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.

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.