One measure of the surge in speculative activity is the sharp rise in foreign exchange (FX) dealing. In September 2004 the Bank for International Settlements (BIS) published its sixth triennial survey of foreign exchange and derivatives trading activity.
Speculative activity on global financial markets has increased sharply over the last two or three years. Hedge funds, which use short-term, high-risk strategies, have been leading this trend. The number of hedge funds is multiplying fast, and they are manipulating ever-bigger volumes of speculative capital. Intensified speculation is always a symptom of an approaching crisis in the world capitalist economy. Lynn Walsh writes.
Speculative activity surges in the global economy
One measure of the surge in speculative activity is the sharp rise in foreign exchange (FX) dealing. In September 2004 the Bank for International Settlements (BIS) published its sixth triennial survey of foreign exchange and derivatives trading activity. (BIS press release, 28 September 2004, www.bis.org) Average daily global turnover in traditional FX markets rose to $1.9 trillion in April 2004, up by 57% at current exchange rates and by 36% at constant exchange rates compared to April 2001.
Another measure is the trade in derivatives, which are complex, security-like instruments for trading equities (shares), bonds, currency, futures, options, swaps, etc. Derivatives trading also increased sharply. The average daily turnover in trade of derivatives sold by banks (so-called ‘over the counter’ (OTC) derivatives) increased to $1.2 trillion in April 2004, a rise of 112% at current exchange rates and of 77% at constant exchange rates compared to April 2001.
Only a small fraction of this foreign exchange is required to finance cross-border trade of goods and services. Most of it is being used to trade in securities (shares, government and private bonds, etc), derivatives, commodity futures, etc, and increasingly to gamble on currency markets themselves.
The growing dominance of financial activity over production and trade points to the deep-rooted crisis within world capitalism. Massive global over-capacity in most major industries has resulted in saturated markets and falling prices for many manufactured goods. There are always some new growth sectors and regions but, overall, scope for profitable investment in production has not kept pace with the accumulation of capital.
The international capitalist offensive against the working class in the 1980s and 1990s intensified the exploitation of workers everywhere. Existing inequalities were widened, dramatically increasing the share of the wealth taken by the capitalist class. At the same time, the squeeze on wages and cuts in public spending, together with stagnation or decline in most underdeveloped countries, restricted the growth of effective (money-backed) demand. Unable to harvest sufficient profits from productive investment (either through intensive investment in new technology or through extensive development across the whole world), the hyper-rich ruling class has increasingly turned to speculation in the financial sector. Money is churned to make more money, skipping the intermediary stage of producing useful goods and services. Never has capitalism been more parasitic.
Cyclical trends in the 1990s
There was an enormous and continuous increase in speculative activity during the decade of the 1990s, the period of accelerated ‘globalisation’ (mainly based on investment in a handful of Asian countries) and the US-dominated bubble economy. BIS figures for global FX market turnover show that daily average turnover (at April 2004 exchange rates) increased from $650 billion in April 1989 to $1,590 billion in April 1998. (BIS Quarterly Review, December 2004, p68)
This acceleration of currency trading, however, was interrupted between 1998 and 2001, when there was actually a fall in average daily turnover from $1,590 billion to $1,380 billion. The BIS attributes part of this decline to the launch of the euro and an accelerated concentration of major banks, which reduced demand for foreign currency, especially in Europe. The main reason for the decline, however, was the 1997-98 global economic crisis, with the Asian currency turmoil and slump, the collapse of the Russian bond market, and the near-collapse of the US hedge fund, Long Term Capital Management (LTCM). There was a sharp reduction of liquidity on world financial markets. Banks, financial institutions and wealthy investors temporarily curbed some of their more risky speculative activity. The 1997-98 crisis, moreover, was followed at the end of 2000 by the collapse of the stock exchange bubble.
Since 2001 there has been a new surge in FX markets. Following the collapse of the stock exchange bubble in 2001, big investors were no longer able to make big profits through trading in equities (company shares). At the same time, low interest rates, especially in the US (where the inflow of foreign funds allowed the Fed to reduce the base rate to 1%), depressed the profitability of trading on bond markets. Speculators therefore turned increasingly to buying and selling currency as a source of profit.
