Friday, March 20, 2015

ESMA Report Offers New Way to Monitor Hedge Fund Industry Systemic Risk

[This story previously appeared in Securities Regulation Daily.]

By John Filar Atwood

The European Securities and Markets Authority’s (ESMA) semi-annual report on trends, risks, and vulnerabilities in the European Union securities markets provides a new method for monitoring systemic risk in the hedge fund industry. The report claims that the methodology works for the entire global hedge fund industry and can be applied to other parts of the fund industry with only limited adjustment, making comparable indicators available for systemic risks in different fund sectors.

The report, which covers July to December 2014, examines the performance of EU securities markets to develop a comprehensive picture of systemic and macro-prudential risks in the EU. The report is designed to help member states and EU regulators in their risk assessments.

In a press release, ESMA said that market conditions in the EU generally remained tense, with high asset valuations, stable asset prices over time but with rising short-term price volatility across key markets. There were strong price movements in foreign exchange and commodity markets, while capital-market issuance for corporate funding continued to increase.

The report identified several sources of market uncertainty, including the low-interest-rate environment, public debt policies in EU member states, and strong swings in exchange rates and commodity markets. Political and geopolitical risks in the EU’s vicinity also helped to drive increased levels of liquidity and market risk.

Hedge fund systemic risk. The new system for monitoring systemic risk in the hedge fund industry is based on sector-wide aggregated individual interdependencies of performance rates between individual hedge funds and the entire industry. The information is extracted by using a large set of fund-individual regression analyses and aggregating significant coefficients found across the industry. According to the report, when tested, the new method was able to identify successfully almost all financial crises included in the reporting sample, which was January 1995 through October 2013. The report claims that the results were robust with respect to variations in model specification, which increases the econometric reliability of the proposed measures.

Future vulnerabilities. The report includes ESMA’s findings on market developments that may present future vulnerabilities. One potential issue is the growth of funds investing in loans. ESMA acknowledged that this does offer a portfolio diversification opportunity, but it also creates exposure to credit and liquidity risk. The report concludes that while loan origination funds contribute to SME financing, the resulting financial stability risk should be carefully monitored.

A second area that could create future market vulnerability is the rapid growth of alternative index products. These products minimize certain weaknesses of traditional market capitalization-based indices, but they also expose investors to sector volatility and other risks. ESMA notes that alternative index products are not necessarily more risky than traditional models, but are often more opaque. A low level of transparency makes it difficult for investors to understand the risk-return profile of alternative indices, the report states.

Systemic stress. The report identifies trends in other areas, such as systemic stress. It finds that systemic stress showed higher volatility than in the previous reporting period, driven mainly by the equity markets. The report warns that, as evidenced by the higher implied fixed income volatilities, the potential for market corrections is high. Drivers of such a correction include weaker-than-expected economic recovery, persistent down-side influences including geopolitical tensions, pockets of stress in debt markets, expectations of divergent monetary policies, commodity prices and exchange rates dynamics, and the increasing emergence of vulnerabilities in market functioning, ESMA said.