Bank of England Governor Andrew Bailey warned that the growing popularity of multi-manager hedge funds could pose a threat to financial stability. These funds, characterized by diverse trading strategies managed in separate units or “pods,” have attracted significant investment in recent years, promising steady returns and diversification.
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alt text: Andrew Bailey, Governor of the Bank of England
Bailey highlighted the potential for correlated activity among these funds, coupled with aggressive risk-management practices. This combination, he argued, could lead to a mass exodus during market downturns, exacerbating systemic risks. He expressed this concern in a speech delivered at the University of Chicago Booth School of Business in London.
Deleverage Risk and Market Instability
Multi-manager funds, also known as multi-strategy or pod shops, allow individual pods to rapidly deleverage in stressful market conditions. This rapid deleveraging, Bailey cautioned, could amplify market fluctuations and create broader instability. “There could be circumstances in which the means by which multi-manager funds protect themselves in this respect can create risks to the system,” he stated.
Strain on Prime Brokerage Capacity
In a Q&A session following his speech, Bailey addressed the expanding non-bank financial sector, which includes hedge funds. He noted that this growth is straining prime brokerage capacity, referring to the investment banking divisions that facilitate trades for large clients like hedge funds. The concentration of this capacity within a few institutions adds another layer of vulnerability, particularly in light of events like the Archegos collapse, which prompted a review by the BOE.
Benefits and Risks of the Multi-Manager Model
While acknowledging the benefits of sophisticated risk management within the multi-manager structure, Bailey emphasized the potential for unintended consequences. He pointed out that although individual pods operate under a centralized risk management framework, correlation can still emerge across different funds. This arises because multiple multi-managers often gravitate toward similar strategies, creating systemic interconnectedness.
Regulatory Scrutiny and Industry Response
Global regulators, including the BOE, are increasingly focused on the rapid expansion of financial activity outside traditional banking. A recent BOE System Wide Exploratory Scenario revealed potential vulnerabilities in the preparedness of hedge funds, asset managers, and pension providers for crisis events. This concern led the BOE to introduce a repo facility for lending directly to specific buy-side firms during market stress, a direct response to the 2022 gilt market crisis.
The Managed Funds Association (MFA), representing the alternative asset management industry, responded to Bailey’s remarks by emphasizing the inherent stability of hedge funds. The MFA argued that these funds lack government backstops, avoid liquidity mismatches, and isolate losses to individual funds and their investors. Furthermore, the MFA highlighted the existing regulatory reporting and broker-dealer counterparty relationships that provide oversight into hedge fund activities.
Conclusion: Balancing Innovation and Stability
The rise of multi-manager hedge funds presents a complex challenge for regulators. While these funds offer diversification and potentially higher returns, their interconnectedness and rapid deleveraging capabilities raise concerns about systemic risk. The ongoing dialogue between regulators and industry participants is crucial to navigate this evolving landscape and ensure financial stability. Striking a balance between fostering innovation and mitigating potential risks will be paramount in maintaining a resilient financial system.
