operate largely outside the framework of other requirements established by regulatory authorities to protect the stability of the financial system. they are not unique in these attributes. some of the same things are true of other types of financial institutions. it ’ s the combination of the capacity for leverage, the complexity in assessing the risks they present, together with their apparent importance in many markets, that makes hedge funds an important focus of attention from a systemic perspective. for policy makers, the concerns associated with hedge funds range from investor protection, to market practices and potential manipulation, to the potential conflicts and reputational risks they present to the financial institutions they transact with, and to potential risks to the stability of the financial system. i want to focus on the latter set of concerns - those associated with systemic risk. these systemic concerns have two dimensions : first is the possibility that the behavior of hedge funds in periods of market stress could amplify rather than mitigate the shock, induce larger moves in asset prices, or cause broader damage to the functioning of markets when it is most important they function well. second is the possibility that the failure of a major hedge fund or group of funds could significantly damage the viability of a major financial institution, both through direct exposure to the fund and losses resulting from the impact on other market risks to which the institution is exposed. these concerns existed before the events associated with long - term capital management ( ltcm ) in 1998, but that episode provided a powerful example of both sets of risks, and how the erosion of counterparty discipline can magnify those risks. how significant are these risks today? this is not a question that can be answered by a clear set of facts that can inform a judgement of probabilities. and of course how the financial system responds to a shock is substantially dependent on the nature of the event. in assessing this question today, there are numerous factors to consider : • the number of hedge funds, and their total assets under management, have increased dramatically since 1998, significantly more rapidly than total financial assets. although they still represent a relatively small share of total financial assets, they play a significant role in some market segments. total exposure of the major bank and non - bank financial intermediaries to hedge funds as a group may be larger today, but that exposure is probably more diversified than in 1998. market participants seem to believe that average leverage in the hedge fund community, and the extent of leverage for the more highly leveraged hedge funds, is lower than in 1998

, but clearly it is difficult to assess these issues with any precision. • on balance, the quality of risk management by counterparties to hedge funds has, we believe, improved substantially since 1998. this is important, given the gaps revealed in market practice at that point. more on this later. • capital in banks and in the parts of the financial system affiliated with banks has increased significantly in absolute terms - that is, the major intermediaries are significantly larger than in 1998. however, when bank capital is measured relative to the risk of the activities it is intended to support, the resulting measures - while strong - are not significantly different from 1998 levels. the earnings capacity of the largest institutions has increased substantially and in some cases the volatility of those earnings has declined with the increased scope of their operations. • the infrastructure of the financial system, meaning the clearing and settlement system, is stronger and seems better able to handle much larger volumes, which is an important source of resilience in periods of stress. our overall judgement is that the u. s. financial system today is significantly stronger than it was in 1998. it has proven to be quite strong in the face of a number of fairly substantial recent adverse events. and there is some evidence that hedge funds have helped contribute to this resilience, not just in the general contribution they provide by taking on risk, but as a source of liquidity in periods of increased stress and risk aversion in the rest of the financial system. and yet, hedge funds – and financial leverage more generally - still present a source of potential risk to the financial system. the nature of these risks are worth reassessing, given the rapid growth in the hedge fund sector, the increased complexity of their interactions with major dealers, and concerns about unevenness in risk management practices and some recent possible erosion in the quality of counterparty discipline across the financial sector. how can these risks best be mitigated in practice? let me comment on the range of possible options that stop short of direct regulation. prudential regulations, in the form of capital or leverage requirements, have not been considered a necessary or desirable step to date within the official sector in the united states, and are not on the horizon. investors in hedge funds have a compelling direct interest in ensuring they are well managed. a more discerning and pro - active approach by investors in hedge funds should help to reduce the risk of failure by a major fund. the increasing share of institutional money