## Chapter 2 — "Hedge Funds and Financial Stability"

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### Key findings
- Gross assets of hedge funds reached about $13 trillion in early 2026.
- Hedge funds account for about 5 percent of total nonbank financial intermediation.
- Gross notional exposure (including off-balance-sheet derivatives) rose from $13 trillion in 2013 to more than $40 trillion in early 2026.
- Since 2013, the gap between gross and net assets—a measure of borrowing—has risen by nearly $6 trillion for hedge funds.
- Prime brokerage and repurchase (repo) financing expanded by more than $5 trillion since 2013.
- Hedge funds’ sovereign bond exposures have more than doubled since 2022, with about two-thirds of the increase concentrated in US Treasuries.
- Hedge funds’ share of outstanding US Treasury securities rose from about 4 percent in 2022 to 9 percent in 2025.
- Equities held by more vulnerable hedge funds experience larger price declines and higher volatility during market stress.
- Leverage amplifies adverse effects of crowded positions and investor redemptions, including through widening spreads when leveraged sovereign bond trades unwind.
- Hedge fund vulnerabilities remain difficult to monitor because of significant data gaps on leverage, derivatives exposures, counterparty relationships, and cross-border activities.

### Policy recommendations
- Close data gaps and strengthen risk monitoring, including through stress testing and scenario analysis.
- Address risks from crowded trades and synchronized deleveraging through targeted and well-calibrated activity-based measures, including stronger collateral management practices.
- Where risks are concentrated, deploy entity-based measures, such as risk-based leverage limits, capital or margin add-ons, and limits on concentrated exposures.
- Improve market resilience by strengthening counterparty risk management.
- Maintain credible crisis backstops to contain severe market disruptions and strengthen international coordination to limit regulatory arbitrage.

### Conceptual framework for shock transmission and amplification
- Hedge funds can support market liquidity, price discovery, and risk sharing in stable conditions but can cause forced deleveraging, crowded liquidation, derisking, redemption pressures, and contagion in stress conditions.
- Key vulnerabilities driving amplification:
  - Crowding and concentration: concentrated positions and similar exposures increase sensitivity to adverse price moves and synchronized unwinding risk.
  - Leverage: secured financing and derivatives-based leverage are highly procyclical and can turn hedge funds from liquidity providers into liquidity demanders during stress.
  - Correlated end-investor flows: synchronized redemptions can force simultaneous selling, exacerbating price declines and liquidity strains.
  - Interconnectedness: links to prime brokers, repo markets, and other dealers can transmit losses and strain intermediary balance sheets.
- Typical feedback loop: margin calls → unwinding of crowded positions → price declines → additional margin calls and investor redemptions → further deleveraging.

### Market impact and strategy heterogeneity
- Strategy-specific observations:
  - Macro and relative-value strategies often rely on significant leverage and are susceptible to margin calls and forced deleveraging.
  - Equity funds are more exposed to equity valuation and market liquidity changes.
  - Managed futures strategies can be sensitive to abrupt reversals in market trends and may also be leveraged.
- Trading behavior:
  - In calm markets, hedge funds generally trade contrarian (increase positions in falling equities and reduce positions in rising equities), contributing to price discovery and liquidity improvement.
  - Contrarian behavior weakens in periods of elevated volatility and market stress.
  - The largest funds remain contrarian in both tranquil and stressed conditions; smaller funds are contrarian mainly in calm times and behave more like mutual funds in stress.
- Empirical episodes:
  - March 2020 “dash for cash” when hedge fund deleveraging and larger portfolio adjustments than mutual funds contributed to market stress.
  - July 2026 stress episode at a major hedge fund (Situational Awareness) where losses on highly leveraged and concentrated AI-related equity positions triggered margin calls and forced deleveraging; the fund’s publicly listed portfolio was subsequently acquired by another market participant, facilitating an orderly unwind.

### Sector evolution, data, and methodology
- Growth patterns:
  - Gross assets: $4 trillion in 2013 → about $13 trillion in early 2026.
  - Gross notional exposures: $13 trillion in 2013 → more than $40 trillion in early 2026.
- Funding composition:
  - Repo borrowing correlated with sovereign bond exposure growth.
  - Prime brokerage borrowing correlated with equity exposure growth.
- Data and coverage:
  - Analysis integrates multiple commercial hedge fund databases covering more than 25,000 unique hedge funds domiciled in 78 advanced and emerging market economies from 1990 to 2026.
  - Data include fund size, investment strategies, leverage, redemption terms, and counterparty relationships (including links to prime brokers), complemented by quarterly security-level equity and bond holdings data.
  - Important data gaps: incomplete information on leverage, derivatives exposures, prime broker relationships, and weaker coverage of bond holdings than of equities; offshore structures and uneven data coverage complicate aggregate exposure measurement and cross-border spillover assessment.

