large positions against other Asian currencies. This reflects the fact that many hedge fund managers, like other market participants, were surprised by the speed and virulence of the Asian contagion.

Regulation of collective investment vehicles can be justified on three grounds: consumer protection, systemic risk, and market integrity. Few regulators see a need for stricter regulation on the first two grounds. But there is some concern that hedge funds can dominate or manipulate particular markets. Limited measures to strengthen supervision, regulation, and market transparency might be considered to deal with this concern. These include replicating in other markets the large-trade and position reporting mechanisms in place in countries like the United States as a way of rendering hedge fund operations more transparent, raising margin and collateral requirements, and restricting the ability of financial institutions to lend domestic assets to nonresidents.

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