I came across this useful paper on hedge funds. It is very basic and explains number of financial concepts as we go along reading the paper.
Its central idea is that financial markets involve risk. To mitigate these risks the market participants should do counterparty risk management properly. And this is still the best weapon against hedge funds, which are often criticised for posing high risks on the system.
What are hedge funds? Hedge funds are private unregulated pools of capital.
How are they different from other money management funds?
1) They can invest in all kinds of assets and are flexible in their positions.
2) Use leverage liberally , as they are unregulated
3) Opaque to outsiders , again because they are unregulated
4) 2 and 20 pay structure for fund managers.
Now, first 3 make hedge funds different but not unique. For instance, we have mutual funds that do shortselling, Real Estate Investment Trusts etc. Leverage and opacity is common with most financial intermediaries when compared with other non-financial firms.
Fourth point makes hedge fund managers unique and the industry to work for. However, some funds do have things like hurdle rates (no incentive fee if returns are below the hurdle rate) and watermarks (incentive fee only on new profits).
Hedge Funds are often criticised for creating systemic risk. But what does it mean?
In our view, an essential feature of systemic risk is when financial shocks have the potential to lead to substantial, adverse effects on the real economy, e.g., a reduction in productive investment due to the reduction in credit provision or a destabilization of economic activity.
Indeed, it is the transmission of financial events to the real economy that is the defining feature of a systemic crisis, and which distinguishes it from a purely financial event. As discussed in more detail below, these real effects might occur if credit provision is interrupted through shocks to the banking sector or through capital market disruptions.
This is simplicity at its best.
The paper says as stable financial markets are like public goods. As it is the case with Public Goods, everybody needs them but nobody wants to provide them. And we have problems of free-riding etc.
While, in principle, every bank should monitor its exposure and limit excess risk-taking by the hedge fund, each bank also has an incentive to free-ride by reducing its CCRM and enjoying the benefits of the CCRM of the other banks. This is a classic example of “tragedy of the commons” where private markets may under-provide the public good and create a rationale for official sector intervention.
So you need regulation, as private sector may not do the needful risk management properly. Simple ideas but conveyed pretty effectively.
Read it to revise issues like moral hazard, externalities, agency problems etc.
A nice, simple, effective read.