Banque de France • Financial Stability Review – Special issue on hedge funds • No. 10 • April 2007 67 Hedge funds and prime broker dealers: steps towards a “best practice proposal”

The rapidly growing hedge fund industry has brought substantial benefi ts to fi nancial markets. At the same time, hedge funds can in some circumstances give rise to a number of potential risks. Not unlike in the period following the Asian crisis and the collapse of Long-Term Capital Management, governments, regulators, and central banks have been called upon to assess whether additional regulatory initiatives are required to mitigate these risks. There are three potential regulatory objectives that can be invoked. They are investor protection, market integrity protection and fi nancial system protection. The link between hedge funds and the stability of the fi nancial system relates to the possibility that large losses in one or several hedge funds get transmitted to one or several large internationally active banks. This paper discusses the benefi ts and the risks of hedge funds. It outlines the steps towards a best practice proposal aimed at strengthening the credit relationship between prime broker dealers and hedge funds. The objective of such an internationally endorsed standard would be to minimize the risks of the credit links between prime broker dealers and hedge funds being unwound in a disorderly fashion in times of extended market stress. The basic elements of the proposal are: • Prime broker dealers should ensure that they have a complete risk metric of each of the largest hedg