Preliminary Draft

Not for Citation

Hedge Funds and Financial Market Dynamics:

Some Perspectives From the Asian Experience

Charles Adams

September 2005

The views expressed are those of the author and do not necessarily represent the views

of the International Monetary Fund. The paper has been prepared for a seminar at

Nanyang Technological University, Singapore I. Introduction

Hedge funds by their nature seem to invite strong views. On the one hand, there is what

could be characterized as the ultra-positive view of hedge funds. According to this view,

hedge funds play a critical role in modern capital markets on account of their nimble and,

in some cases, contrarian-position taking, their ability to take long and short leveraged

positions, and their potentially long time horizons. Any efforts to directly regulate hedge

funds are seen, according to this viewpoint, as not only being inherently undesirable

because they could take away key market players that provide liquidity to markets (and,

perhaps, impractical given the very large number of hedge funds) but also as potentially

giving rise to new problems, such as moral hazard (in so far as regulated financial firms

may be viewed as being covered by official safety nets) or being offset by regulatory

arbitrage (with hedge funds morphing into other entities). Moreover, any regulation is

seen as potentially reducing welfare by limiting the choice sets of investors who seek the

high and uncorrelated market returns that currently largely unregulated hedge funds claim

to deliver

On the other hand, and in sharp contrast, a number of emerging market governments

(especially but not exclusively) in Asia have, at least in the recent past, taken a much less

benign view of hedge funds. Based largely on the Asian crisis experience, several Asian

governments raised numerous concerns in the late 1990s about the possible destabilizing

effects of large and concentrated positions apparently taken by a small number of large

macro hedge funds in their foreign exchange, money and equity markets (“Big Elephants

in Small Ponds”). In addition, several Asian governments raised concerns about (what

they saw as) aggressive and manipulative tactics on the part of some macro hedge funds

(including so-called double plays across markets) that might have comprised market

integrity and interfered with the price-discovery process. In response, a number of

countries called for the direct regulation of hedge funds albeit without always specifying

Given the paucity of data on hedge funds and possible significant survivor bias in the

limited data that is reported, claims of high and uncorrelated (with the market) returns of

the hedge fund asset class as a whole need to be treated with care. See Eichengreen and

Mathieson (1998) and the FSF Report on Highly Leveraged Institutions (2000). who would be responsible for any regulation (national authorities or some supranational

entity), whether the regulation would be directed primarily at addressing issues of

financial stability or market integrity

, and the form any regulation would take.

With memories of the Asian financial crisis receding, it is a moot point whether there is

currently the same degree of concern on the part of Asian countries about hedge funds as

there was in the late 1990s. Economies are considerably stronger, domestic lines of

defense have been built up (most notably through massive international reserve buildups),

some progress has been made strengthening regional financing arrangements (through the

Chiang Mai Initiative), and exchange rates are generally somewhat more flexible than

before the Asian crisis (de facto less than de jure). Based on admittedly incomplete and

imperfect data, the large macro hedge funds that were active in Asia and elsewhere in the

late 1990s appear to have largely departed the scene, with the recent apparent strong

growth in the hedge fund industry

largely accounted for by the proliferation of a very

large number of small hedge funds (and by “funds of funds”), that may be less leveraged

than some of the bigger directional macro hedge funds in the second half in the 1990s

And, in what may appear as something of an irony, at least one of the Asian governments

that expressed the strongest concerns about hedge funds in the late 1990s has recently

moved to reduce restrictions on retail investment in the hedge fund industry as part of the

broader global mainstreaming of hedge funds

In the past, hedge funds avoided much direct regulation by being confined to large

investors for whom investor protection is not seen as an issue. It remains to be seen

whether the recent mainstreaming of hedge funds and their partial opening to smaller

retail investors will lead to calls for greater regulation on investor protection grounds.

According to Tremont TASS, the global hedge fund industry currently has assets under

management of between $725 and $750 billion whereas the figure in 1997 was around

$300 billion.

In practice, however, reliable data on leverage does not exist to make a definitive

judgment.

