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In order to manage credit risks associated with lending to hedge funds, prime brokers and banks re-calculate their positions vis-à-vis hedge funds daily at market prices, request daily payments, and collateralize their lending. They monitor the funds' investment strategies, monthly returns and investor withdrawals. Based on the results of this monitoring and the length of their relationship with each fund, creditor banks and brokers establish limits on their credit exposure to each fund.

In spite of these procedures, risk management by financial institutions has not always been adequate. Thus, it is important for bank supervisors to monitor banks' exposure to creditors that lend in turn to hedge funds, and to demand corrective action when that exposure is excessive or poorly managed. The constituents of adequate supervision and regulation are well known, and are by no means peculiar to the business banks do with hedge funds. The heavy use that some hedge funds make of derivative financial instruments, however, compounds problems of information and evaluation for bank management and supervisors alike.

Conclusion

Hedge funds differ from other borrowers in this respect only insofar as they tend to be highly leveraged, so that when things go wrong, they go very wrong. The question of market integrity remains as to how they can dominate or manipulate markets.

An obvious way of addressing this concern is for countries with large trade and position reporting systems in place to extend their coverage and for countries without such systems to adopt them. Though for this centralized system of reporting is desired, periodic large-position reporting is feasible even in a decentralized environment.

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* Contributed by -
Swetha Narayanaswamy,
M.B.A. II year (Finance),
ICFAI Business School, Mumbai.