With their high share of trading turnover, hedge funds play a critical role in providing liquidity for mis-priced assets, particularly when large volumes are traded in thin markets – thereby reducing volatility. This activity is particularly important, given the rapid growth in volume of new-generation structured products issued by investment banks.
      Hedge fund leverage estimated via an induction technique suggests a leverage ratio that must be above 3 (versus total AUM of USD 1.4 trillion). Gearing is required to boost returns where low risk and low return styles are implemented. Investment banks are well capitalised against hedge fund exposure.
      “Structured products” are one of the fastest growing areas in the financial services industry, and may already be over half of the notional size of the hedge fund industry (AUM plus leverage). These products, constructed by investment banks, are extremely complex using synthetic option replication techniques, and offering a variety of guarantees in returns. They are sold to retail, private banking and institutional clients. Hedge funds help reduce volatility risk for investment banks in supplying these products.
       Structured products are passive in nature (unlike hedge fund active styles), focusing on providing returns for different risk profiles of clients. These products have not been tested when major anomalies in volatility arise. They are highly exposed to downward price gaps in the „risky‟ assets used in their construction. Considering the potential for such a crisis scenario, two major
policy conclusions emerge: The importance of (1) stress testing of investment banks‟ balance sheets; and, (2) given the large retail market segment, consumer education and protection.