European Central Bank sees Hedge Funds as Risky

European Central Bank (ECB) is warning traders that hedge funds have created a “major risk” to global financial stability. Franz Müntefering, who is the deputy German chancellor, described them as “locusts”.

In an interview with Scotland’s Sunday Herald, the ECB put that risk right up there along with a major bird flu pandemic in terms of shocks that could trigger a disruption in financial markets. It warns of the risk of an “idiosyncratic collapse of a key hedge fund or a cluster of smaller funds”.

The ECB review also pointed out that current hedge funds work in a herd-like way, investing in the same kind of assets returns, therfore able to create a domino-like effect in collapsing. This behaviour was seen just before the near collapse of Long-Term Capital Management in 1998. That company was developed by the combined brainpower of Nobel Prize winning economists, and even that did not stop its spectacular failure.

But the ECB has been easier on hedge funds than most. Along with Germany’s Bundesbank and its proposed self-regulatory strategy, the International Monetary Fund and the Bank of England have had a less-alarmist approach to the possible impact of hedge funds on the global financial system.