RBI governor warns of hedge fund risks

Mumbai: Hedge funds operating through a single brokerage or prime broker could pose great risk to financial sector stability, RBI governor Y V Reddy said.

The prime broker, who acts as a settlement agent, provides custody of assets and also offers leveraged finance for hedge funds, which are operating outside the usual dealer customer relations.

Hedge funds, long used to operating outside know-your-investor norms to execute trades with several dealers, are now increasingly consolidating the clearing and settlement of their trades through a single brokerage — the `prime broker', Reddy said.

Normally, in stock trading, counterparty risk is borne by clearing houses. But the liability in the event of a default by a seller or a buyer could be huge when hedge funds deal through a single broker who also provides leverage finance, Reddy said while speaking on `Globalisation and monetary policy' at a conference on 'Advances in open economy macroeconomics,' in Mumbai.

Prime brokerage poses some unique challenge for the management and counterparty credit and operational risk. Recent events have reinforced the possible adverse impact of their risk, Reddy said.

Reddy made a case for monitoring hedge funds and private equity funds currently dominating international financial markets, while being outside the purview of know your customer (KYC) norms.

The lack of transparency in deals of hedge funds is a global issue and regulators worldwide are looking to monitor them, Reddy added.

"Hedge funds are opaque. Information about their portfolio is infrequent," he said. But from the policy perspective, transparency for investors is important, he said.
Monetary authorities, therefore, need to maintain database of positions held by hedge funds, he added.

The RBI governor's observation assumes significance, as hedge funds operating through participatory notes (PN) account for nearly 50 per cent of the FII investments in Indian market. In such investments, the source of funds, or their beneficiaries, are not known.

The RBI has been suspicious of the use of PNs, which is seen as a tool used for money laundering.

To counter the risk of this possibility, capital market regulator SEBI is now toying with the idea of allowing hedge funds to trade in the Indian markets directly. Once registered with SEBI, hedge funds would be operating like foreign institutional investors and counterparty risk could be limited.