Hedge funds transformed into a new type of “shadow bank”, and systemic financial risks loom

The Zhitong Finance App learned that according to data from the Financial Stability Board, “shadow banking” currently manages assets of 250 trillion US dollars, accounting for 49% of global financial assets. Meanwhile, the total asset size managed by hedge funds has increased 15 times compared to 2008. Recently, bond yields have soared due to large-scale liquidation of hedge fund positions and highly leveraged transactions, and many people have begun to worry: will this industry lacking regulation be the trigger for a new round of 2008 financial crisis?

The concept of “shadow banking” was proposed by economist Paul McCary in 2007, just over a year before Lehman Brothers went out of business. Soon, the market realized that easy credit was the catalyst for the subprime mortgage crisis, which had brought the global financial system to the brink of collapse. Nearly 20 years later, Trump's chaotic tariff policy triggered a wave of sell-offs in the bond market, and people once again panicked about the liquidity crisis.

The 2008 financial crisis revealed a fact: many non-bank institutions are also involved in lending, but are not regulated to the same extent as banks, although they are critical to the stability of the financial system. This time, the market focus has shifted from investment banks and mortgage institutions to hedge funds and private equity firms. Taking the US Treasury bond market as an example, abnormal fluctuations in yield reveal how highly leveraged hedge fund transactions can activate the currency market while also having a systemic impact on the economy when the market crashes.

Banks turn customer deposits into long-term illiquid assets, such as home mortgages and commercial loans; shadow banking institutions essentially do something similar, except that they raise and borrow funds from investors rather than relying on depositor deposits.

Amit Theroux, a professor of finance at Stanford University's School of Business and a senior researcher at the Hoover Institution, pointed out that although the term “shadow banking” sounds quite negative, the system itself is not guilty. In fact, moving high-risk lending operations out of the traditional banking system will help make the financial system more resilient. “This is often overlooked,” he said.

The risk tolerance of hedge funds far exceeds that of banks. Since its capital mainly comes from high-net-worth clients who are willing to lock in investments for a long time, this gives the fund more buffer in the face of short-term losses. Seru stressed that these investors play an important role in the price discovery process in the bond and other securities markets.

Taking “spread trading” as an example, hedge funds profit from small price differences by buying treasury bonds and selling related futures contracts. This kind of arbitrage has effectively filled the gap in strong demand for treasury bond futures from institutions such as mutual funds, pensions, and insurance companies.

However, to achieve arbitrage gains, hedge funds often need to borrow heavily, and leverage multiples are sometimes as high as 50 to 100 times. Once such deals worth $800 billion are concentrated and closed, the short-term bond market will be hit hard.

“This will trigger a ripple effect,” Cerru warned. “This domino effect cannot be underestimated at any time.”

Next Lehman Brothers?

Although hedge funds don't rely on depositor deposits, that doesn't mean that governments can stand idly by when a crisis breaks out. As early as ten years before the controversial bank bailout in 2008, long-term capital management companies (LTCM) were interfered with by the government because they were “too big to fail.”

LTCM's core business is betting on arbitrage opportunities in the bond market through high leverage. At its peak, it managed about 5% of the world's total fixed income assets. In 1998, Russia's debt default caused the fund to suffer devastating losses. To prevent the crisis from spreading, the US government coordinated Wall Street Bank to inject $3.6 billion to help it liquidate in an orderly manner — an astronomical figure at the time.

Itay Goldstein, head of the Department of Finance at the Wharton School of the University of Pennsylvania, put it bluntly: “Our exposure to risk today is far greater than it was back then.”

Ten years later, in 2008, Lehman Brothers and Bearsden went out of business one after another, threatening not only the US banking system, but even government-backed companies such as Fannie Mae and Freddie Mac in jeopardy. Although these investment banks did not absorb deposits, the short-term bond market froze instantaneously. A credit crunch ensued, and banks and businesses were in the throes of capital exhaustion.

