Much of the post-crisis reform effort has been aimed at reducing the systemic risks that derivatives can create through the way they interconnect multiple actors in the system and can amplify market shocks. Mandatory margining, central counterparty clearing and trade reporting are all designed to create resilience and to simplify the network and make exposures more transparent. It may be however that widespread and increasing use of derivatives by market-based finance will over time make the opacity and complexity too difficult to manage. What is sensible for risk management at the fund level simply may be too difficult to manage risk at the system level. 18  Hedge funds and banks have different business models, which complicates comparisons of financial leverage. But, in aggregate, hedge funds’ non-derivative liabilities (made up primarily of borrowings through repo and prime brokerage) are roughly the same size as their total net asset value. Banks’ non-derivative exposures are over 15 times greater than their tier 1 capital. However, whilst the hedge funds industry’s financial leverage is lower than banks, some individual hedge funds make extensive use of financial leverage. 8  All speeches are available online at www.bankofengland.co.uk/speeches  8  Second, and more importantly, given the channel of interconnectedness created by funds’ use of derivatives, to what extent could the failure of a fund or a number of funds create systemic risk? Again, the post crisis reforms around margining and clearing reduce that risk.
14  It is of course difficult to gauge the probability of a stress event leading to a self-reinforcing downward spiral of redemptions and forced asset sales. The Bank of England has developed simulation models that give an indication of the point at which liquidity would break down and such effects could set off. 15  These are only simulations. But given that we are paid to think about what could happen – what is unlikely but plausible – there is enough here to be of concern to macroprudential authorities. This concern is the backdrop to the FSB’s recommendations on asset managers that IOSCO published in February this year. 16  From the Bank of England’s point of view, the most important recommendations are  around fund liquidity and ensuring that the liquidity offer matches the investment profile of the fund. IOSCO is also taking forward the FSB recommendation to develop better and more consistent leverage metrics for investment funds. The Financial Policy Committee of the Bank of England has also commissioned work on non–bank leverage. 17  Leverage, as we know, is usually somewhere at the bottom of a banking crisis and the last episode was no exception. Leverage is perhaps the core necessary element of the banking business model. But when it gets out of hand it stokes up the boom phase in the financial cycle and can leave banks with insufficient resources to cope with the correction, so amplifying the bust phase of the cycle.