### Concentration and leverage
- Concentration metrics:
  - The largest 16 managers oversee over $20 billion in investor capital each and account for about one-third of total net assets.
  - About 300 firms manage more than $1 billion in net assets and account for about 85 percent of the sector’s capital.
  - The largest 10 managers account for one-third of total exposures (higher concentration by gross exposures).
  - Domiciles: United States, the Cayman Islands, Luxembourg, and Ireland collectively hold over 80 percent of the sector’s assets under management.
  - Funds raise approximately 70 percent of their investor capital through offshore structures.
  - The five largest prime brokers serve an estimated two-thirds of funds by assets under management.
- Leverage and strategy concentration:
  - Relative-value and macro strategy funds exhibit the highest financial leverage and account for most of the increase in leverage since 2023.
  - Leverage of relative-value funds has been more variable over time.
  - Larger firms combine higher financial leverage with greater use of balance sheet and synthetic leverage through derivatives, implying concentration of leverage among a small group of managers.
  - Prime broker exposures vary considerably across strategies.

### Portfolio similarity, investor behavior, and redemption terms
- Overlap in equity holdings (cosine similarity index) has risen over time, especially among the largest funds, with acceleration since 2022.
- Investor sensitivity:
  - End investors in hedge funds are highly sensitive to performance; investor flows are strongly linked to past returns and especially pronounced following large losses.
- Typical redemption mechanics:
  - Lockup periods range from two to six months.
  - Redemption frequencies are generally monthly or quarterly.
  - Notice periods average just over 30 days.
- Redemption restrictions vary by fund size: smaller managers tend to impose more restrictive terms; larger, more leveraged funds often offer greater liquidity.
- Offshore capital is raised mainly through feeder and parallel funds.

### Market impact of hedge fund trading and empirical effects
- Securities with greater hedge fund ownership tend to be more liquid in calm markets (narrower bid-ask spreads), but this effect is not significant during stress.
- Event-study evidence:
  - Equities bought by hedge funds subsequently overperform (cumulative abnormal returns rise gradually with little reversal).
  - Increases in mutual fund ownership are associated with lower subsequent abnormal returns.

### Hedge fund vulnerabilities and their market effects
- Crowded positions:
  - The most crowded stocks exhibit about 10 percentage points higher volatility and 4 percentage points larger drawdowns than the least-crowded stocks during stress.
  - Average stress-period realized volatility of daily returns: 37 percent.
  - Maximum stress-period drawdowns: 17 percent.
  - Effects stronger for US equities and weaker for emerging market stocks.
- Correlated investor redemption pressures (flow fragility):
  - Stocks with the least-stable hedge fund investor base exhibit 7 percentage points higher volatility and 2 percentage points deeper drawdowns than comparable stocks.
  - Redemptions tend to be about seven times smaller for funds with lockup periods of at least one year and four times smaller for funds with redemption frequencies longer than one month, compared with funds with more flexible terms.
- Leverage:
  - Equities more exposed to leveraged hedge funds experience larger price declines and higher volatility during market stress, though the average effect of leverage alone is smaller than that of crowdedness and investor base fragility.
- Interaction effects:
  - Leverage amplifies the effects of crowdedness and investor base fragility: equities simultaneously exposed to high leverage and crowded positions experience significantly larger increases in volatility and deeper drawdowns during stress.
- Overall conclusion: hedge funds often improve price discovery and liquidity in tranquil times; during stress, crowding, correlated redemptions, and leverage can amplify price dynamics and market volatility.

### Macrofinancial spillovers and amplification channels
- Prime broker spillovers:
  - A one-standard-deviation increase (decline) in hedge fund returns, equivalent to around 2 percentage points, raises (reduces) prime broker returns by 1.4 percentage points during the month of the shock.
  - Spillovers dissipate over subsequent months.
  - Spillovers are larger for prime brokers with riskier clients and with more leveraged clients.
- Systemic propagation:
  - Adverse shocks to hedge fund clients can induce prime brokers to reduce lending and risk taking, potentially transmitting stress to the broader financial system.
  - Resilience of hedge fund balance sheets and funding arrangements is critical in determining whether hedge funds dampen or amplify shocks.

### Effect on prime broker returns and aggregate equity amplification
- Prime broker analysis:
  - Figures report the effect of a one-standard-deviation shock to hedge fund returns on prime broker returns, with brokers split by median average variance of fund returns and fund leverage; error bars show 90 percent confidence intervals.
- Equity amplification:
  - A one-standard-deviation increase in aggregate hedge fund ownership (1.3 percentage points) amplifies the effect of a global risk shock on quarterly domestic equity returns by about 1 percentage point.
  - This amplification is sizable relative to the average 7 percent decline following such a shock.
  - Amplification is substantially more pronounced in less-liquid markets (Amihud illiquidity measure above its median).
  - Effects are not observed for mutual fund ownership.

