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The systemic risk to the financial system posed by hedge funds has been downplayed over the past year by regulators and legislators from several countries. But with the sub-prime meltdown and the publishing of a new book by a consummate industry insider, the topic of hedge fund-induced contagions has forced its way back onto the media’s agenda.

To begin with, this paper was released last month by the New York Fed. Widely reported (such as here at InstititutionalInvestor.com), this report now seems totally apropos given the market mayhem since it was published.

This paper makes several observations that bear a striking resemblance to Richard Bookstaber’s "A Demon of Our Own Design". Bookstaber is a former risk manager at Ziff Brothers, Moore, Salomon and Morgan Stanley. He contends that regulation can actually compound market dislocations since they create artificial, non-economic behavior that can feed a self-reinforcing death spiral for markets. (A full review of this fascinating account of systemic risk over the past two decades is forthcoming on these pages.)

For example, the Fed report says:

Market liquidity shocks strain a trader’s ability to fund its positions as additional funds (for instance to meet variation margin calls) can be raised only by selling assets into a falling market.

This mutual dependence creates the potential for market instability. Consider the trading losses from a price shock. If the losses are severe enough to seriously erode traders’ capital, then risk management trading limits that are defined relative to capital would compel traders to reduce their trading and market liquidity would decline. At the same time, the increased volatility that typically accompanies price declines can lead to higher initial margin and collateral calls, which raises the cost of maintaining trading positions and reduces funding liquidity. If the shock is large enough, a financially constrained trader will be compelled to sell assets, further depressing prices in the market under stress or transmitting the price shock to other markets as positions in those market are liquidated to meet cash depends. These sales depress prices further, causing a further negative shock to trading positions and setting in motion further assets sales and a downward spiral in asset prices. (Page 15 of the report)

And similarly, Bookstaber argues that “tight coupling” in the financial system can result in a systemic “death spiral”. On page 94, he says:

…Suppose that when a fund [is forced to sell] 10% of its original assets as a result of a price shock, that sale lowers the market by 1 percent. And suppose further that this relationship is linear, so, for example, a sale equal to 5 percent of its initial assets will drop the market price by 0.5 percent. The cycle will continue to work itself out by the subsequent 1 percent drop leading to a sale of 10 percent of the fund’s remaining assets. The price will then drop by only 0.9% because now the fund’s remaining assets are only 90 percent of its original portfolio. This price drop will lead to a margin-induced sales by the fund of 9 percent of its still-remaining assets, which in turn will trigger further price drops by the market, inducing more margin sales, and so on.

…The cycle would become a market crisis as the drop in the market price led to similar needs to liquidate at other firms…

…once the losses move beyond a critical point, the crisis becomes self-sustaining…

Source: Hedge Fund Induced Market Troubles May Not Be Imagined After All