There are several reasons: HLIs are perceived as a highly risky industry which is not subject to supervision. HLIs are perceived as non-transparent and opaque. HLIs use complex financial instruments and employ non-traditional investment strategies, partially based on complex mathematical models. HLIs are active shareholders, as the recent example of ABN Amro showed. HLIs are part of the glamorous world of high-net-worth investors and high-salary investment managers. And, probably most important, in recent years, the importance of HLIs has grown tremendously. Why is the risk they pose to financial stability perceived as being so high? HLIs account not only for a significant share of trading volume in some market segments, especially complex ones, they are also important counterparties and clients which provide a significant source of revenue for large international banks. This raises the question of whether HLIs are indeed a threat to financial stability and, if so, whether there is a need for regulation. These are the two questions we will try to answer in this paper. To begin with, let me point out what central banks understand by financial stability and why we consider financial stability to be important. In our view, a financial system should be able to absorb shocks affecting financial institutions (e.g., banks) and/or links between institutions (e.g., payment systems) without jeopardising the system’s vital functions such as financial intermediation, i.e. the transfer of funds from savers to investors, monitoring debtors and transporting payments between economic agents.

Currently there are some 9,000 HLIs with assets under management of about USD 1,600 billion. 4 Despite these impressive figures, the HLI industry remains modest in relative terms. HLIs have a market share which is smaller than the trading books of the five largest international banks and they represent only a fragment of the total debt securities (USD 65,000 billion) and credit default swaps outstanding (USD 25,000 billion). However, more important is the activity of HLIs in some market segments, especially in the more complex ones. In the markets for credit default swaps, distressed debt and emerging market bonds, for instance, roughly half of the trading volume can be attributed to HLIs. In the more traditional markets for interest rate derivatives and mortgagebacked securities, their share drops to only 10% again. 5  2. The benefits of HLIs  HLIs have undoubtedly been a source of innovation in the global asset management industry, especially with regard to traded credit products. Moreover, through their flexible and largely unconstrained investment approaches as well as through their extensive use of innovative financial instruments, they have contributed to improving the efficiency of price discovery in financial markets. By buying assets that are perceived to be undervalued and by selling assets that are perceived to be overvalued, HLIs help to move mispriced assets toward their fundamental values. HLIs play an important role in trading and distributing risk. Thus, they enhance market liquidity, perhaps even in periods of stress, when nobody else is willing to take risks.