### Data, transparency, and risk monitoring — needs
- Priority areas for improved information:
  - leverage;
  - exposures to derivatives;
  - securities financing transactions;
  - prime broker relationships;
  - investor redemption arrangements.
- Recommended systemwide surveillance and stress-testing features:
  - incorporate hedge funds’ linkages with other financial intermediaries;
  - include cross-asset positions to assess how leverage, margin calls, funding pressures, and asset liquidations affect market liquidity and asset prices;
  - identify vulnerabilities, transmission channels, and amplification mechanisms before they materialize.
- Stronger cross-border reporting frameworks and information-sharing arrangements are essential given offshore domiciles and global activity.

### Risk-based prudential toolkit — policy options
- Activity-based measures for synchronized deleveraging risks:
  - minimum margin and haircut requirements in securities financing transactions and derivatives markets;
  - stronger collateral management practices;
  - measures to ensure preparedness for margin calls during periods of market stress.
- Entity- and concentration-based measures where risks are concentrated:
  - risk-based leverage limits;
  - enhanced reporting of large positions;
  - capital or margin add-ons;
  - large-exposure limits.
- Design considerations:
  - account for uneven application across jurisdictions and counterparties;
  - assess potential adverse effects on market liquidity;
  - recognize constraints from synthetic leverage, cross-border activity, and limits on information sharing.

### Market resilience and crisis preparedness
- Prime brokers should maintain robust counterparty risk management, including enhanced risk assessment, monitoring of concentrated exposures, and prudent collateral practices.
- Central banks should maintain credible, targeted, and operationally ready backstops to address episodes of severe dysfunction in core financial markets; backstops should:
  - aim to preserve market functioning rather than support solvency of individual institutions;
  - complement ex ante resilience at prime brokers and other key intermediaries;
  - be discretionary and informed by predefined, data-driven indicators of market dysfunction.
- Potential backstops could include collateralized lending, securities financing operations, and market-functioning asset purchases with eligibility, collateral, and pricing set ex ante.

### Hedge funds and foreign exchange carry trades
- Hedge funds accounted for about 8 percent of global foreign exchange turnover in April 2025.
- Case study evidence:
  - Noncommercial yen shorts rose during yen depreciation of 2022–24, reaching a record 3.5 standard deviations above their historical average before unwinding abruptly.
  - A one-standard-deviation increase in leveraged short positions is associated with significantly worse lower-tail outcomes up to one quarter, with cumulative effects reaching 2 percentage points for funding currencies and related equity indices.
  - When crowdedness is elevated, a buildup is associated with a 9-percentage-point decline in the 10th percentile of the Nikkei, compared with 1.5 percentage points otherwise.
- Multistrategy funds (especially offshore) reduced both carry trade and Japanese equity exposures after the yen unwind.
- Multistrategy hedge funds had leverage of about 4:1 on traditional measures and 14:1 including synthetic leverage through derivatives before the August 2024 episode.
- Policy implications:
  - monitor leveraged and crowded carry trade exposures, particularly among offshore-domiciled funds;
  - collect granular data on over-the-counter derivatives, prime broker financing, and cross-asset exposures;
  - assess procyclicality of margining practices and volatility-sensitive risk models that can amplify shocks through synchronized deleveraging.

### Hedge funds and the US Treasury market (basis trades)
- Hedge funds’ share of outstanding Treasury securities rose from about 4 percent in 2022 to 9 percent in 2025.
- Treasury cash‑futures basis trading by hedge funds relies on large leveraged positions and uninterrupted access to funding; shocks to volatility, margins, or funding can force rapid deleveraging, amplifying stress through asset sales, reduced liquidity, and tighter financing conditions.
- Basis-trade footprint dynamics:
  - grew during periods of elevated basis-trade activity;
  - became insignificant following the March 2020 Treasury market turmoil;
  - strengthened again after 2022;
  - moderated more recently, consistent with declines in leveraged funds’ short Treasury futures positions.
- Basis-trade exposure concentrated in relative-value and macro strategies and greater among more leveraged funds; exposures were particularly pronounced among offshore-domiciled and larger funds during the buildup before the COVID-19 pandemic.
- Empirical effects:
  - A one-standard-deviation increase in leveraged positioning leaves the median basis unchanged but raises its 90th percentile by 1.5 basis points over eight weeks.
  - The impact is larger when the Federal Reserve balance sheet is smaller relative to the debt stock (quantitative tightening amplifies the market impact).
  - When dealer intermediation capacity is ample, greater positioning helps absorb Treasury supply and reduces basis widening; when dealer capacity is constrained, greater positioning amplifies market dislocations.
- Policy relevance:
  - monitor growth and concentration of basis-trade exposures;
  - consider interactions among funding conditions, dealer balance sheet capacity, and quantitative tightening.