“In the context of a global search for yield [profits]”, comment two BIS economists, “so-called ‘real money managers’ [banks, pension funds, corporations, etc, investing their own funds] and leveraged investors [hedge funds that use borrowed funds] became increasingly interested in foreign exchange as an asset class alternative to equity [shares] and fixed income [bonds]”. (Galati and Melvin, Why has FX trading surged? BIS Quarterly Review, December 2004)
Mainly using the US dollar, the Japanese yen and the Swiss franc, big speculators followed the strategy of investing in currencies of national economies offering higher interest rates or in currencies tending to appreciate over a sustained period. “A popular form of this investment strategy was the so-called ‘carry trade’. In a carry trade, an investor borrows in a low interest rate currency, such as the US dollar, and then takes a long position [buying FX] in a higher interest rate currency, such as the Australian dollar, betting that the exchange rate will not change so as to offset the interest rate differential”. (Galati and Melvin)
Of course, speculative flows into a high interest rate currency will themselves tend to push up its value against other currencies. The UK pound is one of the ‘target’ currencies pushed up by this kind of speculative flow. Recently, there have also been big speculative flows into the Chinese renminbi (RMB, also known as the yuan), with some hedge funds betting that the Chinese government will break the current peg with the US dollar ($1 = 8.28 yuan) and substantially revalue its currency (a development which is far from certain in the near future).
Hedge funds lead the herd
A wide spectrum of big investors is involved in currency trading: financial institutions (insurance companies and pension funds), currency and commodity dealers, commercial banks – and hedge funds. While hedge funds are not the biggest players, they often appear to be the ‘lead steers’ in the ‘herding’ activity of speculators, leading the stampede in episodes of intensified volatility.
Hedge funds were implicated in the October 1992 collapse of the European Exchange Rate Mechanism (ERM), when George Soros’s Quantum Fund made over $1 billion speculating against the UK pound on ‘Black Wednesday’, and in the 1994 crisis in international bond markets. During the 1997 Asian crisis Soros was accused (by Mohamad Mahathir, the Malaysian premier, among others) of breaking the ringgitt and other regional currencies. In 1998 the near collapse of the US hedge fund LTCM brought the world financial system to the brink of meltdown.
The recent multiplication of the number of hedge funds and their ever more adventurous activities have again focussed attention on their role. Under the headline ‘Voracious traders set market running’, a feature in the (London) Times (Richard Irving, 8/9 November 2004) reported on the increase in hedge fund activity. The feature reflected fears among some capitalist leaders about the destabilising effects of the predatory activity of hedge funds. (“Hedge fund aspirations may have to be trimmed”.) Some commentators are particularly concerned by the growing trend of big company and local government pension funds to invest in hedge funds, which undoubtedly exposes workers’ retirement savings to even greater risks than before.
The number of hedge funds has been growing rapidly, doubling over the last five years. There are now estimated to be about 9,000 internationally, controlling about $1 trillion of investors’ assets. On the strength of these assets, they are estimated to have borrowed between $1.5 and $2 trillion – giving them control of up to $3 trillion assets (with around half based in the US). This is only a small fraction of total global investment assets, perhaps 4% to 5% of the global institutional investment assets of advanced capitalist countries (which were about $54 trillion at the end of 2003). Moreover, most hedge funds are relatively small, managing assets under $500 million. For various reasons, however, hedge funds have a disproportionate impact on markets. The ‘ripple’ effects of a hedge fund collapse could have a devastating effect on the world financial system.
Commenting on the role of hedge funds, Paul Woolley, head of GMO Europe (an investment management firm), says: “We are moving towards a highly polarised [investment market] structure in which the behaviour of the few [hedge funds, etc] is shaping markets for the many [financial institutions]”. (How hedge funds are destabilising the markets, Financial Times, 28 September 2004)
On the one side, over 95% of funds are managed by big institutions (pension funds, insurance companies, mutual funds, etc) that generally follow a passive investment policy, aiming to achieve returns roughly in line with the main stock exchange share indexes (for example, S&P 500, FTSE 100, etc). On the other side, are hedge funds (now being joined by some other investment groups), which actively manage their portfolios, seeking a higher rate of return. Rather than holding a balanced portfolio, they tend to concentrate on particular segments of the market, and use more risky strategies like leveraging, short selling, and derivatives trading. Falling returns on a broad range of investments since the bubble burst in 2000 have led more investors to turn towards hedge funds – which appear to offer bigger short-term profits. Also, other institutions (like the trading arms of investment banks and some pension funds) have begun to adopt the hedge funds’ methods.