Since then, the Dodd-Frank Act (Dodd-Frank) has not only greatly strengthened the supervision of large banks, but also included non-bank lenders within the scope of control. However, the size of shadow banking exploded after the crisis. According to data from the Financial Stability Board, its assets have now reached 250 trillion US dollars, accounting for nearly half of the world's financial assets, and the growth rate in 2023 is more than double that of the traditional banking industry. According to Bloomberg data, the total assets managed by hedge funds increased 15 times compared to 2008.

The “Volcker Rule” in the Dodd-Frank Act prohibits investment banks from engaging in proprietary transactions and restricts them from acting as market makers through aggressive arbitrage practices. This gap was immediately filled by hedge funds. However, hedge funds' reliance on short-term debt and lack of regulation make them face questions similar to those in 2008: are they huge, and once they collapse, will they also be “too big to fail”?

Goldstein warned: “If hedge funds explode, they will not only impact banks and other financial institutions, but also affect the real economy.”

Michael Greene, portfolio manager and chief strategist at ETF provider Simplify Asset Management, pointed out that currently the fastest growing business sector in the US banking industry lends to hedge funds, private equity, credit companies, and shadow banking institutions such as “buy now, pay later” platforms. According to the Federal Reserve data, the size of related loans has exceeded 1.2 trillion US dollars. Greene founded a hedge fund funded by George Soros and managed Peter Thiel's personal assets. He believes that a crisis similar to 2008 is extremely likely to break out.

“The risk probability has increased dramatically; the two are not on the same scale at all.” he asserted.

Take margin trading as an example. Once the market is under pressure, hedge funds may be forced to sell treasury bonds on a large scale due to pressure such as additional security deposits, etc., and it is often difficult for the market to accept such huge sales. Fears of this liquidity crisis will quickly spread to the buyback market — the core area of short-term borrowing with US Treasury bonds as the main collateral.

This scene unfolded in the early days of the COVID-19 pandemic, forcing the Federal Reserve to urgently buy $1.6 trillion in treasury bonds within a few weeks. Meanwhile, in the recent wave of bond sell-offs, economists and market observers are constantly watching whether the central bank will intervene again. Data from the Office of Financial Research shows that in the past two years, the size of repurchase loans from the top ten US hedge funds has doubled to 1.43 trillion US dollars.

Regulatory dilemmas

Some scholars suggest that the Federal Reserve set up a special loan mechanism for hedge funds to deal with the treasury bond market crisis. However, if Congressional Republicans successfully push Treasury Secretary Scott Bessent to limit the government's recognition of “systemically important financial institutions,” this plan will be reduced to empty talk.

Seru pointed out that regulating shadow banking institutions has always faced a dilemma: if they are strictly controlled according to traditional banking standards, the market price discovery function and fund allocation efficiency will be affected; however, if left to themselves, even if funds only risk their own funds, the hidden risk of risk contagion still exists.

“Fish and bear are inseparable.” Seru confessed.

Furthermore, strengthening regulation of hedge funds alone may have little effect. After all, when investment banks were limited by tighter regulations, hedge funds quickly filled the gap in the market. As Goldstein said, “This kind of regulation doesn't make the financial system safer.”

Although Seru opposes excessive regulation, he emphasized the importance of improving transparency in the open market and private equity market. For example, if a hedge fund takes a large amount of risk, it must be clarified whether it is linked to a financial institution guaranteed by the government (such as a major Wall Street bank).

He believes that once it is discovered that the risk exposure of shadow banking institutions may threaten the stability of the financial system, they should be required to meet regulatory standards such as capital adequacy ratios. However, Seru also cautioned that risk is often hidden in the details — as shown by the collapse of Silicon Valley Bank in 2023, even traditional financial institutions that are strictly regulated may have no sign of a crisis before it breaks out.

“Both regulators and the market itself should remain in awe,” Serou concluded, “because both areas harbor unknown risks.” This is especially true at a time when complex risks are hidden in the dark.