### Box 2.2 — Implications of US Treasury cash‑futures basis trades of hedge funds (core implications)
- Treasury net-basis volatility can explain a nontrivial share of residual hedge fund return variation over rolling 36-month windows, with statistical significance varying over time (joint significance tested at the 10 percent level).
- A measurable “basis-volatility footprint” of hedge fund strategies is associated with official leverage measures from OFR; higher footprints align with higher leverage measures.
- Leveraged hedge fund positioning can move the 10-year Treasury basis:
  - Magnitude and persistence of basis moves differ across the distribution (10th, 50th, 90th percentiles).
  - Market stress (VIX above its 90th percentile) amplifies the effect of positioning on the basis, particularly when Federal Reserve Treasury holdings are below their mean.
  - Dealer capacity conditions modulate the basis response to auction surprises: available dealer capacity versus binding dealer capacity produces different basis outcomes after DV01-weighted auction shocks.

*Source: Chapter 2, Global Financial Stability Report, International Monetary Fund | October 2026.*

### Chapter 2 at a Glance

### Chapter 2 at a Glance

### Key findings
- Hedge funds have become increasingly important participants in global financial markets; gross assets reached about $13 trillion in early 2026.
- Hedge funds account for only about 5 percent of total nonbank financial intermediation but their assets grew substantially faster than most other nonbank financial segments since the global financial crisis.
- Gross notional exposure of the hedge fund sector, including off-balance-sheet derivatives positions, tripled from $13 trillion in 2013 to more than $40 trillion in early 2026.
- Since 2013, the gap between gross and net assets—a measure of borrowing—has risen by nearly $6 trillion for hedge funds.
- Prime brokerage and repurchase (repo) financing expanded by more than $5 trillion since 2013; repo borrowing has largely funded increased sovereign bond exposures, while prime brokerage financing has supported growth in equity exposures.
- Hedge funds’ sovereign bond exposures have more than doubled since 2022, with about two-thirds of the increase concentrated in US Treasuries.
- In the US Treasury market, hedge funds are estimated to have increased their share of holdings from around 4 percent in 2022 to 9 percent in 2025.
- Equities held by more vulnerable hedge funds experience larger price declines and higher volatility during market stress.
- Leverage amplifies adverse effects of crowded positions and investor redemptions, including through widening spreads when leveraged sovereign bond trades unwind.
- Adverse shocks to hedge funds can spill over to prime brokers, typically large dealer banks, and broader financial markets, with potential implications for macrofinancial stability.
- Hedge fund vulnerabilities remain difficult to monitor because of significant data gaps, particularly regarding leverage, derivatives exposures, counterparty relationships, and cross-border activities.

### Policy recommendations
- Close data gaps and strengthen risk monitoring, including through stress testing and scenario analysis, to better identify vulnerabilities in markets with significant hedge fund participation.
- Address risks from crowded trades and synchronized deleveraging through targeted and well-calibrated activity-based measures, including stronger collateral management practices.
- Where risks are concentrated, deploy entity-based measures, such as risk-based leverage limits, capital or margin add-ons, and limits on concentrated exposures.
- Improve market resilience by strengthening counterparty risk management.
- Maintain credible crisis backstops to contain severe market disruptions and strengthen international coordination to limit regulatory arbitrage.

### Conceptual framework for shock transmission and amplification
- The chapter presents a framework showing how hedge funds can support market liquidity, price discovery, and risk sharing in stable conditions, but can cause forced deleveraging, crowded liquidation, derisking, redemption pressures, and contagion in stress conditions.
- Key vulnerabilities that drive amplification:
  - Crowding and concentration: concentrated positions and widespread similar exposures increase sensitivity to adverse price moves and risk of synchronized unwinding.
  - Leverage: secured financing and derivatives-based leverage are highly procyclical and can turn hedge funds from liquidity providers into liquidity demanders during stress.
  - Correlated end-investor flows: synchronized redemptions can force simultaneous selling, exacerbating price declines and liquidity strains.
  - Interconnectedness: links to prime brokers, repo markets, and other dealers can transmit losses and strain intermediary balance sheets, reinforcing deleveraging and tightening financing conditions.
- Feedback loops described include margin calls → unwinding of crowded positions → price declines → additional margin calls and investor redemptions → further deleveraging.

