Financial stability does not mean that bank insolvencies should be excluded or that stock markets should develop smoothly. We are concerned about financial stability because of the macroeconomic implications of financial turmoil. First, financial stability is a prerequisite for the successful implementation of monetary policy. Second, a stable financial sector is necessary for the smooth functioning of the economy as a whole. Third, central banks have an interest in financial stability because they know that in the event of financial crisis their role as ultimate liquidity provider could interfere severely with their traditional objective of price stability. 1  Greenspan, 1998. BIS Review 74/2007  1  1. The HLI industry  In order to assess whether HLIs constitute a major risk to financial stability, it may be helpful to discuss the exact meaning of the terms “highly leveraged institution” and “hedge fund”. Legal – or any other generally accepted – definitions do not exist yet. However, there are several characteristics that such institutions have in common. They are privately offered investment vehicles that pool the investments of high-net-worth individuals and family businesses, the HLI managers themselves and, increasingly, institutional investors. Often there are minimum investment requirements that restrict access to HLIs. Thus retail investors are mainly indirectly exposed to HLIs: actively through investments in funds of funds or passively through pension funds. HLIs deploy active investment strategies to pursue superior absolute return. Usually HLIs also employ leverage. HLIs are only lightly regulated and are not subject to supervision.

They are largely exempt from reporting and disclosure requirements and there are no restrictions with regard to investment strategies, financial instruments or leverage. The term “hedge fund” goes back to the 1950s, when the first hedge funds were established. These funds were designed to be neutral to general market movements. Their investment strategy was to combine short and long positions to hedge some of the market risk and thus to achieve absolute returns in different market conditions. Nowadays, they no longer just “hedge” since they apply a wide range of investment strategies. They make intensive use of short selling and of complex financial instruments such as derivatives. The term “highly leveraged institution” is also of limited value in terms of defining the entity it designates. 2 At a rough estimate, HLIs have an average leverage of 1.4. 3 This is indeed a much higher leverage than traditional investment funds have, for which there are strict restrictions on indebtedness. In Switzerland, for instance, traditional investment funds are only allowed to have a leverage of up to 0.1, and this only on a temporary basis. However, a leverage of 1.4 is low compared to large international banks which have a leverage of ten to fifty. In terms of market share, the role of HLIs is less important than is generally believed although, in the last few years, their activity has grown tremendously. Since 1999, HLI assets under management have increased by a factor of five. An important driving factor has been the increased inflows from institutional investors.