High levels of synthetic leverage used by some hedge funds could trigger market instability, global finance officials warned Wednesday in an annual risk report to G20 countries.
The Financial Stability Board, whose members represent finance ministers, bankers and regulators in G20 countries, also warned that "significant data gaps" are preventing a full picture of vulnerabilities within non-bank financial institutions, which now represent nearly half of global financial assets. "As a result, the importance of NBFI for the financing of the real economy has increased," the FSB report said.
A key concern raised in the FSB's annual progress report on non-bank resiliency is hedge funds with "very high levels of synthetic leverage" through the use of derivatives or other complex financial instruments that may not appear on balance sheets.
Pension funds, insurance companies and other investment funds that now represent two-thirds of non-bank global assets also use financial leverage tactics like liability-driven investment strategies. While those exposures show up on balance sheets, off-balance sheet leverage exposures by hedge funds and other non-bank financial institutions "have grown significantly over the past decade," the report said.
"Within the hedge fund sector, there is a group of funds, typically pursuing macro and relative value strategies, with very high levels of synthetic leverage," the report said, and their borrowing from a few dominant prime brokers to accomplish that "can also create hidden leverage in the financial system."
Hedge funds in the U.S., U.K. and Europe featuring those practices make it hard to assess or react to problems, FSB said in the report.
FSB officials pledged to work with respective jurisdictions to improve risk assessment and address the containment issues raised in the report.
G20 ministers gather for their annual meeting Sept. 9 in New Delhi, India.