### Market impact and strategy heterogeneity
- The chapter documents that the market impact of hedge funds depends on strategy type:
  - Macro and relative-value strategies often rely on significant leverage and are susceptible to margin calls and forced deleveraging.
  - Equity funds are more exposed to equity valuation and market liquidity changes.
  - Managed futures strategies can be sensitive to abrupt reversals in market trends and may also be leveraged.
- Hedge funds’ flexible mandates, short selling, derivatives use, and data-driven trading allow rapid position adjustments that can both correct mispricing in calm markets and amplify stress when funding liquidity or market volatility deteriorates.
- Empirical episodes noted:
  - The March 2020 “dash for cash” when hedge fund deleveraging and larger portfolio adjustments than mutual funds contributed to market stress.
  - A July 2026 stress episode at a major hedge fund (Situational Awareness) when losses on highly leveraged and concentrated AI-related equity positions triggered margin calls and forced deleveraging; the fund’s publicly listed portfolio was subsequently acquired by another market participant, facilitating an orderly unwind.

### Sector evolution, data, and methodology
- Growth patterns:
  - Gross assets increased from $4 trillion in 2013 to about $13 trillion in early 2026.
  - Gross notional exposures increased from $13 trillion in 2013 to more than $40 trillion in early 2026.
- Funding composition:
  - Repo borrowing correlated with sovereign bond exposure growth; prime brokerage borrowing correlated with equity exposure growth.
- Data and coverage:
  - The chapter’s analysis integrates multiple commercial hedge fund databases covering more than 25,000 unique hedge funds domiciled in 78 advanced and emerging market economies from 1990 to 2026.
  - Data include fund size, investment strategies, leverage, redemption terms, and counterparty relationships (including links to prime brokers), complemented by quarterly security-level equity and bond holdings data capturing sovereign and corporate issuers.
  - Important data gaps remain, including incomplete information on leverage, derivatives exposures, prime broker relationships, and weaker coverage of bond holdings than of equities; offshore structures and uneven data coverage complicate aggregate exposure measurement and cross-border spillover assessment.

### Financial stability implications
- The chapter emphasizes that even when hedge funds hold a modest share of outstanding securities, their role in arbitrage and information-driven trading allows them to influence speed and magnitude of price adjustments, potentially transmitting and amplifying global macrofinancial shocks.
- Systemic transmission hinges on market footprint and interconnectedness; when hedge funds with significant presence across core markets deleverage, they can strain prime brokers and dealers, potentially limiting intermediation capacity and amplifying market stress across jurisdictions.
- The combination of leverage, crowding, and correlated redemptions can create powerful amplification mechanisms that increase market volatility and reduce liquidity, posing risks to broader macrofinancial stability.

*Source: Chapter 2, Global Financial Stability Report, International Monetary Fund | October 2026.*

### Annex Figure 2.2.2, panel 3).

### Annex Figure 2.2.2, panel 3).

### Concentration of the hedge fund sector
- The largest 16 managers oversee over $20 billion in investor capital each and account for about one-third of total net assets.
- About 300 firms manage more than $1 billion in net assets and account for about 85 percent of the sector’s capital.
- Concentration is higher by gross exposures: the largest 10 managers account for one-third of total exposures.
- Hedge funds are domiciled mainly in a small number of financial centers: the United States, the Cayman Islands, Luxembourg, and Ireland collectively hold over 80 percent of the sector’s assets under management.
- Other major manager domiciles include Brazil, Hong Kong SAR, Singapore, and the United Kingdom.
- Funds raise approximately 70 percent of their investor capital through offshore structures.
- Prime brokerage concentration: the five largest prime brokers serve an estimated two-thirds of funds by assets under management.

### Leverage and strategy concentration
- Relative-value and macro strategy funds exhibit the highest financial leverage and account for most of the increase in leverage since 2023.
- Leverage of relative-value funds has been more variable over time, indicating greater susceptibility to deleveraging during stress.
- Larger firms combine higher financial leverage with greater use of balance sheet and synthetic leverage through derivatives, implying concentration of leverage among a small group of managers.
- Prime broker exposures vary considerably across strategies, creating channels for shock transmission between hedge funds and dealer banks.

### Portfolio similarity, investor behavior, and redemption terms
- Overlap in equity holdings across hedge funds (cosine similarity index) has risen over time, especially among the largest funds, with acceleration since 2022.
- End investors in hedge funds are highly sensitive to performance; investor flows are strongly linked to past returns and are especially pronounced following large losses.
- Typical redemption mechanics:
  - Lockup periods range from two to six months.
  - Redemption frequencies are generally set at monthly or quarterly intervals.
  - Notice periods average just over 30 days.
- Redemption restrictions vary by fund size: smaller managers tend to impose more restrictive terms; larger, more leveraged funds often offer greater liquidity.
- Offshore capital is raised mainly through feeder and parallel funds; feeder funds channel investor capital into a common master portfolio, whereas parallel funds hold similar portfolios in separate legal vehicles tailored to different investor groups.