Hong Kong and Singapore have recently allowed hedge funds to be marketed to retail

investors subject to limits. Hong Kong was very vocal in the late 1990s regarding its

concerns about hedge funds. Of course, partly opening the door to some retail investment

in hedge funds is not necessarily inconsistent with having other concerns about hedge

funds. At the same time, however, it is clear that concerns about the possible destabilizing

impact of hedge funds have not disappeared. Many Asian governments continue to flag

concerns about hedge funds in official meetings and policy fora. A number of Asian

countries continue (at some cost) to address the (perceived) “dark side” of hedge funds

(and of aggressive currency speculation) through measures ranging from “soft” forms of

market monitoring (that may nevertheless have chilling effects on large and aggressive

speculative position taking) through to the adoption or continued use of exchange or

capital controls that limit the ability of hedge funds (and other market players) from

taking large speculative positions in their markets, and/or limit offshore trading in their

currencies.

With current efforts to develop local currency bond markets (under the broad umbrella of

the ASEAN + 3 Asian Bond Market Initiative (ABMI)), the potential costs of some of

these measures may become clearer as countries seek to develop the local currency swap

and other derivative markets that will be needed to help “grow and deepen” local

currency bond markets. Consideration will need to be given to whether any relaxation of

capital and exchange controls to help develop swap markets will open up countries to

speculative and other attacks by hedge funds (or others) and, more generally, to whether

hedge funds might represent the same threat as perceived in the late 1990s.

Against this background, the purpose of this paper is to revisit some of the earlier work

on the role of hedge funds in Asia (and elsewhere) in the late 1990s with particular

attention to the 2000 Report of the Financial Stability Forum Working Group on Highly

Leveraged Institutions (HLIs)

. The objective is two fold: on the one hand, the paper

seeks to shed light on the major issues addressed in the Report, the difficulties assessing

The author represented the IMF on the Working Group that prepared the 2000 FSF

Report and convened the Study Group that considered the market dynamic issues in

emerging markets. The FSF Report considered the broader role of Highly Leveraged

Institutions (HLIs). HLIs cover not only hedge funds but also the proprietary trading

desks of commercial and investment and a small number of other market players. the role of hedge funds, as well as the main conclusions and policy recommendations; on

the other, consideration is given to the extent to which changes in global and regional

financial markets and in the hedge fund industry since the Report was prepared might

affect it main policy conclusions and recommendations.

The paper is organized as follows: Following this introduction, Section II considers the

background to the 2000 FSF Report focusing, in particular, on the key market events that

led to its preparation, and the Report’s key objectives as regards the role of hedge funds

in emerging markets

. Section III considers the main difficulties encountered in

attempting to assess the role and impact of hedge funds in emerging markets, and the

approaches taken to get around these difficulties. Section IV outlines the main

conclusions and policy recommendations of the Report, seeking to make clear some of

the reasons reaching consensus was difficult. Finally, the last section stands back and

considers some of the broader implication of the Report, including how financial market

and other developments in recent years might affect its main conclusions and

recommendations.

II. Background and the Report’s Objectives

Concerns about hedge funds did not suddenly appear in the late 1990s and, as noted

above, have not altogether evaporated in recent years. Dating back at least to the early

1990s and the U.K.’s “forced” exit from the Exchange Rate Mechanism of the European

Monetary System, many commentators have questioned the role that hedge funds (and, in

particular large directional macro hedge funds

) might have played in various periods of

market stress and, in particular, in helping bring about the collapse of the U.K.’s pegged

Accordingly, not much attention in this paper is paid to the systemic concerns raised by

the near-term collapse of the LTCM hedge fund in 1998.

There is a range of different styles adopted by different hedge funds. See Eichengreen

and Mathieson (1998). LTCM was a relative value hedge fund that traded across

generally wafer-thin differences in prices across assets and required high leverage to

generate high returns on capital. exchange rate regime. And, in the U.S. in 1994-95, many commentators saw hedge funds

as having played a potentially important role in the bond market turbulence experienced

as short-term policy interest rates were raised and hedge funds (and others) sought to

close out highly leveraged positions. Subsequently, in the wake of the 1994-95 Mexican

(or Tequila crisis) fingers were again pointed at hedge funds albeit with the domestic

retail and wholesale investors generally seen as more important than hedge funds in the

case of the 1994-95 Mexican crisis (International Monetary Fund (1994,1995).

