Despite the unique risk challenges posed by hedge funds, the practices currently used by financial institutions to manage counterparty credit risk are still the best starting point for limiting the funds’ potential for generating systemic disruptions, according to a study forthcoming in the Federal Reserve Bank of New York’s Economic Policy Review, Hedge Funds, Financial Intermediation, and Systemic Risk.
The first line of defense against market disruptions with potential systemic consequences are banks’ counterparty credit risk management (CCRM) practices, according to authors John Kambhu, Til Schuermann, and Kevin J. Stiroh. Banks use CCRM to assess credit risk and limit counterparty exposure. Largely unregulated hedge funds, which interact with banks via such channels as prime brokerage relationships, complicate CCRM through their unrestricted trading strategies, liberal use of leverage, opacity to outsiders, and convex compensation structure, explain the authors.
Kambhu, Schuermann, and Stiroh acknowledge that while certain market failures have shown CCRM to be imperfect, it has improved markedly in recent years. They point to developments such as enhanced risk management techniques by counterparties, improved supervision, more effective disclosure and transparency, strengthened financial infrastructures, and more efficient hedging and risk distribution techniques. Accordingly, the study concludes that the current emphasis on CCRM as the primary check on hedge fund risk-taking is appropriate.
John Kambhu is a vice president, Til Schuermann an assistant vice president, and Kevin J. Stiroh a vice president at the Federal Reserve Bank of New York.