### Market impact of hedge fund trading
- In calm markets, hedge funds generally trade contrarian (increase positions in falling equities and reduce positions in rising equities), contributing to price discovery and liquidity improvement.
- Contrarian behavior weakens in periods of elevated volatility and market stress; hedge funds are less likely to provide stabilizing liquidity when liquidity conditions deteriorate.
- The stabilizing role differs by fund size:
  - The largest funds remain contrarian in both tranquil and stressed conditions.
  - Smaller funds are contrarian mainly in calm times; in stress they behave more like mutual funds (buying rising stocks, selling falling stocks).
- Securities with greater hedge fund ownership tend to be more liquid in calm markets (narrowing bid-ask spreads), but this effect is not significant during stress.
- Event-study evidence: equities bought by hedge funds subsequently overperform (cumulative abnormal returns rise gradually with little reversal), consistent with information-based or valuation-driven accumulation after price weakness; increases in mutual fund ownership are associated with lower subsequent abnormal returns.

### Hedge fund vulnerabilities and their market effects
- Key vulnerabilities that amplify downside risk during market stress:
  1. Crowded positions
     - The most crowded stocks exhibit about 10 percentage points higher volatility and 4 percentage points larger drawdowns than the least-crowded stocks during stress.
     - Average stress-period realized volatility of daily returns: 37 percent.
     - Maximum stress-period drawdowns: 17 percent.
     - Effects stronger for US equities and weaker for emerging market stocks.
  2. Correlated investor redemption pressures (flow fragility)
     - Stocks with the least-stable hedge fund investor base exhibit 7 percentage points higher volatility and 2 percentage points deeper drawdowns than comparable stocks with less-correlated redemption pressures.
     - Redemption terms materially influence outflows: redemptions tend to be about seven times smaller for funds with lockup periods of at least one year and four times smaller for funds with redemption frequencies longer than one month, compared with funds with more flexible terms.
  3. Leverage
     - Equities more exposed to leveraged hedge funds experience larger price declines and higher volatility during market stress, though the average effect of leverage alone is smaller than that of crowdedness and investor base fragility.
  4. Interaction effects
     - Leverage amplifies the effects of crowdedness and investor base fragility: equities simultaneously exposed to high leverage and crowded positions experience significantly larger increases in volatility and deeper drawdowns during stress.
- Overall conclusion: in tranquil times hedge funds often improve price discovery and liquidity; during stress, vulnerabilities (crowding, correlated redemptions, leverage) can amplify price dynamics and market volatility.

### Macrofinancial spillovers and amplification channels
- Prime broker spillovers
  - A one-standard-deviation increase (decline) in hedge fund returns, equivalent to around 2 percentage points, raises (reduces) prime broker returns by 1.4 percentage points during the month of the shock.
  - Spillovers dissipate over subsequent months, suggesting relatively short-lived effects.
  - Spillovers are larger for prime brokers with riskier clients (measured by the volatility of client returns) and for prime brokers with more leveraged clients, consistent with exposure to lower-quality collateral and higher client leverage.
- Systemic propagation
  - Adverse shocks to hedge fund clients can induce prime brokers to reduce lending and risk taking, potentially transmitting stress to the broader financial system.
  - The resilience of hedge fund balance sheets and funding arrangements is critical in determining whether hedge funds dampen or amplify shocks across markets and counterparties.

*International Monetary Fund, Global Financial Stability Report, October 2026, Chapter 2.*

### 1. Effect of a Hedge Fund Shock on

### Effect of a Hedge Fund Shock on

### Effect on Prime Broker Returns
- The figures report the effect of a one-standard-deviation shock to hedge fund returns on prime broker returns.  
- Panels split brokers by median average variance of fund returns and fund leverage; error bars show 90 percent confidence intervals.

### Hedge Fund Equity Footprint and Amplification of Global Risk Shocks
- A one-standard-deviation increase in aggregate hedge fund ownership (1.3 percentage points) amplifies the effect of a global risk shock on quarterly domestic equity returns by about 1 percentage point.
- This amplification is sizable relative to the average 7 percent decline following such a shock.
- Amplification is substantially more pronounced in less-liquid markets (where the Amihud illiquidity measure is above its median).
- Effects are not observed for mutual fund ownership, indicating hedge funds transmit shocks and respond more forcefully to global risk conditions.