The 2000 FSF Report had its immediate origins in two developments, in particular. The

first, and most important, was the near-collapse of the LTCM hedge fund in the fall of

1998 in the wake of the spreading of the Asian crisis and Russia’s default and

devaluation. Rightly or wrongly, the New York Federal Reserve decided to intervene to

“broker” a private-led rescue of LTCM, citing potential concerns about the implications

for financial market stability were LTCM allowed to suddenly collapse. Given that

LTCM was not itself a very large hedge fund

(concerns arose on account of its very

high and complex leveraged positions across many markets) and was largely unregulated

(as is the case with most hedge funds), questions naturally arose as to whether some form

of direct regulation of hedge funds (and, perhaps, of leverage more generally) might be

required in order to help avoid the kind of turbulence in financial markets that

accompanied the problems at LTCM and help maintain financial stability. Interest in the

possibility of the direct regulation of hedge funds was concentrated mainly outside the

U.S. with the U.S. authorities expressing skepticism both on the desirability and

feasibility of seeking to regulate hedge funds.

The other development was a growing chorus of voices from Asia, in particular, about the

possible destabilizing impact of large concentrated hedge fund positions and the use of

“aggressive” position taking and tactics on the part of certain funds. These voices had

first been raised in the latter half of 1997 by, in particular, Indonesia, Malaysia, Thailand,

and the Philippines. And they had led to an early 1998 IMF study of the role of hedge

Estimates of LTCMs’ assets under management range between $10-$14 billion in the

first half of 1998. funds in Asia (Eichengreen and Mathieson (1988)). That study, however, did not find a

major role for hedge funds in the countries at the heart of the Asian crisis during 1996-97,

but was seen by many Asian governments as not fully coming to grips with the role of

hedge funds and, less generously, as a “white wash”. What changed in 1998/99, was that

an increasing number of countries from both within and outside Asia began to actively

raise concerns about hedge funds (similar to the concerns raised earlier). Concerns started

to be raised by countries that had much stronger fundamentals than the ASEAN countries

at the heart of the Asian crisis in 1997 (Indonesia, Malaysia, Thailand, and the

Philippines).

While it had been possible to argue in early 1998 that the finger pointing at hedge funds

on the part of some national authorities was part of the “blame game”, this dismissive

approach became increasingly untenable as countries with much stronger fundamentals

started raising concerns. Moreover, with the Asian financial crisis deepening and

spreading through the fall of 1998, it was becoming clear that many aspects of financial

market dynamics were imperfectly understood, including the role of hedge funds. And if-

-as was the case in the fall of 1998-- the near-collapse of a single hedge fund could raise

issues of financial stability in the very deep and liquid financial markets of the U.S. then

it could surely be the case that such funds could raise issues of financial stability in much

smaller emerging market economies

Against this background, the 2000 FSF Report on Highly Leveraged Institutions was

asked both to assess the systemic and other concerns raised by highly leveraged hedge

funds (such as LTCM) and propose policy and other ways of addressing the systemic

risks posed by these funds. In addition, in response largely to Asian concerns, the Report

was asked to consider the risks posed to financial stability and integrity in small and

medium sized markets—and the implications for market dynamics--of the activities of

leveraged hedge funds in these markets, and propose appropriate policy responses.

Moreover, a number of Asian governments cited the New York Fed’s role in helping

facilitate a (private) bailout of LTCM as validating similar approaches taken in the

region. As the systemic and other concerns posed by hedge funds such as LTCM have been

widely covered elsewhere—including in some action-packed “thrillers” such as “When

Genius Fails”—this paper focuses on the second set of concerns: the market dynamics

and integrity risks posed by hedge funds in small and medium-size emerging markets.

There are three main differences between these concerns and those regarding the

systemic risks involved in the LTCM case.