Hedge funds, explains Woolley, are “acquiring a pivotal role in determining securities prices” (equities, bonds, derivatives, etc). This is partly because of leveraging (which may more than double the sums they are gambling with) and partly because they are actively buying and selling much more frequently than big financial institutions. “As a result”, says Woolley, “hedge funds account for a far higher proportion of trading volumes than they do of assets managed. In the US and UK, for example, their activity already accounts for about 40% and sometimes as much as 70% of daily trading in equity markets”.
Moreover, hedge funds thrive in volatile markets. One hedge fund tactic is so-called ‘momentum investing’, where they follow rising or falling trends in security prices, betting that they will later be able to profit from eventual ‘corrections’ of over- or under-priced securities. In many cases, the ‘momentum’ tactic actually amplifies the swing in the market, increasing volatility.
“This combination of activity and the search for volatility”, warns Woolley, “means that, in certain situations, hedge funds have become the marginal, price-determining investors… The fact is that unstable markets provide hedge funds with their ideal conditions. But unstable markets lead to an inefficient allocation of capital, impede economic growth, and can cause turmoil in financial sectors. Unless greater balance can be restored between the investment approaches that now dominate, the markets will become less stable and less efficient”.
But who can ‘restore balance’ in the anarchic market system of capitalism? The recent burgeoning of hedge funds and their high-risk, short-term speculative methods is not simply the result of irresponsible, ‘unbalanced’ investment strategies on the part of a minority of investors. The speculative surge is a symptom of the organic crisis of capitalism, which arises from the system’s contradictory logic. Instead of the restoration of ‘balance’, wider sections of capitalists are turning towards hedge funds or independently adopting their methods. This is despite indications that intensified competition between more and more hedge funds, in almost totally integrated global financial markets, is undermining their profitability.
Hedge fund profits lagging behind
“For hedge funds overall last year, performance was less than stellar. The Standard & Poor’s Hedge Fund index showed a year-to-date return of 3.79% through December 28, less than half the gain in the S&P 500 [share index] of 8.99% last year. In 2003, the hedge fund index rose a healthy 11.12%, but the gain in the S&P 500 was more than double that, up 26.38%”. (Kevin Maler, From simple to complex, hedge funds gain ground, New York Times, 3 January 2005) Some speculators, however, claim that (unlike the big financial institutions) hedge funds get above average returns in periods of market downturn – provided, of course, they do not go bust.
Currently, 20% to 30% of hedge funds are wound up every year. Some have recently made big losses. Last year the London-based Man Group, the world’s largest stock-exchange-listed hedge fund operator, had negative returns on its four main funds and lost $2.2 billion of its clients’ money. Nevertheless, it continues to attract more money into its funds. Mega gamblers are evidently ready to take the rough with the smooth.
But some commentators are asking whether hedge funds have reached the limits of their success as high-profit investment vehicles. The flood of funds and the multiplication of hedge funds have resulted in an overcrowded marketplace. It is no longer a situation where a handful of maverick funds (there were only around 200 in the early 1970s when Soros and co first made their fortunes) are able to pounce on obscure corners of the market or anomalously priced assets. All the tricks of the hedge fund trade are common knowledge now. Intensive competition between thousands of funds has ironed out the very ‘aberrations’ on which they previously relied for super profits.
And yet, not only is the flood of capital into hedge funds still growing, but other financial entities are also adopting the same high-risk, speculative tactics. The trading arms of investment banks are using short trading, high leveraging, and derivatives on a big scale. This was clear during the surge in oil prices in the last quarter of 2004, when speculation by hedge funds and investment banks is estimated to have accounted for about 15% to 20% of the increase.
In their article in the BIS Quarterly Review, December 2004, Gelati and Melvin show that the distinction between hedge funds and other investment vehicles is being steadily eroded, especially (but not only) in currency trading. Institutional investors (pension funds, insurance companies), commodity trading advisers (CTAs – who advise companies and institutions), and currency overlay managers (COMs – who advise on actively trading cash reserves) have all begun to act like other types of funds, trading in currency, equities, bonds, commodities, derivatives, etc. Increasingly, the only thing that distinguishes hedge funds from other financial entities is their secretive, unregulated character.
