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Friday, 24 August, 2001, 16:59 GMT 17:59 UK
Hedge fund threat
New York traders
Some believe investors should be bailing out of the US market
Remember the shock to the world's financial system when the LTCM hedge fund faltered? The BBC's Rodney Smith reports on rumours that another nasty shock could be just around the corner.

A large hedge fund may be in trouble.

That is the story circulating a few days ago in New York, London, Hong Kong and South Africa.

The trouble may have passed by, by now - and it may not.

The derivatives business is very transparent at one level - dangerously opaque at another. The effect could be that another neutron bomb may be humming away under the financial sector, potentially bigger than the Long Term Capital Market (LTCM) hedge fund crash of 1999.

The market rumour

Several days ago, the Reuters financial news wire reported a rumour that a hedge fund was unloading huge positions in the sophisticated debt and interest rates swaps market.

Bars of gold
Visionaries are convinced of a producer and central bank conspiracy to cap the gold price

This is a liquid market; movements are usually small as buyers readily find sellers and vice versa.

On this occasion though a 0.3% increase in spread on a 10-year swap (that's a wide gap between bid and offer prices by swaps markets standards) took the market by surprise.

One trader described is at "astonishing", another described it as like the Russian economic and banking crisis in 1998.

Yet others were sceptical, said Reuters, pointing out that hedge funds were invariably blamed for any unexplained sudden or dramatic move in the derivatives markets.

The same day the market information service Bridge News reported conditions as "dislocated for a while". Not quite a disorderly market, but nearly.

The new players

The hedge fund business has grown exponentially since the dot.coms imploded, as the fast buck brigade has shifted from tech stocks to derivatives.

A result is that a market that was dominated by a few big players until a couple of years ago, like the Tiger Fund, Quantum and so on, is now heavily populated by a multitude of much smaller funds.

Sometimes these are little more than computerised extensions of day-traders.

TASS Research in the United States reports that in the first quarter of this year, about $7bn new money was invested in hedge funds - almost as much as the whole of last year.

At least 100 new hedge funds have started since January this year. New York hedge fund advisers, The Hennessy Group, estimate that in the year to March, hedge fund assets grew by a quarter to well over $400bn, and the number of funds grew by a similar proportion to a shade under 5,000.

Rich on money, short on experience

Old hands worry that the managers running these funds are dangerously short on experience while handling billions of dollars.

Most of them are not the rocket scientists of the pioneering days in hedge funds, but fairly unsophisticated fast buck makers. The same people who precipitated the tech and bubble. They could do the same with derivatives.

But derivatives are not stand alone stocks. A derivates trade can shift whole markets.

Toxic waste

"Toxic waste" is what some US stock market - and economy - bears (brokers worried about a market downturn) like to call them.

There is a clan of American bears who instinctively distrust "toxic waste" not for itself, but for the people who manage it.

Some of them, like John H Mesrobian at Constantinople Advisers, believe investors should be bailing out of the US market, where the bubble would be likely to burst first, and should be selling the dollar and buying the euro, and gold.

It is the oldest hedge of all, but the gold market is overrun with visionaries convinced that there is a producer and central bank conspiracy to cap the gold price.

Like the modern derivatives market, it can be difficult to separate fact from fiction here too.

But these are the market professionals who believe that a hedge fund Krakatoa may be about to blow.

The Federal Reserve would possibly not see it in time, and unlike LTCM, when the US central bank averted a disaster, it could be overwhelmed by the sheer scale of a new crisis.

The everyone would be covered in toxic dust.

See also:

29 Oct 99 | Business Basics
Hedging - a rough guide
25 Sep 98 | The Company File
Wall Street rescue for hedge fund
30 Apr 99 | The Economy
The $1.5 trillion gamble
16 Sep 98 | The Economy
Capitalism 'falling apart'
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