Hedge funds transform into a new type of "shadow banking," with systemic financial risks lurking.

The data from the Financial Stability Board shows that the "shadow banking" sector now manages $250 trillion in assets, accounting for 49% of global financial assets. At the same time, the total assets managed by hedge funds have expanded 15 times since 2008. Recently, concerns have been raised as large-scale hedge fund closures and high leverage trading have led to a surge in bond yields. Many people are beginning to worry: could this unregulated industry become the catalyst for a new financial crisis similar to the one in 2008? The concept of "shadow banking" was introduced by economist Paul McCulley in 2007, just over a year before the collapse of Lehman Brothers. Soon, the market realized that loose credit was the catalyst for the subprime crisis, which nearly caused a global financial system collapse. Nearly twenty years later, Trump's chaotic tariff policies triggered a sell-off in the bond market, causing people to once again fear a liquidity crisis. The 2008 financial crisis revealed a fact: many non-bank institutions are also involved in lending, but they are not subject to the same level of regulation as banks, despite their critical importance to the stability of the financial system. This time, the market focus has shifted from investment banks and mortgage institutions to hedge funds and private equity firms. In the case of the US Treasury market, the abnormal fluctuations in yields have exposed how hedge fund high leverage trading can have a systemic impact on the economy in times of market collapse. Banks convert customer deposits into long-term illiquid assets, such as mortgage loans and commercial loans; shadow banking entities essentially do the same thing, except they raise funds from investors and borrowing, rather than relying on deposits. Amit Seru, a professor of finance at the Stanford Graduate School of Business and senior fellow at the Hoover Institution, points out that while the term "shadow banking" may sound negative, the system itself is not inherently sinful. In fact, moving high-risk lending activities out of traditional banking systems can enhance the resilience of the financial system. He says, "This is often overlooked." Hedge funds have a much higher risk tolerance than banks. Because their funds mainly come from high-net-worth clients willing to lock in long-term investments, this makes the funds more cushioned in the face of short-term losses. Seru emphasizes that these investors play a key role in the price discovery process in bond and other securities markets. For example, in "basis trading," hedge funds profit by buying government bonds and selling related futures contracts to capture small price differences. This type of arbitrage effectively fills the gap in demand for government bond futures from mutual funds, pension funds, insurance companies, and other institutions. However, to achieve arbitrage profits, hedge funds often need to borrow heavily, with leverage ratios sometimes reaching 50 to 100 times. If a large concentration of such trades worth $800 billion is unwound, the short-term bond market will suffer greatly. "This will trigger a chain reaction," Seru warns, "the domino effect cannot be underestimated at any time." The next Lehman Brothers? Although hedge funds do not rely on customer deposits, it does not mean that the government can stand idly by when a crisis erupts. Long before the controversial bank bailout actions of 2008, the Long-Term Capital Management (LTCM) was intervened by the government because it was deemed "too big to fail." LTCM's core business was to leverage bets on bond market arbitrage opportunities, and at its peak, its fixed income assets managed accounted for about 5% of the global total. In 1998, the Russian debt default caused the fund to suffer catastrophic losses. In order to prevent the crisis from spreading, the US government coordinated Wall Street banks to inject $3.6 billion in capital to assist in an orderly wind-down - at the time, this was considered a astronomical sum. Itai Gorshten, head of the finance department at the Wharton School of the University of Pennsylvania, bluntly states, "The risk exposure we face today is much larger than before." Ten years later, in 2008, Lehman Brothers and Bear Stearns collapsed, not only threatening the US banking system, but also government-supported enterprises such as Fannie Mae and Freddie Mac were also in jeopardy. Although these investment banks do not absorb deposits, the short-term bond market still froze instantly. Credit tightened, and banks and businesses found themselves in a situation of dwindling funds. Subsequently, the Dodd-Frank Act not only strengthened regulation of large banks but also brought non-bank lending institutions under control. However, the shadow banking sector has exploded in size since the crisis. Financial Stability Board data shows that its assets now amount to $250 trillion, accounting for nearly half of global financial assets, with a growth rate in 2023 that is more than twice that of traditional banking. Bloomberg data shows that the total assets managed by hedge funds have grown 15 times compared to 2008. The "Volcker Rule" in the Dodd-Frank Act prohibits proprietary trading by investment banks and restricts their ability to act as market makers through aggressive arbitrage activities. This gap was then filled by hedge funds. However, the reliance of hedge funds on short-term debt, as well as the lack of regulation, has raised similar questions to those of 2008: are they so large that if they collapse, they will also be "too big to fail"? Gorshten warns, "If hedge funds collapse, it will not only impact banks and other financial institutions, but will also affect the real economy." Michael Green, portfolio manager and chief strategist at ETF provider Simplify Asset Management, points out that the fastest-growing sector of the US banking industry is lending to shadow banking institutions such as hedge funds, private equity firms, credit companies, and "buy now, pay later" platforms. The Federal Reserve data shows that the size of these loans has exceeded $1.2 trillion. Green, who founded a hedge fund funded by George Soros and managed Peter Thiel's personal assets, believes that the likelihood of a crisis similar to 2008 is very high. "The risk probability has increased significantly, they are not in the same league at all." He asserts. For example, in the case of basis trading, once the market is under pressure, hedge funds may be forced to sell government bonds on a large scale due to the pressure of additional margin calls, and the market often struggles to absorb such a huge volume of sell orders. The concerns of this liquidity crisis will quickly spread to the repurchase market - the core area of short-term borrowing with US Treasury securities as the main collateral. This scene had previously occurred in the Covid-19 pandemic.In the initial performance, forcing the Federal Reserve to urgently purchase $1.6 trillion in government bonds in a matter of weeks. In the recent wave of bond sell-offs, economists and market observers are closely watching whether the central bank will intervene again. Data from the Financial Research Office shows that in the past two years, the repurchase borrowing size of the top ten hedge funds in the United States has doubled, reaching $1.43 trillion.Regulatory Dilemma Some scholars suggest that the Federal Reserve should establish a special loan mechanism for hedge funds to deal with the crisis in the government bond market. However, if the Republican-controlled Congress successfully pushes Treasury Secretary Scott Bennett to restrict the government's designation of "systemically important financial institutions," this plan will be in vain. Seeru pointed out that regulatory shadow banking entities are always faced with a dilemma: if they are strictly controlled according to traditional bank standards, the market price discovery function and capital allocation efficiency will be affected; but if left unchecked, even if the funds only take risks with their own capital, the hidden dangers of risk contagion still exist. "You can't have your cake and eat it too," Seeru admitted. Furthermore, strengthening regulation only for hedge funds may have little effect. After all, when investment banks are restricted due to tightened regulations, hedge funds quickly fill the market gap. As Goltzstein put it, "This kind of regulation does not make the financial system any safer." Although Seeru is against excessive regulation, he emphasizes that improving transparency in both the public and private markets is crucial. For example, if hedge funds bear a large amount of risk, it must be made clear whether they are related to government-guaranteed financial institutions (such as Wall Street banks). He believes that once it is discovered that the risk exposure of shadow banking entities may threaten the stability of the financial system, they should be required to meet regulatory standards such as capital adequacy ratios. However, Seeru also warns that risks are often hidden in the details - as evidenced by the collapse of Silicon Valley Bank in 2023, even traditionally regulated financial institutions may show no signs of crisis before an outbreak. "Both regulatory agencies and the market itself should maintain a sense of awe," Seeru concluded, "because both areas harbor unknown risks." In the current complex where risks are hidden in the dark, this is especially true.