Some commentators, however, are particularly alarmed at the growing involvement of pension funds in hedge funds. Faced with a global shortfall of $1.5 trillion as a result of the post-2000 stock exchange slump, many pension funds are desperately seeking higher returns. Since 2000 the proportion of US and British pension funds investing in hedge funds has almost doubled, from 12% to 23%. Moreover, over the last year pension funds investing in hedge funds have increased their allocation in hedge funds by 36%, to around $70 billion. Last year the chair of the US National Association of Pension Funds “warn[ed] against over reliance on hedge funds, saying the industry is inherently unstable because it uses leverage and seeks to generate long-run returns from short-term horizons”. (Hedge Funds: How risky bets can sneak into a portfolio, International Herald Tribune, 10/11 April 2004) Clearly, the collapse of one or more big hedge fund involving significant pension fund investments could have a catastrophic effect on the security of workers’ pensions.
Another new source of investment capital for hedge funds is the so-called ‘funds of hedge funds’. Operating like US mutual funds or British unit trusts, they accept investments from small investors, with a low participation threshold (for example, $2,500) and then invest their funds in hedge funds. The global funds managed by funds of hedge funds grew 22% in 2004 and are currently estimated to be around €3 billion ($4bn). (International Herald Tribune, 8 February 2005)
The accelerated growth of hedge funds and involvement of a wider range of investors has led to demands from some sections of big business for regulation, requiring them to register, disclose their activities and submit to audits by the regulators. In the US, the Securities and Exchange Commission (SEC) has begun to introduce a regulatory regime. Some hedge fund managers are strongly opposed to any scrutiny of their activities and are currently contesting the new SEC rules in the US courts. Others, however, welcome regulation on the grounds that it will encourage greater participation in hedge funds by financial institutions and small investors. The European Commission and Britain’s Financial Services Authority (FSA) are both reviewing the role of hedge funds, but seem in no hurry to subject them to a regulatory regime. Many commentators take the view that if restrictive regulatory controls are introduced many more hedge funds will simply transfer their operations to offshore havens where they will be beyond the reach of regulators.
The crunch is coming
“Business is always thoroughly sound and the campaign in full swing”, wrote Karl Marx, “until the collapse suddenly overcomes them”. Even now, the global speculative surge is still gathering momentum. Recent interest rate rises by the US Federal Reserve (with a current base rate of 2.5%) are trailing behind the rising rate of US inflation (3.0%), bringing a reduction of real (inflation adjusted) interest rates. The global tidal wave of excess liquidity is actually growing, mocking Alan Greenspan’s timid ‘tightening’ of monetary policy. This is fuelling even greater excesses of speculative investment – with hedge funds leading the charge into ever more risky adventures.
Two fields, in particular, have been prominent in recent months. One has been the rush of ‘mergers and acquisitions’, highly leveraged buy-outs financed by junk bonds – that is, high-yield, but high-risk company bonds. The corporate predators that issue the bonds aim to pay high rates to bond-holders (and big dividend bonuses to their own shareholders) through asset-stripping the companies they swallow up. But many deals go wrong, and the bonds become ‘junk’.
“The head of one of the biggest commercial lenders in the US describes the amount of leverage [borrowing] on some buy-out deals as ‘nutty’. Much of the wildest lending is being done by hedge funds awash with cash, he says. ‘Some funds believe they have to invest the money even if it’s not a smart investment. They think the people that gave them the money expect them to invest it. But it’s madness’.” (Dan Roberts, David Wighton and Peter Thal Larsen, The end of the party? Financial Times, 14 March 2005) Roberts reports growing fears that this cycle will end like the last one, “with a lot of over-leveraged companies in trouble”. Some commentators are raising the spectre of the major junk bond crisis at the end of the 1980s boom.
