THE ROLE OF HEDGE FUNDS AND THEIR IMPACT ON FINANCIAL MARKETS

Abstract

This study investigates the dual function of hedge funds as providers of liquidity and amplifiers of systemic risk within global financial markets over the period from 1998 to 2023. Employing an extensive dataset comprising 4,126 hedge funds from the United States, Europe, and Asia, it establishes an integrated theoretical and empirical framework that captures state-contingent behaviour through the application of regime-switching models. The results from System GMM estimation indicate that hedge funds demonstrate marked procyclical leverage in stable periods, whereby a 1% increase in returns corresponds to a 2.18% rise in leverage. However, this association reverses markedly during times of crisis, with funds undergoing net deleveraging of 2.54%. Network analysis reveals a critical structural shift under market stress, as network density triples, the average path length reduces to 2.17, and clustering coefficients rise by 172%, thereby creating “small world” characteristics that significantly enhance the potential for contagion transmission. The analysis identifies notable variation across investment strategies, with global macro funds displaying heightened sensitivity to crises (deleveraging coefficient: -6.892) relative to long/short equity funds (-3.234). Panel VAR analysis further illustrates that the intensity of spillovers doubles during crises, increasing from 25.5% to 50.5%, with the United States emerging as the predominant source of shocks. Dynamic CoVaR estimates show that systemic risk contributions from hedge funds triple during crisis episodes, peaking at 9.21% among European funds. These findings call into question the assumptions underpinning the efficient market hypothesis by demonstrating that hedge funds’ role in liquidity provision is both asymmetrical and unreliable during periods when market stability is most essential. The evidence supports the implementation of macroprudential regulatory measures aimed at mitigating the accumulation of procyclical leverage and underscores the importance of monitoring network density as a potential early warning indicator. Methodologically, the study contributes to the existing literature by combining high-frequency network construction from publicly available data, regime-sensitive modelling techniques, and multiple systemic risk metrics within a single framework that connects micro-level hedge fund activities with macro-level financial stability implications.