First, the concerns in the case of LTCM for the most part covered the consequences of

financial stability of the rapid and potentially disorderly unwinding of large leveraged

positions that had already been taken. The market dynamic issues in emerging markets,

on the other hand, were mainly concerned with the impact of hedge funds putting on

positions and, in the process and through various means, moving and distorting markets.

Second, there continues to be much less understanding of the issues posed by any efforts

of large hedge funds to move and manipulate macro markets such as foreign exchange

and money markets than of the implications of a rapid unwinding of positions such as in

the case of LTCM. Moreover, while there was near-universal agreement in the FSF that

the high levels of leverage acquired by hedge funds such as LTCM were (at least, in

some sense) a problem, there were wide differences of view (particularly between

emerging and mature market representatives) as to whether there were in fact any

substantive problems associated with the activities of hedge funds in emerging markets.

In short, the consideration of the issues posed by LTCM began from the premise that

there was a problem. In the case of the market dynamics and integrity concerns in

emerging markets, however, it was necessary first to establish that there was any problem

at all.

Finally, many of the large hedge funds that were seen by Asian governments as

threatening financial stability and integrity in their markets were ultimately based in—or, at least, operated through—the financial centers of new York and London

. In these

circumstances, it was very easy for the issues to become highly politicized and for some

countries to be put on the defensive

III. Difficulties Assessing the Impact of Hedge Funds and the Approaches Taken

For a variety of interrelated reasons (in addition to political sensitivities), it was very

difficult for the 2000 FSF Report to assess fully the role and impact of hedge funds in

emerging markets such as in Asia. Three reasons for these difficulties, in particular, stand

out.

First, and perhaps most importantly, there were difficulties associated with the

opaqueness of the Over-The-Counter (OTC) foreign exchange and money markets in

which many hedge fund operated. This opaqueness made it difficult to assess whether

and to what extent hedge funds built up positions in these markets, whether positions

represented a significant share of the total positions in those market (to help assess

concerns about position concentration), when those positions were put on and taken off

(to help assess whether positions were associated with large price movements), and more

generally to assess the trading strategies followed by hedge funds (to help assess whether

they were aggressive), and how they differed from other market players.

Moreover, not only were many of the markets in which hedge funds operated opaque, but

many—if not most—of the hedge funds that were thought to be active in these markets

were themselves opaque. This reflected to a significant degree very light reporting

requirements on such funds in their home countries as well as, in the case of some hedge

funds, deliberate efforts to be “off the radar screen”.

This was the case although several were registered in offshore financial centers.

LTCM also operated across markets in different countries but there were no apparent

concerns about manipulation. It was necessary, in these circumstances, for the Report to rely mainly on market

intelligence to arrive at a sense of the positions taken by hedge funds and their trading

strategies. In less grandiose terms, much use was made of informal off-the-record

meetings with various private and official market participants including the prime brokers

and traders for various hedge funds, and a number of the large hedge funds. Such market

intelligence is, of course, not without its problems. Most market participants typically

“see” only a small part of an overall OTC market that they inhabit. Incentives may not

always be aligned to provide a complete picture (for example, if a financial firm trades on

behalf of hedge funds and risk loosing their business). And hedge funds may have

deliberately spread and concealed their transactions as they were put in place so as to

avoid imitation and copycat trades

. Moreover, markets are frequently driven by rumors

of both a founded and unfounded nature and it may be the case that widely cited rumors

of hedge fund activity are nothing more than rumors.

In some rare cases, for example in the case of the so-called double play across the Hong

Kong equity and money markets, some of the trading occurred in the spot and futures

markets for equities which are in an organized exchange. In these circumstances, it was

possible, with the cooperation of the authorities, to obtain (confidential) position data that

showed the size and extent of concentration of hedge fund positions but this was the

exception rather than the rule. Short positions in Hong Kong equities futures turned out to

have been very large and concentrated in the fall of 1998.

At the same time, however, other approaches were informally considered to try to assess

the role of hedge funds in various markets. Drawing on an already emerging literature

and using what limited data was available on the mark-to-market values of certain hedge

funds portfolios, statistical techniques were considered to try to determine where

particular funds were invested and, more broadly, whether changes in the values of

certain fund’s portfolios were correlated with abrupt movements in certain emerging

Interestingly, several of the larger macro hedge funds spoke of spreading their trades

across several institutions so as to avoid front running.