Another newly fashionable field of risky speculative investment is so-called ‘emerging market debt’. With low interest rates in the US, Europe and Japan, speculators have recently been pumping cash into government and company bonds in Brazil, Russia, Mexico, Colombia, Turkey and a few other countries (mostly denominated in potentially volatile local currencies). Such countries have to pay a ‘risk premium’ over US interest rates, though this has been approximately halved recently – more by the flood of liquidity than any reduction of risk. “All this is reminiscent of the mood that preceded successive financial crises in the 1990s”. (Roberts, The end of the party?) Yet another debt bubble is being inflated to dangerous dimensions.
The complexity of the credit system, Marx long ago commented, creates the illusion for capitalists that “capital produces money as a pear tree produces pears”, entirely divorced from production, the exploitation of labour, and the realisation of profit through sales to consumers. Today, many capitalists appear to believe that profits are conjured up on computer screens from the virtual universe of electronic financial markets. Yet, a growing number fear that a reality check is not far away. “The range of voices expressing concern has widened. ‘The next time around is going to come sooner rather than later’, says Paul Kirk, head of global restructuring at PwC, the professional services firm. ‘The investment goals that are being pursued right now have nothing to do with business fundamentals’.” (Roberts, The end of the party?)
The low interest rate ‘regime’ on which the current speculative bubble rests cannot last much longer. Exactly how it will end is unpredictable. A collapse of one or more hedge funds or finance houses could trigger a financial crisis. A sharp fall in the US dollar could force higher US interest rates, bringing a fall in asset prices (equities, housing, junk bonds, ‘emerging market’ debt, etc) and a downturn in the US economy. Without an expanding US market, China’s investment and property boom would collapse. The end of the debt-financed US consumer boom would definitely mean the end of the global party.
When will it happen? If only we could say. But the strategy of a growing number of capitalists is “to gather more cash and wait for it to go bang”. (Roberts) The legendary financier, Warren Buffett, for instance, is sitting on $45 billion of cash “waiting for a market correction”. He, no doubt, will be laughing. Billions of workers and poor people, who have nothing in the bank except debts, will pay a terrible price for the greed-driven chaos and bankruptcy of the capitalist system.
On 16 March 2005, the exchange rate for the US dollar was: $1 = 0.5186 pounds or 0.7478 euro or 104.52 yen or 8.2765 yuan. Note that other bilateral rates, for example the euro/yen rate, vary independently and cannot simply be calculated from these values.
What are hedge funds?
Hedge funds are secretive clubs of mega-wealthy investors (typically under 100 members).
On the grounds that they are private partnerships (not public companies) and their clients are all super rich (the minimum investment is usually around one or two million dollars), they have not been subject to regulation by financial authorities. In other words, they have not been required to disclose their assets or activities. In any case, many are registered in tax havens (Soros’s Quantum Fund is registered in Curação, Netherlands Antilles). Recently, however, there have been moves, especially in the US, to subject hedge funds to regulation.
Originally, hedge funds were supposed to be high-return but relatively safe investment vehicles. Alfred Winslow Jones, who launched the first hedge fund in 1949, developed the technique of ‘hedging’ (as in ‘hedging your bets’). For every share he bought ‘long’ (to hold for a period on the assumption its price would rise) he bought another similar share ‘short’. The ‘short’ trading of shares means they are borrowed (usually from brokers, with payment of interest) and sold quickly on the assumption that their price will fall – allowing the hedge fund to buy them back more cheaply, and return them to the lender at a profit. The idea is that the hedge fund can gain whether share prices rise or fall. Hedge funds made high profits through active, concentrated trading in targeted corners of financial markets, attempting to identify ‘anomalies’ (for example, ‘under-valued’ shares to buy ‘long’ or ‘over-valued’ shares to sell ‘short’). They also exploited price differences between different regional markets.
The profit per transaction may only be marginal. But Jones used ‘leveraging’ to magnify the profits. This means borrowing big sums to allow the hedge fund to buy and sell on a huge scale – activity that may itself influence the fluctuations in share prices to the advantage of the speculating funds. Far from being safe, however, both short selling and leveraged trading are high-risk strategies.
Hedge funds today are still using short selling as a major trading tactic. At the same time, they have increasingly diversified their speculative activity from equities (shares) into every corner of the international capitalist market: junk bonds (high-yield, high-risk company bonds), commodities, currency, mergers and acquisitions (company takeovers), etc.
