There are many issues raised because of the sudden proliferation of hedge funds today. Primary concern is the sizable amounts of the funds which can cause systemic risks to the financial systems of the world. This was highlighted by the recent collapse of the Long-Term Capital Management Fund (LTCM) back in 1998. At that time, it had under its control investment assets of approximately US$130 billion with only US$4 billion investors’ capital. In other words, it was highly leveraged (more than 30 times!) and in addition, also had other unreported off-balance sheet positions with a notional value of close to a trillion dollars! LTCM had 2 economics Nobel-prize winners on its team (Myron Scholes and Robert Merton) and used very sophisticated and arcane computer-based financial modelling techniques.
The U.S. Federal Reserve had to step in and provide funds to prevent a global financial catastrophe caused by a sudden disorderly exit from crowded trades. There were other big hedge funds that collapsed since then and finance ministers want the hedge fund industry monitored. The U.S. SEC is also conducting hearings to eventually regulate hedge funds. The hedge fund industry controls so much money that a single hedge fund collapse or a collapse of a group of funds with billions under its management and multiplied by leverage can sway world markets. The interdependence and counter-party risks involved in hedge funds make finance ministers worried that a failure of one or more participants to settle their trades could deprive other parties of liquidity and trigger a financial domino effect.