Hedge funds likely to pose a risk to retail investors

Hedge funds do not pose a systemic risk to the world's financial system, but there is a need to look into the way in which they are sold to smaller investors, according to Malcolm D Knight, general manager, the Bank for International Settlements (BIS).

Asked by reporters at a banking conference in Mumbai, organised by Federation of Indian Chambers of Commerce and Industry (Ficci), whether there is a need to regulate global hedge funds, Knight said, the hedge funds are regulated the least.

"All hedge funds have trillion dollar assets and have a heterogeneous group of investors. They also have different strategies. So, I do not think they pose a systemic risk to the world's financial system," he said.

Knight's comment on hedge funds assumes special significance in the context of the rising influence of hedge funds on the Indian bourses.

The recent market rally has been aided by the liquidity induced in the system by foreign hedge funds that have registered as foreign institutional investors in the recent past.

There have been apprehensions about hedge funds being market drivers, as they are known for buying big and selling big, with no strings attached.

Hedge funds have been alleged to be responsible for destabilising the financial systems, as experienced in the East Asian crisis. Some of the countries have, in fact, changed their regulatory norms on these funds.

A black mark was first impressed on the activities of hedge funds when the Emerging Markets Committee pointed to the role played by some of the hedge funds as one of the causes for the East Asian crisis. Some market analysts have expressed fears that if these funds decide to shed the bulk they have bought, the market would crash badly.

There is a big risk, as there can be many triggers that can induce a change in these funds' approach to the market - anything from a geopolitical issue to a mere global trend.

The Basel-based BIS, a forum for the world's central bankers, had called for more transparency in hedge funds earlier this year, saying that banks' exposure to them was rising.

Authorities around the world are becoming increasingly nervous about this lack of transparency in hedge funds, which use a wider range of financial instruments than traditional funds and also carry more risks.

"At the same time, these (hedge funds) are vehicles that are appropriate for investment by the sophisticated investor, and it is important that some concern is reflected... to look into the marketing to smaller asset holders," Knight said.

Until recently, hedge funds had been available only to very wealthy investors but are now able to attract smaller investors after lowering the minimum investment requirements.

CATCH 22

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• Market rally in India has been aided by the liquidity induced in the system by foreign hedge funds that have registered as FIIs in the recent past.
• Hedge funds have been alleged to be responsible for destabilising the financial systems, as experienced in the East Asian crisis.
• There is a big risk, as there can be many triggers that can induce a change in these funds' approach to the market - anything from a geopolitical issue to a mere global trend.
• Authorities around the world are becoming increasingly nervous about this lack of transparency in hedge funds