### Data, Transparency, and Risk Monitoring — Key Findings and Needs
- Significant data gaps limit assessment of vulnerabilities and interconnections involving hedge funds; priority areas for improved information include:
  - leverage;
  - exposures to derivatives;
  - securities financing transactions;
  - prime broker relationships;
  - investor redemption arrangements.
- Stronger cross-border reporting frameworks and information-sharing arrangements are essential because of the global nature of the hedge fund industry and the prominent role of offshore fund domiciles.
- Systemwide surveillance and stress-testing frameworks should:
  - incorporate hedge funds’ linkages with other financial intermediaries;
  - include cross-asset positions to assess how leverage, margin calls, funding pressures, and asset liquidations affect market liquidity and asset prices;
  - identify vulnerabilities, transmission channels, and amplification mechanisms before they materialize.

### Risk-Based Prudential Toolkit — Policy Options
- Where risks stem from synchronized deleveraging (for example, margin calls or correlated investor redemptions), activity-based measures could be appropriate, including:
  - minimum margin and haircut requirements in securities financing transactions and derivatives markets;
  - stronger collateral management practices;
  - measures to ensure preparedness for margin calls during periods of market stress.
- Where vulnerabilities are concentrated in specific firms or exposures, entity- and concentration-based tools may be warranted, including:
  - risk-based leverage limits;
  - enhanced reporting of large positions;
  - capital or margin add-ons;
  - large-exposure limits.
- Design considerations:
  - account for uneven application across jurisdictions and counterparties;
  - assess potential adverse effects on market liquidity;
  - recognize constraints from synthetic leverage, cross-border activity, and limits on information sharing.

### Market Resilience and Crisis Preparedness
- Supervisors should ensure prime brokers maintain robust counterparty risk management, including enhanced risk assessment, monitoring of concentrated exposures, and prudent collateral practices to limit contagion to the banking sector.
- Central banks should maintain credible, targeted, and operationally ready backstops to address episodes of severe dysfunction in core financial markets; such backstops should:
  - aim to preserve market functioning rather than support solvency of individual institutions;
  - complement ex ante resilience at prime brokers and other key intermediaries;
  - be discretionary and informed by predefined, data-driven indicators of market dysfunction.
- Because hedge funds operate across borders, effective international cooperation is needed to promote consistent implementation of policy measures, reduce regulatory gaps, and limit opportunities for regulatory arbitrage.
- Backstops could include collateralized lending, securities financing operations, and market-functioning asset purchases; eligibility, collateral, and pricing should be set ex ante to limit use to periods of acute dysfunction.

### Hedge Funds and the Foreign Exchange Market (Carry Trades)
- Hedge funds accounted for about 8 percent of global foreign exchange turnover in April 2025.
- Evidence from case studies (Swiss franc floor removal in January 2015; yen carry trade unwind in August 2024):
  - hedge fund exposures to carry trade risks increased notably ahead of both unwinds and declined sharply thereafter;
  - noncommercial yen shorts rose during yen depreciation of 2022–24, reaching a record 3.5 standard deviations above their historical average before unwinding abruptly;
  - a one-standard-deviation increase in leveraged short positions is associated with significantly worse lower-tail outcomes up to one quarter, with cumulative effects reaching 2 percentage points for funding currencies and related equity indices.
- Nonlinearity and crowding:
  - when crowdedness is elevated, a buildup is associated with a 9-percentage-point decline in the 10th percentile of the Nikkei, compared with 1.5 percentage points otherwise.
- Multistrategy funds (especially offshore) reduced both carry trade and Japanese equity exposures after the yen unwind.
- Multistrategy hedge funds had leverage of about 4:1 on traditional measures and 14:1 including synthetic leverage through derivatives before the August 2024 episode.
- Policy implications:
  - monitor leveraged and crowded carry trade exposures, particularly among offshore-domiciled funds;
  - collect granular data on over-the-counter derivatives, prime broker financing, and cross-asset exposures;
  - assess procyclicality of margining practices and volatility-sensitive risk models that can amplify shocks through synchronized deleveraging.

### Hedge Funds and the US Treasury Market (Basis Trades)
- Hedge funds’ share of outstanding Treasury securities rose from about 4 percent in 2022 to 9 percent in 2025.
- Treasury cash-futures basis trading by hedge funds relies on large leveraged positions and uninterrupted access to funding; shocks to volatility, margins, or funding can force rapid deleveraging, amplifying stress through asset sales, reduced liquidity, and tighter financing conditions.
- The basis-trade footprint (share of hedge fund return variation explained by Treasury net-basis volatility) has:
  - grown during periods of elevated basis-trade activity;
  - become insignificant following the March 2020 Treasury market turmoil;
  - strengthened again after 2022;
  - moderated more recently, consistent with declines in leveraged funds’ short Treasury futures positions.
- Basis-trade exposure is concentrated in relative-value and macro strategies and is greater among more leveraged funds; exposures were particularly pronounced among offshore-domiciled and larger funds during the buildup before the COVID-19 pandemic.
- Effects on market functioning:
  - a one-standard-deviation increase in leveraged positioning leaves the median basis unchanged but raises its 90th percentile by 1.5 basis points over eight weeks while helping reduce dislocations when the basis is already converging.
  - The impact is larger when the Federal Reserve balance sheet is smaller relative to the debt stock (quantitative tightening amplifies the market impact of hedge fund positioning).
  - When dealer intermediation capacity is ample, greater positioning helps absorb Treasury supply and reduces basis widening; when dealer capacity is constrained, greater positioning amplifies market dislocations.
- Policy relevance:
  - monitor the growth and concentration of basis-trade exposures;
  - consider how funding conditions, dealer balance sheet capacity, and quantitative tightening interact with hedge fund positioning to affect Treasury market functioning.

