In the wake of the financial crisis of 2007–2008, investors and policymakers alike have called for renewed attention to hedge funds and their role in the financial system. In part, this interest has been prompted by recent insider-trading scandals at the Galleon Group hedge fund and other funds.¹ However, the interest also derives from deeper concerns about the role that hedge funds have come to play within the financial system and about a regulatory framework that may not effectively address the risk they pose to the financial system. The concern was articulated by the chairperson of the U.S. Securities...

Hedge funds are a dynamic and innovative part of the U.S. and global financial systems.¹ They are one of several institutions involved in moving money from capital suppliers to capital users. This chapter provides an overview of the industry and outlines the features of hedge funds that tend to exacerbate and mitigate systemic risk.

Hedge funds in the United States are a type of private fund. A private fund is defined in terms of exemptions from certain federal securities laws and regulations that apply to other investment pools, such as mutual funds.² Dodd-Frank defines a private fund as “an issuer...

Between January and September 1998, LTCM lost nearly all of its value. Financial-system regulators concluded that the rapid failure of one of the then-largest U.S. hedge funds might destabilize world financial markets and coordinated a private-sector buyout of the firm. LTCM’s failure raised awareness among regulators, banks, and other actors in the financial system that hedge funds could be a source of systemic financial risk. This chapter examines the factors that caused the collapse of LTCM and the policy response.

During the second half of the 1990s, LTCM pursued a strategy of “fixed-income arbitrage,” which exploited short-term differences in government...

The financial crisis of 2007–2008 was the worst financial meltdown in the United States since the Great Depression. The crisis precipitated a major decline in output and unemployment from which the economy is still recovering as of this writing. Hedge funds were active participants in many of the financial markets and instruments closely linked to the financial crisis, and it is appropriate to ask whether they contributed to the collapse. This chapter examines whether and how hedge funds may have helped precipitate the financial crisis. This chapter begins with a brief overview of the factors underlying the crisis, followed...

Although hedge funds did not play a pivotal role in the financial crisis, our examination of the crisis reveals ways in which they can potentially contribute to systemic risk. Similarly, our review of the LTCM episode illuminates potential threats to financial-system stability. From this analysis, we identify six areas of concern regarding hedge funds’ potential contribution to systemic risk moving forward:

lack of information on hedge funds

lack of appropriate margin in derivatives trades

runs on prime brokers

short selling

compromised risk-management incentives

lack of portfolio liquidity and excessive leverage.

We then examine the extent to which these concerns are...

Hedge funds are a dynamic part of the global financial system. They engage in innovative investment strategies that can improve the performance of financial markets and facilitate the flow of capital from savers to users. Although hedge funds play a useful role in the financial system, there is concern that their dynamism can contribute to system instability. Such concerns are reinforced by the lack of information about hedge fund operations and investments. The lack of information has made it easy to characterize hedge funds as villains operating in the shadows of the financial system.

From our analysis, we conclude that...