on the bank. depending on the size of the open position vis - a - vis the hli, this might threaten the bank's solvency in an extreme case. the effective risk emanating from hlis depends primarily on the margin and collateral requirements set by the banks. these requirements help not only to constrain losses but also to determine the amount of leverage hlis are allowed to use. moreover, banks can partially hedge their risk and diversify their exposures. in general, we do not see a substantial difference between banks ’ exposures to hlis and other risky exposures, such as, for instance, derivatives. both make high demands on banks ’ risk management and their value may react sharply to market movements because of leverage. investments in hlis are thus comparable to other risky investments. let us now have a look at the collapse of ltcm – by far the largest hedge fund to date – in order to obtain some idea of the potential disruptive capacity of hlis. almost all of the fund's capital was destroyed in the collapse. losses amounted to usd 4. 4 billion, of which usd 1. 9 billion were incurred by the manager of the hedge fund, usd 0. 7 billion by ubs and usd 1. 8 billion by other investors. moreover, if the federal reserve bank of new york had not intervened to organise a bailout, the hedge fund's counterparties would have incurred estimated losses of about usd 5 billion. 7 although these amounts seem high, they are in fact modest in relation to the involved banks'capital and to the size of the financial markets. second transmission channel : banks as price takers on financial markets hlis act as buyers and sellers on the financial markets. their actions have an impact on prices, liquidity and volatility in just the same way as any other market participant's action. however, there are two reasons why the impact of hli trading could be stronger. first, in certain market segments they have an above - average share in trading volume. second, margin calls can force hlis with a high leverage and a focus on derivatives to liquidate large positions in a very short period of time. in stressful market conditions, both of these phenomena could further depress market prices, reduce market liquidity and increase volatility. this is the second transmission channel through which hlis may amplify shocks and spread negative effects in the banking sector. see also hildebrand, 2007.

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. 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