• With assets under management approaching an estimated $1.5 trillion in 2006, hedge funds have become important players in the U.S. and global capital markets.
  
  
• A key channel through which largely unregulated hedge funds interact with regulated financial institutions such as banks is prime brokerage relationships, where banks provide the funds with services such as trading and execution, clearance and custody, securities lending, technology, and financing through margin loans and repurchase agreements.
  
  
• Central to these relationships is the extension of credit to hedge funds, which exposes banks to counterparty credit risk.
  
  
• Kambhu, Schuermann, and Stiroh explain that counterparty credit risk management (CCRM) practices, used to assess credit risk and limit counterparty exposure, are banks’ first line of defense against market disruptions with potential systemic consequences.
  
  
• The authors examine how the unique nature of hedge funds may generate market failures that make counterparty credit risk for exposures to the funds intrinsically more difficult to manage, both for regulated institutions and for policymakers concerned with systemic risk.
  
  
• Hedge funds, according to the study, complicate CCRM because of the funds’ unrestricted trading strategies, liberal use of leverage, opacity to outsiders, and convex compensation structure—all of which exacerbate potential market failures stemming from agency problems, externalities, and moral hazard.
  
  
• Kambhu, Schuermann, and Stiroh acknowledge that certain market failures have shown CCRM to be imperfect, such as the events surrounding the 1998 collapse of hedge fund
  Long-Term Capital Management. However, they observe that CCRM has improved significantly since then, and point to industry groups that have reported:
  
  

• enhanced risk management techniques by counterparties,
  
  
• improved supervision,
  
  
• more effective disclosure and transparency,
  
  
• strengthened financial infrastructures, and
  
  
• more efficient hedging and risk distribution techniques.

• The authors add that the institutionalization of hedge funds, driven by the demands of new investors such as hedge fund of funds and other institutional investors, is also increasing discipline and transparency.
  
  
• The study concludes that counterparty credit risk management practices remain the best starting point for limiting the potential for hedge funds to generate systemic disruptions.

John Kambhu is a vice president and Til Schuermann an assistant vice president at the Federal Reserve Bank of New York; Kevin J. Stiroh was a vice president at the Bank at the time the article was written.

The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.