In particular, see Brown et al (1988). market’s prices such as exchange rates. Such approaches are, of course, not without their

own difficulties if hedge funds are active across many markets and countries and

frequently change their positions. But these approaches can, in principle, provide a

potentially independent check on the information obtained from market intelligence.

Unfortunately, however, these approaches—at least at the time of the 2000 Report—did

not appear to be very robust and there was considerable skepticism about their usefulness.

Such approaches tended to confirm what was apparent from some simple eyeballing of

the data—for example, that several large hedge funds were affected by the sharp

deleveraging and bounce back of emerging and mature market exchange rates around the

time of the problems at LTCM—but even here the results were not very clear. Overall, a

decision was taken not to use the reconstructed portfolio approach and to rely mainly on

market intelligence.

Another major difficulty concerned the lack of macroeconomic models that include an

explicit role for particular classes of economic agents (such as hedge funds) to influence

economy-wide prices such as exchange markets and/or which allow for the possibility

that certain agents can systematically manipulate macroeconomic markets such as the

foreign exchange market.

To be sure, there is one branch of literature that deals with speculative attacks on pegged

exchange regimes and the conditions under which “large” attacks can force a central bank

to run out of reserves and/or a government to choose to alter a pegged exchange rate

when the costs of maintaining the peg become too large in terms of their implications for

meeting other objectives

. In the main, however, this literature does not ascribe a

particular role to any particular class of economic agent even though there seems to be a

presumption that one or two “large” investors could by taking sufficiently large positions

tip the balance and lead to a change in the peg. Leverage would, of course, allow for large

position taking.

See the discussion in the FSF Report (2000) and Eichengreen and Mathieson (1988). Influenced importantly by the recent spate of emerging market crises, there has also been

a growing literature that builds on the first generation models of balance of payments

crises to include various endogenous policy responses as well as,importantly, balance

sheet effects that can create zones of vulnerability and multiple equilibria associated with

currency and maturity mismatches as well as weak balance sheets

. For the most part,

however, these models are constructed on the assumption of many atomistic (private)

economic agents and they do not generally allow for the possibility of one or two

economic agents driving the market. Such models may, however, potentially provide a

way of thinking about how economic agents might under certain conditions seek to move

economies into zones of vulnerability.

One needs to turn to some of the micro-based and market structure models to allow for

the possibility of one or two large or well-informed economic agents driving and

manipulating financial markets. In these cases, however, the markets involved are

typically trading assets that are in finite supply (where market cornering is a possibility)

and/or in which certain agents possess some kind of informational advantage (from which

there can be benefits to insider trading). Needless to say, it is not immediately clear that

these models would apply to economy-wide markets such as the foreign exchange market

which are generally seen as being potentially infinitely expandable (and hence not

capable of cornering) and which, for the most part, trade largely on the basis of publicly

available information (making insider trading difficult). There is, however, a very recent

literature (much of which was not available at the time of the 2000 Report) of models in

which large economic agents can, under certain typically quite stringent conditions, move

markets to their advantage when their reputations or positions are perceived by other

market players as implying that they have some kind of informational advantage

In these circumstances, the 2000 Report had to rely for the most part on back-of-the

envelope models of the possible role of large players based, inter alia, on market

Krugman (2001, 2003)

See, for example, Corsetti et al (2004) and the Annex to the Market Dynamics Study

Group Report (prepared by Nouriel Roubini) in the 2000 FSF Report. intelligence on the kinds of strategies certain large hedge funds were perceived as

following and taking into account that in the unsettled market conditions that existed in

Asia in 1997-98, with market liquidity low, that it might be possible for large players to

move markets at least temporarily and earn an above normal return from their actions

when they can influence the behavior of other market participants (see below). While

such an approach is obviously not intellectually satisfying, it allowed the work to be

done.

