Hedge Funds Improve Market Functioning, but Can Also Amplify Stress

Hedge funds have become increasingly important participants in financial markets, even though they still represent a relatively small share of the nonbank financial sector. Since 2013, gross assets under management have tripled, to $13 trillion, while gross notional exposures, which include on- and off-balance-sheet positions, are about $40 trillion. Their presence is especially notable in sovereign bond markets, where they held about 9 percent of US Treasurys in 2025.

Unlike most other financial intermediaries, hedge funds invest and borrow with relatively few constraints. This flexibility allows them to invest in illiquid assets, make extensive use of leverage, and adjust positions rapidly. This supports liquidity, price discovery, and risk sharing in normal times. But these features can also transmit and amplify shocks when markets deteriorate, as we show in an analytical chapter of the latest Global Financial Stability Report. 

Whether hedge funds support markets or worsen stress depends on the vulnerabilities that can manifest in their balance sheets—notably, leverage, crowded positions, and redemption pressures. 

Leverage can force hedge funds to retrench precisely when markets are least able to absorb asset sales. Many hedge fund strategies rely on borrowed funding, including short-term financing against securities through repurchase agreements, prime broker credit, and derivatives. When volatility rises or financing conditions tighten, hedge funds may face margin calls, requiring them to reduce exposures or unwind positions. In these circumstances, hedge funds can shift from acting as liquidity providers to amplifiers of market stress.

These dynamics may be reinforced when many hedge funds hold similar positions, known as crowded trades, and have investors who are quick to pull money after losses. In such cases, losses can trigger synchronized unwinds across hedge funds that exacerbate asset price declines, while investor withdrawals may force additional asset sales, creating self-reinforcing feedback loops between losses, deleveraging, and withdrawals.

Our analysis shows that these vulnerabilities materially worsen market outcomes during periods of stress, as measured by spikes in the CBOE Volatility Index, or VIX. Stocks most widely held by hedge funds are 10 percentage points more volatile and suffer 4 percentage points deeper peak-to-trough losses than the least crowded stocks. Volatility and losses are also greater when the hedge funds holding these stocks experience simultaneous investor redemptions. These effects are amplified by leverage, underscoring how the combination of borrowing, crowded positions, and correlated investor withdrawals can magnify the transmission of shocks through financial markets.

Leverage also plays an important role in key funding markets such as the US Treasury market. In calm times, hedge funds use borrowed money in so-called basis trades, seeking to profit from small price differences between Treasury securities and related derivatives. These trades help align prices and support market liquidity. But when funding becomes more expensive, hedge funds may be forced to unwind positions quickly, straining market liquidity and worsening market dislocations.

Stress transmission

As hedge funds have become more active across financial markets, shocks to the sector can quickly spread. An important channel runs through prime brokers, typically large dealer banks that provide financing and trading services to hedge funds. Losses at hedge funds can weigh on these banks and may reduce their capacity to lend when markets are already under pressure.

Hedge fund stress can also spill across borders. When the VIX rises and global risk sentiment deteriorates, stock markets with a larger hedge fund presence tend to suffer larger declines. This is especially true in less liquid markets, where there may be fewer buyers available to absorb sales as hedge funds reduce positions.

Strengthening resilience

Safeguarding financial stability requires policy frameworks that identify where vulnerabilities are concentrated and how they could interact under stress. Many authorities still lack important information, particularly on leverage, derivatives exposures, prime broker relationships, and cross-border activities. Better reporting and information sharing are therefore central to effective surveillance.

Policy measures should be calibrated to the source of risk. Where vulnerabilities arise from synchronized deleveraging across many funds, measures that apply across markets, such as minimum margins and haircuts, and stronger collateral management can help. Where risks are concentrated, such as in specific firms or exposures, entity- and concentration-based measures, including risk-based leverage limits, margin or capital add-ons, and large-exposure limits, may be warranted. 

Supervisors should ensure that prime brokers maintain strong counterparty risk management and monitor exposures to highly leveraged hedge funds. System-wide stress tests can show how hedge funds and their counterparties would respond to shocks, and how pressures could propagate across financial institutions and markets. Identifying such vulnerabilities early can help prevent them from becoming systemic risks.

—This blog is based on Chapter 2 of the October 2026 Global Financial Stability Report, “Hedge Funds and Financial Stability.”