Generally negative hedge fund performance figures during the month of June are testimony to the gapping nature of the price movements following the Fed’s interest rate decision. 6  There is no definitive source for hedge fund data. Most vendor databases collect data that hedge funds voluntarily disclose. Many large hedge funds that are closed to new investors do not report to the data vendors. In addition, hedge funds that perform poorly often stop reporting to the vendor databases as their performance deteriorates, leaving the series exposed to the problem of ‘survivor’ bias. 2  BIS Review 8/2005  It is important to point out that extreme care needs to be exercised when interpreting such examples. First of all, any number of factors can cause markets to move to new equilibrium points. Second, price action is often shaped by overall liquidity conditions in a specific market segment. Sharp price movements are more likely to occur in markets where trading activity is light. Third, the nature of market participants engaged at any particular time will impact the nature of price movements. Analyzing price action is not a precise science. Indeed, I strongly suspect it never will be. Nonetheless, the previous example suggests that in some specific cases, it is at least plausible that large asset pools have recently been deployed in related strategies which have contributed to cases of heightened market volatility. Performance correlation figures in some hedge fund market segments lend some support to such a hypothesis.

These problems notwithstanding, the question of leverage in the hedge fund industry deserves further study. The primary focus should continue to be directed at the risk management operations and processes of the world’s major investment banks. They are the primary trading partners of the hedge fund industry. They are also the most important providers of leverage to the industry. Since the LTCM crisis, the global investment banks have clearly strengthened their risk management operations. On the other hand, the hedge fund business has become a significant source of profit for the big banks. Competition in providing lending and brokerage services to the hedge fund industry is fierce. Some erosion of lending standards is a likely consequence of such an intensely competitive environment. In light of the previously discussed difficulties in measuring leverage, senior bank executives, risk managers and bank supervisors should be particularly vigilant in ensuring disciplined lending frameworks, fierce competition notwithstanding. If the leading global investment banks maintain adequate counterparty risk and liquidity risk management systems and operations, leverage in the hedge fund industry should represent but a marginal risk to the stability of the global financial system. Fortunately, the global investment banking community is a small and concentrated one. Moreover, adequate bank supervisory structures exist and are currently being modernized. This should facilitate further study of the nexus between the risk taking of individual hedge funds and the risk management systems and processes within the world’s most important financial institutions.