Finally, a major difficulty in assessing the impact of hedge funds concerned the need for

a counter-factual against which the impact of hedge funds could be judged. Hence, even

if one could on the basis of, say, market intelligence reach the conclusion that hedge

funds had established large and concentrated positions in certain markets, one needed to

confront the question as to whether these positions had made a difference and/or had

moved markets closer to or further away from equilibrium. In short, one needed to

confront the question as to whether hedge funds were simply acting as messengers (sic)

that helped move markets towards equilibrium. Given the lack of satisfactory exchange

rate models and the unsettled market conditions at the time, it was clearly a “tall order” to

try to construct counter-factual equilibrium prices. Accordingly, it was necessary to rely

to a large extent on the views of market players and analysts in seeking to reach

reasonably informed judgments.

IV. Report’s Main Conclusions and Policy Recommendations

Given all the problems and difficulties noted above, it might have been tempting for the

Report to avoid reaching conclusions on the role of hedge funds during the Asian crisis.

Policymakers, however, do not usually have the luxury of being agnostic (even when

there are few facts to tie things down) so an attempt was made to try to assess the

concerns about hedge fund expressed by a large number of Asian countries. Not

surprisingly given the problems noted above as well as certain political sensitivities,

consensus proved elusive on several points and several participants contributing to the Report probably did not substantially move from their “priors” when the Report was

prepared.

Two points are worth underscoring before considering some of the specific and

potentially more contentious conclusions of the Report.

First, on the basis both of the market intelligence obtained as well as prior beliefs, a

decision was taken not to question the widely held belief that hedge funds under normal

market conditions had the potential to contribute importantly to market efficiency and

liquidity, and could be a source of stability. Most contributors to the Report appeared to

hold the view that financial markets function best when there is a large and diverse set of

participants including those that are willing and able to take speculative positions based

on the fundamentals.

Secondly, a decision was made not to explicitly revisit/reinterpret the experiences of the

countries at the heart of the Asian crisis during 1996 and 1997 (Indonesia, Thailand,

Malaysia, and the Philippines). This was the case even though a number of contributors

to the report thought that the role of hedge funds in these countries had been

underestimated in the 1998 IMF Hedge Fund study. It was felt, however, that the

message of the Report would be most effective (and less controversial) if the focus was

for the most part on cases or time periods not covered in the earlier IMF study. In making

this decision, the intention was not to suggest that there were not concerns about the very

large movements in exchange rates and other asset prices in these earlier cases or

significant worries about overshooting and contagion. Key questions here involved more

general issues about the factors underlying the severity of the Asian crisis and whether

the “punishment was far in excess of the crime”.

In the case of the six case studies for the Report (Australia, Hong Kong, Malaysia, New

Zealand, Singapore, and South Africa), detailed write-ups were provided both of the

1997-98 experiences as well as of the authorities’ own and sometimes different

interpretations of the role of hedge funds. At the risk of simplification, the following general but tentative conclusions from the

Report can be noted.

o In contrast to the 1998 IMF hedge fund study, concerns were expressed about the

large apparent size and concentration of macro hedge fund positions (made

possible by leverage) in a number of markets and their implications for market

dynamics especially in unsettled market conditions. Not surprisingly, however,

views differed on the potential significance of these hedge fund positions and

about how long lasting their impact on market behavior was.

o Quite often it appeared that the same three or four large macro hedge fund has

short and (in some cases) concentrated positions across several Asian countries

(and Australia and New Zealand) at the same time.

o Based on discussions with a wide range of market participants, there appeared to

be a number of actions taken by hedge funds (and others) including aggressive

talking–of-books, spreading rumors, aggressive trading at illiquid times etc that

could be seen as efforts to move markets. Views differed, however, on how

widespread these practices had been and how long lasting their impact was. While

a number of contributors to the Report felt that these practices amounted to

possibly damaging efforts at market manipulation, others felt that there was not

sufficient evidence to reach such a judgment even though there was concern about

these practices.

o Consistent with orthodox thinking, the most effective defense of any country

against the possible destabilizing effect of hedge funds was seen as maintaining

strong economic fundamentals and avoid operating in zones of vulnerability

where multiple equilibria could arise (with a view to being pushed over the edge).

