Conclusions Free of narrow constraints embedded in traditional investment guidelines, hedge funds have been an important source of innovation in the asset management industry. Lucrative compensation structures have played an important role in attracting talented individuals to the industry. Admittedly, these same financial incentives have encouraged many lesser talents to disguise themselves as hedge fund managers. I suspect, over time, investors will only be willing to pay prevailing hedge fund fees for truly outstanding managers. Hedge funds have rendered financial markets more liquid, more efficient and, ultimately, more flexible. Nonetheless, market observation suggests that in some specific cases, certain segments of the hedge fund industry may have recently had some impact on market volatility, either by accentuating existing market trends or by causing sharp price reversals or gapping price movements. The use of leverage is a central characteristic of the hedge fund industry. Overall industry leverage is extremely difficult to measure. Market and survey evidence suggests that it is currently moderate. However, such leverage estimates must be interpreted with great caution. They are unlikely to capture the real extent of leverage embedded in the hedge fund industry. Leverage matters in a number of ways. One particular concern is that diminishing hedge fund returns in the aftermath of large capital inflows might motivate hedge fund managers to use extreme leverage to generate returns commensurate with the prevailing hedge fund fee structure. Systemic risks could conceivably result from such elevated levels of financial leverage, primarily through large credit risk transfers to the global banking system.
These problems notwithstanding, the question of leverage in the hedge fund industry deserves further study. The primary focus should continue to be directed at the risk management operations and processes of the world’s major investment banks. They are the primary trading partners of the hedge fund industry. They are also the most important providers of leverage to the industry. Since the LTCM crisis, the global investment banks have clearly strengthened their risk management operations. On the other hand, the hedge fund business has become a significant source of profit for the big banks. Competition in providing lending and brokerage services to the hedge fund industry is fierce. Some erosion of lending standards is a likely consequence of such an intensely competitive environment. In light of the previously discussed difficulties in measuring leverage, senior bank executives, risk managers and bank supervisors should be particularly vigilant in ensuring disciplined lending frameworks, fierce competition notwithstanding. If the leading global investment banks maintain adequate counterparty risk and liquidity risk management systems and operations, leverage in the hedge fund industry should represent but a marginal risk to the stability of the global financial system. Fortunately, the global investment banking community is a small and concentrated one. Moreover, adequate bank supervisory structures exist and are currently being modernized. This should facilitate further study of the nexus between the risk taking of individual hedge funds and the risk management systems and processes within the world’s most important financial institutions.