Over the Hedge?

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Hedge funds are essentially a means through which investors pour money into financial markets with the hope of making huge profits. The money is used to invest in all sorts of assets, but most commonly hedge funds trade liquid securities – debts, stocks and derivatives that can be easily bought and sold. They aim to maximise their absolute returns whether markets are rising or falling [1]. Since their hazy creation, these funds have come to be commonly associated with speculation, short selling and leverage; all taboo words after the recent financial crisis, which hedge funds have been largely criticised in the midst of.

In this article, I explore the role of hedge funds in the financial crisis and ask whether they are actually to blame for it. I then go on to assess whether these funds have a permanent place in the financial world or whether they are a short-term phenomenon that higher powers will push to extinction.

The global financial crisis that was sparked in 2007 is seen by many to be the worst since the Great Depression of the 1930s. The explanation of the crisis begins in America; here, a sub-prime mortgage market emerged due to regulatory failure. This meant that careless banks were able to grant loans that were unlikely to be repaid. Meanwhile, house prices were rising due to the promotion of home ownership and low interest rates, which made borrowing in order to buy a house easier. [2]

By 2007, the US housing bubble had peaked, only to burst in 2008. As house prices came crashing down, households went under water and defaulted on their mortgages. This meant that banks made losses due to the difference between the mortgages that went amiss and the reduced price of houses that they repossessed. This whole process was amplified by leverage, whereby excessive borrowing by banks meant that they did not have enough capital to absorb the losses they were making. As a result, some banks went bankrupt; those that survived initiated a fire sale in the stock markets as they tried to regain as much capital as possible. [2]

At this point, hedge funds come into our explanation. Clearly, these funds were exposed to events in the US and so, like banks, they needed to sell their assets quickly to minimise loss. Ultimately, the fire sale in the stock market was the main channel through which the financial crisis hit the global economy. So clearly hedge funds played a role in transmitting the crisis, but as active participants in global markets, that hardly comes as a surprise. In this case, hedge funds were a link in the chain between cause and effect, not the cause itself. Put simply, any blame should like with careless banks and bad regulation, both directly related to the cause of the financial crisis.

Nonetheless, hedge funds continue to demonstrate characteristics within the global economy that clearly need addressing. Their speculation has obvious destabilising effects, as the Asian financial crisis shows, where an attack on national currencies by international investors brought whole countries to their knees [3]. Meanwhile, short selling, where assets are sold with the intention of lowering their price so that they can be bought back at the lower price, results in unnecessary fluctuations in the market. Clearly, hedge funds contribute to instability across the financial system [4]. Furthermore, these funds lack transparency and are not obliged to disclose their activities to third parties [5]; this allows them to lure investors based on false pretences and creates the potential for fraud.

In essence, hedge funds are elusive and destabilising bodies that add to the gambling culture that is rife within the global economy. However, they remain a mere component of a much wider problem. In this discussion, hedge funds are inferior; our focus should be on the financial system as a whole.

The free market’s problem is clearly displayed in its name: it is free. Regulation of global financial markets has been flawed at best. Any onlooker, whether they possess financial knowledge or not, can clearly see that governments remain subordinate to the whim of the market. Even with increased regulation, there is only so much governing bodies can do. So how do we correct this fundamental problem, as a financial system that is too big and complex to fail edges ever closer to the brink of destruction? The answer is simple: responsibility.

Financial markets should not be casinos. They are home to forces that are seminal in shaping the future of an entire planet and, thus, have a duty to ensure the safety and stability of global finance. Despite this, banks and bankers go about their business recklessly and evade the consequences of their actions, which are rarely held to account. There is a mentality within the financial sector that it is ‘”too big to fail”. It is this sort of complacency that has led responsibility astray. To reassert responsibility within the global market, the whole system must change its way of thinking.

The doctrine of corporate social responsibility provides the perfect framework for this change. However, until now it has been largely ineffectual. Should it suddenly become effective, responsibility would once again run through the veins of the market. Such an enormous change is unlikely and it would certainly take time. However, governments are the perfect vehicles through which to initiate the promotion and enforcement of this principle. If governments were to pursue corporate social responsibility, it would mark the beginning of the restoration of trust for global markets.

Without such responsibility, the whole capitalist model is under threat. The future of hedge funds are explicitly entwined with the future of financial markets. As long as we have capitalism we will have hedge funds. However, as the need for greater responsibility within markets grows, it becomes more and more unlikely that these inherently irresponsible creations will continue to exist in their current form.

Article by Joe Austin. Edited by Nathan Tanswell.

[1] The Economist (2012) “Economics A-Z”, The Economist [online], retrieved 14 May, 2012, from: http://www.economist.com/economics-a-to-z

[2] Blanchard, O., Giavazzi, F. and Amighini, A. (2011) Macroeconomics: A European Perspective, Harlow: Pearson Education Limited.

[3] Brown, S. (2008) “The Role of Hedge Funds in the Financial Crisis”, EconoMonitor [online], retrieved 14 May, 2012, from: http://www.economonitor.com/blog/2008/10/the-role-of-hedge-funds-in-financial-crisis

[4] Woolley, P. (2004) “How hedge funds are destabilising the markets”, Financial Times [online], 27 September, retrieved 14 May, 2012, from: http://www.ft.com/cms/s/1/b6b909a6-10b8-11d9-a73b-00000e2511c8.html#axzz1urvocE7N

[5] Johnson, C. (2006) “Scrutiny urged for hedge funds”, Washington Post [online], 29 June, retrieved 14 May, from: http://www.washingtonpost.com/wp-dyn/content/article/2006/06/28/AR2006062801909.html