Do Hedge Funds Disrupt Emerging Markets?

By their very nature, hedge funds employ opportunistic trading strategies on a leveraged basis. It is natural to find their footprints in most major market events. A "small bet" by large hedge funds can be a sizeable transaction that impacts a market. However, highly leveraged trading strategies practiced by many market participants, if left unchecked, can lead to a convergence of bets. This, in turn, can leave markets vulnerable to disruption when confidence erodes and the herd heads for the exit. This paper examines the Asian Currency crisis of 1997. The "Asian Carry Trade" was a highly leveraged strategy popular among banks and domestic corporations in 1995-6. When concerns about the viability of the exchange rate pegs surfaced, the unwinding of this popular strategy gave rise to a "one-way bet" adopted by speculators such as hedge funds. Extrapolating from speculative hedge fund activities at the peak of a crisis can lead to the erroneous conclusion that hedge funds, who came at the end of a trade, were the culprits that "disrupted" the market. It is easy to point to the "last" straw that broke the camel's back. However, as is often the case, this last straw is no more responsible than any of the other straws. Here, we provide estimates of the hedge funds involvement during the Asian Crisis and address the question of their impact on the market. We also make recommendations on how hedge funds activities can be used to provide early warnings of "undesirable" convergence of certain highly leveraged trading strategies. This can be achieved in two non-intrusive steps. First, monitor hedge fund activities to detect potential converging speculative trading activities among market participants. This tells regulators where potential problems may be brewing. Second, routinely tabulate major commercial and investment banks' counterparty exposures to key market risk factors on an aggregated basis thus protecting the identity of the specific counterparties involved. When popular "bets" lead to similar positions, it should alert regulators to consider preemptive measures.