“Efficient markets require that prices fully reflect all buy and sell interests. When a short
17seller speculates on or hedges against a downward movement in a security, the transaction is a mirror image of the person who purchases the security based upon speculation that the security’s price will rise or in order to hedge against such an increase.”35The strategies “differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security.”36“Although short selling serves useful market purposes, it also may be used to manipulate stock prices. An example is the “bear raid” where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest.”37Unrestricted short selling can also put added pressure on a declining market in a security by eliminating bids and causing a further reduction in the price of a security by creating an appearance that the price is falling for fundamental reasons38. 2.4 Systemic Risk and Hedge Funds “Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions, typically banks that occur over a short period of time, often caused by a single major event.”39However, since the collapse of a large hedge fund, Long Term Capital Management (LTCM) in 1998, it has become apparent that hedge funds are also being implicated in systemic risk exposures. “The
18hedge fund industry has a symbiotic relationship with the banking sector, and many banks now operate their trading units that are organized much like hedge funds. As a result, the risk exposure of the hedge fund industry has a significant impact on the banking sector, resulting in new sources of systemic risks.”40One of the biggest concerns of hedge funds increasing systemic risk is to do with their extensive use of leverage. Figure 1 illustrates the increasing number of hedge funds readily using leverage as an investment strategy aimed at maximizing returns. Figure 1 – Increasing Amount of Investors Using LeverageSource: The use of leverage exposes counterparties who provide hedge funds with funding to significant illiquidity risks, as the adverse effects of a downturn in the market will make it increasingly difficult for them to get their money back. With lower expected returns in the near future, the aspects of systemic risk are increasing and counterparty exposure is becoming a major concern.