Most of the new regulations that have so far come out of the financial crisis have focused on the country’s largest banks, but now that attention has turned to the role of hedge funds in the market, analysts are debating both how alternatives may have affected the crisis and whether new rules are necessary.

Hedge funds liquidity

Hedge funds’ impact on markets depends on market liquidity

“Using comprehensive data on quarterly changes in hedge fund equity holdings between 2000 and 2012, we find that stocks bought by hedge funds subsequently increase in price efficiency compared with stocks sold by hedge funds in the same period,” says a recent Fed study written by Charles Cao of Penn State University, Bing Liang of the University of Massachusetts, Andrew W. Lo of MIT Sloan School of Management, and Lubomir Petrasek from the Board of Governors of the Federal Reserve System. “This finding supports the view that, on average, hedge funds operate as arbitrageurs and contribute to the informational efficiency of prices. However, this effect was reversed during liquidity crises.”

The study rigorously backs up this effect, but intuitively it’s about what you would expect. Hedge funds are sophisticated investors with skilled research teams (the exceptions don’t survive very long) so when a stock’s price moves away from its fundamental value they are ready to take advantage of the price dislocation.

Hedge funds that used Lehman as prime brokerage were hit hardest

To improve their returns, many hedge funds use short-term financing to leverage their trades, but when there is a liquidity crisis short-term financing dries up and funds are forced to start selling assets into a bear market at cut-rate prices resulting in inefficient pricing and possibly setting off a spiral of asset devaluation as rivals compete for value on falling stocks. The biggest impact was seen in hedge funds that used Lehman Brothers as their prime broker as one of the primary sources of short-term financing didn’t just face harsh constraints, but crashed entirely. In comparison, the study found that banks and mutual funds had a much smaller contribution to price efficiency when markets were liquid, but didn’t make things any worse during a crisis.

While the paper is careful to point out that hedge funds, on average, contribute to market quality, regulations don’t really exist for average situations. Most of the time, the capital requirements of Basel III mean that money is sitting around instead being invested, but if it staves off another crisis it will have been worth it. Regulators may need to find a similar balance for hedge funds’ conflicting impact on markets during healthy times and during crises.

See full study on “Hedge Funds Improve Efficiency, Unless Liquidity Dries Up: Fed” in PDF format here.