*Source: Chapter 2, "Hedge Funds and Financial Stability," Global Financial Stability Report, International Monetary Fund, October 2026.*

### Box 2.2. Implications of US Treasury Cash-Futures Basis Trades of Hedge Funds

### Box 2.2. Implications of US Treasury Cash-Futures Basis Trades of Hedge Funds

### Explanatory power of Treasury net-basis volatility for hedge fund returns
- Empirical specification uses 36-month rolling partial R2 estimates to measure the share of residual hedge fund return variation explained by contemporaneous and lagged Treasury net-basis volatility, after controlling for relevant factors.
- Treasury net-basis volatility is defined as the monthly realized volatility of Bloomberg’s 10-year Treasury futures net basis computed from daily changes in the same-contract net basis.
- Solid (dotted) lines in the analysis denote periods when net-basis volatility factors are jointly significant (not significant) at the 10 percent level.
- Results are presented for HFRI relative-value index, HFRI macro index, and HFRI asset-weighted composite index, with 90 percent confidence intervals around fitted relationships reported.

### Association between hedge fund footprint in Treasury basis trades and leverage
- Quarterly Office of Financial Research (OFR) leverage measures are related to the estimated basis-volatility footprint for the strategies studied.
- The fitted relationships include shaded areas indicating 90 percent confidence intervals around the estimates.
- The analysis reports distributions (10th percentile, median, 90th percentile) of the estimated footprint and relates higher footprint measures to variations in OFR leverage metrics.

### Effect of leveraged hedge fund positioning on the Treasury cash‑futures basis
- Panel analyses report the cumulative response of the 10-year Treasury basis to a one-standard-deviation increase in leveraged positioning at the 10th, 50th, and 90th percentiles.
- The analysis differentiates calm and stress periods:
  - Stress periods are defined as those in which the Chicago Board Options Exchange Volatility Index (VIX) is above its 90th percentile; calm periods are those below the 90th percentile.
  - Stress-period results are compared when Federal Reserve Treasury holdings, as a share of marketable Treasury debt, are at their average level and when they are one standard deviation below average.
- The analysis assesses the effect of a one-standard-deviation increase in positioning on the Treasury basis following Treasury auction shocks, conditional on dealer capacity.
  - Auction surprises are defined as the DV01-weighted change in offering size against the previous auction of the same tenor and reopening status.
- Time horizons in the cumulative-response plots span weeks and days (figures label responses up to at least 8 weeks and up to 20 days depending on panel).

### Core empirical implications
- Treasury net-basis volatility can explain a nontrivial share of residual hedge fund return variation over rolling 36-month windows, with statistical significance varying over time (joint significance tested at the 10 percent level).
- A measurable “basis-volatility footprint” of hedge fund strategies is associated with official leverage measures from OFR; higher footprints align with higher leverage measures (relationships reported with 90 percent confidence intervals).
- Leveraged hedge fund positioning can move the 10-year Treasury basis:
  - The magnitude and persistence of basis moves differ across the distribution (10th, 50th, 90th percentiles).
  - Market stress (VIX above its 90th percentile) amplifies the effect of positioning on the basis, particularly when Federal Reserve Treasury holdings are below their mean.
  - Dealer capacity conditions modulate the basis response to auction surprises: available dealer capacity versus binding dealer capacity produces different basis outcomes after DV01-weighted auction shocks.

### Methodological and data notes relevant for interpretation
- Data sources include Bloomberg Finance L.P.; Hedge Fund Research; Commodity Futures Trading Commission; Federal Reserve Board; TreasuryDirect; Financial Accounts; FR 2004; Office of Financial Research; and IMF staff calculations.
- The analysis conditions on contemporaneous and lagged net-basis volatility, controls for relevant factors, and reports confidence intervals and significance levels explicitly.
- Additional methodological details and robustness checks are provided in Online Annex 2.3 (referenced for further details).

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2026/october/english/ch2.pdf_