Some contributors to the Report felt, however, that even countries with strong fundamentals faced some risks in the presence of aggressive hedge funds and that

unorthodox responses might in extreme cases be required

o Evidence was found consistent with the possibility of double plays across the

Hong Kong equity and money markets

(whereby investors would first short the

liquid equity futures market and then seek to push up interest rates by taking short

positions in the foreign exchange market and thereby earn a return as equity

prices fell). Views differed, however, on whether the evidence really suggested

deliberate double plays or simply reflected hedge funds and others taking

advantage of linkages across markets and/or diversifying their portfolios.

o While it sounds intuitively plausible that big players should be able to push small

markets around, size ends up being a two-edged sword. Big players may be able

to affect prices when they take on positions but-- unless fundamentals change

and/or they can change the behavior of other market players—they will tend to

move prices in the opposite direction when they close out their positions.

Generally, market players face strong incentives to tailor the sizes of their

positions to market size and liquidity.

o Even though there were numerous suggestions of collusion on the part of some of

the larger macro hedge funds that were active in Asia, the evidence was generally

unpersuasive. While positions across larger hedge funds often seemed to be

highly correlated, this most likely reflected common trading strategies based on

common information, rather than collusion. Moreover the cutthroat nature of the

competition across different hedge funds seemed to argue against systematic

collusion.

Including, for example, Hong Kong’s equity market intervention and Malaysia’s

September 1998 decision to impose capital controls.

Some anecdotal evidence also suggested the possibility of double plays across different

currency markets. On the overall question as to whether it was possible to characterize in general terms the

approach to positioning taken by some of the larger macro hedge funds, the following

represents a stylized view, shared in varying degrees by contributors to the Report.

Faced with a situation in which a large hedge fund viewed a currency as, say, overvalued

and likely to be devalued or to depreciate at some point in the future, the fund would

quietly and gradually start to build up short positions in the currency in either the spot or

the forward market. The precise approach would depend on the liquidity of the two

markets and whether it was the official sector (as in the case of a pegged exchange rate

regime) or the private sector (as in the case of a pure float) that was ultimately on the

other side of the transaction. In all cases, however, the fund would generally seek to

move with stealth to avoid in the early stages copycat or imitation trading and moving the

market against itself.

At some point, the fund would need to get out of its short position and this would either

occur when the authorities chose to devalue under a pegged regime or, under a floating

rate regime, when other market players joined the bandwagon in shorting and selling the

currency. In order to trigger or create these latter points, it would generally be optimal for

the hedge fund to start “talking its book” only after its short position had been taken.

And, after its position was taken, it might spread rumors that led other market players to

start shorting the currency and/or it might begin aggressive selling to push prices down

and bring various momentum traders on board. Contributors to the Report differed on the

extent to which large macro hedge funds had, in fact, pushed prices significantly away

from equilibrium in such approaches rather than bringing forward corrections and

adjustments that would otherwise have taken place

In view of the somewhat guarded conclusions reached in the 2000 FSF Report, it is not

altogether surprising that very strong policy recommendations were not made regarding

In addition, there were differences in views as to whether some large hedge funds had

deliberately planned in advance to aggressively move markets or whether some, caught in

large short positions in the third quarter of 1998 became aggressive in order to get out of

those positions and avoid losses. the specific issues posed by large macro hedge funds in emerging markets. Given that

there were concerns, however, about some of the practices followed by a number of

hedge funds (even if there was a lack of consensus on whether they amounted to

manipulation) and about what appeared to be fairly large and concentrated positions in a

number of markets, various possible policy responses were considered.

Free riding to some extent on the policy recommendations drawn up to deal with the high

levels of leverage acquired by funds such as LTCM, improvement were proposed in

hedge-fund transparency in order to strengthen and bring about more timely market

discipline, and calls were made for stepped up oversight by regulators of the

counterparties providing credit to hedge funds and for these counterparties to exercise

more care in providing credit to hedge funds. To the extent to which progress in the areas

was made and leverage reduced, this was seen as to some extent as helping to reduce the

sizes of the positions taken by “big elephants in small ponds”, although this was not the

primary motivation for these recommendations.

