The systemic risk to the financial system posed by hedge funds has been downplayed over the past year by regulators and legislators from several countries.  But with the sub-prime meltdown and the publishing of a new book by a consummate industry insider, the topic of hedge fund-induced contagions has forced its way back onto the media’s agenda.

To begin with, this paper was released last month by the New York Fed.  Widely reported (such as here at InstititutionalInvestor.com yesterday), this report now seems totally apropos given the market mayhem since it was published.

This paper makes several observations that bear a striking resemblance to Richard Bookstaber’s “A Demon of Our Own Design“.   Bookstaber is a former risk manager at Ziff Brothers, Moore, Salomon and Morgan Stanley.  He contends that regulation can actually compound market dislocations since they create artificial, non-economic behavior that can feed a self-reinforcing death spiral for markets.  (A full review of this fascinating account of systemic risk over the past two decades is forthcoming on these pages.)

More…