Offering high returns, hedge funds have been able to attract a growing number of super-rich investors, in spite of the risks involved. “Over the last decade, hedge funds have delivered returns almost four times that of equity markets”. (Hedging smarter, International Herald Tribune, September 2004) Investors have to put in an initial stake of at least $1 million to $2 million. Hedge fund managers charge them 2% commission (compared to an average 1.36% for US mutual funds – equivalent of British unit trusts) and also charge a ‘performance fee’ of 20% of profits. Some hedge funds have made their mangers fabulously rich from their own investments and management fees. Soros, for instance, is estimated to have a personal fortune of over $11 billion. Recently, it has been reported that a ‘publicity-shy’ US hedge fund magnate, Steven Cohen, who manages funds worth $6 billion, has a personal net worth of $2 billion, taking home $350 million in 2003 and even more in 2004. In the last five years he has spent over $500 million on his private art collection, paying $12 million for Damien Hirst’s shark, $52 million for a Jackson Pollock and $25 million for an Andy Warhol painting. (Thomas and Vogel: ‘Financial shark leaves tooth marks on art world’, International Herald Tribune, 4 March 2005)
It is not only the hedge fund managers, however, who draw grotesque incomes from the funds’ activities. The investment banks that handle the funds’ trading activities are also raking in huge amounts in fees. “Such is the voracity of the [hedge] funds’ trading that regulators estimate that some investment banks are generating up to 40% of their total revenues through dealing commissions charged to hedge funds”. (The Times, 8 November 2004)
The collapse of LTCM
Hedge funds are inherently risky.
Capitalist leaders are still haunted by the near-collapse in 1998 of the US hedge fund, Long Term Capital Management (LTCM), an event that came near to triggering a domino-like collapse of the world financial markets. During 1995-97, LTCM made huge profits for its investors, achieving total returns, after management fees, of 33.7%, compared with the average 29.3% return on S&P 500 shares. LTCM made most of its profits through trading in bonds, swaps and options, exploiting (often small) price differences between different markets. To magnify trading gains, LTCM managers operated on the basis of very high leveraging. On capital of $4.8 billion at the beginning of 1998 the hedge fund was playing the markets with about £120 billion. This implied borrowing of 25 times capital. In addition, LTCM was managing ‘off-balance-sheet’ (on the side) derivative contracts with a notional value of about $1.3 trillion.
In August 1998 the Russian government defaulted on its bonds, and the ruble slumped. This sent shock waves around financial markets, particularly hitting Argentina, Brazil and other so-called ‘emerging markets’. The turbulence in global bond markets precipitated a collapse of LTCM in September. After huge losses, LTCM’s net asset was down to only $600 million, while its exposure to the market was about $100 billion – implying borrowing of 167 times assets. This was unsustainable: LTCM was effectively bankrupt.
“Fear[ing] its failure could precipitate a global financial crisis”, the New York Federal Reserve quickly intervened to organise a private, $3.6 billion behind-the-scenes bailout. (Joseph Stiglitz, Globalization and its discontents, 2002, p150) The Fed particularly feared that a fire sale of LTCM’s bonds and derivatives would trigger a slump in prices, draining liquidity from markets. Clearly, there was the danger of a chain reaction of hedge fund and bank failures. The Fed organised a rescue of LTCM by the banks that had extended credit to the hedge fund. “The rescue of LTCM can be seen as an out-of-court bankruptcy-type reorganisation in which LTCM’s major creditors became its new owners, hoping to salvage as much value as possible”. (Barry Eichengreen & Donald Mathieson, Hedge funds: what do we really know? IMF Economic Issues 19, September 1999.)
A chain-reaction financial crisis in the advanced capitalist countries themselves – which would undoubtedly have provoked a slump in the world economy – was averted by the Fed’s rapid intervention. At the time, the seriousness of the crisis was largely concealed from the public by a conspiracy of silence on the part of capitalist leaders and the media. Stiglitz comments: “The United States lectured everyone… about crony capitalism and its dangers. Yet issues of the use of influence appeared front and center… [among other incidents] in the bailout of LTCM”. (Globalization p178)
How many other LTCM-type crises are there now waiting to happen?
This article is taken from the current issue of Socialism Today, journal of the Socialist Party in England and Wales