Three very specific recommendations for dealing with the “big elephants” issue and

questionable market practices were discussed, albeit with very different levels of support.

First, consideration was given at a very early stage to whether to try to increase the

transparency of the OTC markets through some kind of monitoring system in which the

aggregates of various positions would be tallied up and reported to the market according

to different classes of market players (as in organized exchanges

). Both on account of

the potential very high cost of implementing such a proposal (and the very close

cooperation that would be required across countries) this proposal was, however,

dismissed. Moreover, there were genuine differences of view as to whether reporting data

on aggregate positions would necessarily be helpful in so far as it might encourage more

rather than less herding (How would markets react if information was provided that

foreign “speculators” were building up large short positions in a currency?). Conversely,

In addition, a number of very radical proposals were discussed (but quickly dismissed)

including shifting currency trading from opaque OTC markets to organized exchanges. an alternative view was that providing such information to markets would help reduce the

informational advantage enjoyed by some market participants that “see” many of the

trades taking place, would reduce the ability of large players to spread (inside)

information about their positions to try to influence other market participants and drive

markets, and could make it more difficult for market players to build up large positions

by stealth.

Second, consideration was given to the possibility of drawing up a set of voluntary

guidelines on “good practices” in currency market drawing on guidelines already

prepared in a number of countries (including the U.S.). While considerable discussion

went into how those guidelines should be framed and what they should include,

agreement was reached that such guidelines should ideally be prepared by the private

sector, albeit with some official direction. In the event, a group of private sector

institutions did draw up some guidelines shortly after the FSF Report was issued—in part

to deal with concerns some market participants held about various practices in currency

markets—and the guidelines remain in effect. Although it is possible to be quite skeptical

about what such voluntary guidelines can achieve, a number of country authorities

indicated that such guidelines could provide a useful reference point should they need to

discuss with market players any questionable practices and/or trading strategies that

could disrupt normal market functioning. Moreover, such guidelines could also provide a

reference point should a market player wish to raise concerns about approaches used by

other market participants

Finally, there was extensive discussion as to whether regulatory or other authorities

should step up their monitoring of their own financial markets (while recognizing that in

the case of several economies a significant share of trading occurred off shore) to

determine in advance whether large and concentrated positions were starting to be built

See El-Erian (2003) for an example of one market participant raising concerns about

double play type activities of some hedge funds, albeit within fixed income rather than in

currency/money markets and the equity market. up. Needless to say, view differed as to how authorities would deal with any prospective

build up and about whether the enhanced monitoring would have a chilling effect.

V. Conclusions and Reflections on the Report’s Main Policy Recommendations

The 2000 FSF Report on Highly leveraged Institutions represented, at least in this

author’s view, a serious attempt to assess the impact of hedge funds in Asia in the late

1990s. Given the paucity of data, the difficulty of constructing models to address the

impact of large players, as well as various political and other sensitivities it was not

altogether surprising the definitive and consensus conclusions could not be reached.

Some progress was, however, made in understanding how (certain) hedge funds operated

in the unsettled market conditions that existed in Asia (and elsewhere) in the second half

of 1997 and much of 1998 and about various questionable practices that might have

adversely impacted market dynamics and integrity. Most significantly, some degree of

concern was raised about the size and concentration of on the part of an apparently small

number of macro hedge funds (made possible by leverage) and the impact that these

positions might have on market dynamics.

Since the Report was prepared, of course, the hedge fund industry has not stood still.

Reflecting a general search for yield over the last few years, in particular, there has been

a phenomenal increase in the number of hedge funds as well as in the assets under

management by the hedge fund industry. In addition, the large macro hedge funds that

made the headlines in 1997-8 appear to have fallen by the wayside only to be replaced by

a much larger set of smaller funds. On the one hand, this latter development—which

might be seen as the market having eventually weeded out some outsized hedge funds—

could be seen as a positive for those concerned about large concentrated positions.

Outcomes, however, will be influenced importantly by the amount of leverage and

trading strategies of these smaller funds and, in particular, whether a lot of small

elephants herd together and act like “Big Elephants in Small Ponds” and whether they

similar positions to other market players.

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