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BASEL, Switzerland Recent signs of "erosion" of counterparty standards among hedge funds because of ever-rising competition for their business means that financial regulators and market participants need to step up efforts to improve the way they manage their risk, according to the Financial Stability Forum.
The FSF's latest report into potential systemic risks posed by the hedge fund or highly leveraged institutions sector was commissioned because of fears among central bankers that the benefits of hedge funds could be cancelled out by what is described as "signs of complacency about risk taking in financial markets."
"This heightens the importance of strengthening market discipline, buttressed by supervisors and regulators setting expectations regarding stronger counterparty risk management practices," stated the Basel, Switzerland-based FSF this weekend as it updated its first HLI report published in 2000.
The FSF noted that hedge funds have mushroomed since the 2000 report and said that their activity has spurred financial innovation, expanded risk bearing capacity and provided greater depth and liquidity to markets.
It also noted, however, that a small number of intermediaries have come to play an increasingly important role in some key areas of wholesale financial markets. "The relationships between these core intermediaries and hedge funds, through prime broking and counterparty relationships, have thus become more central to the robustness of the financial system," stated the report.
The FSF said that risk management practices within the hedge funds has improved over the period but also noted that products and markets have become more complex, "posing heightened risk measurement, valuation and operational challenges for all market participants."
The FSF, which was created in 1999 by the then G7 group of finance ministers to focus on systemic risk management, made five core recommendations in its report. These were:
"The FSF underscores the importance of ongoing cooperation among financial authorities in taking forward these recommendations and in spreading good practices. It also notes the importance of authorities' market surveillance activities and of their continuing dialogue with a range of market participants and actors to keep abreast of innovation and to assess the adequacy of practices and policy approaches in addressing risks to financial stability," it said.