ESMA Report Highlights Funds’ Rising Use – and Potential Impact on Market Stability – of Synthetic Leverage From Derivative Instruments

Synthetic leverage – the use of derivative instruments, rather than direct borrowing, to gain exposure in financial markets – has grown in popularity with investment funds. The rising prominence of this practice has attracted a correspondingly greater level of attention from regulators, making it critically important for hedge fund managers to be aware of the risks it poses to financial stability and how regulators may respond to its use. See “European Central Bank Official Regards Hedge Fund Leverage As Risk to Financial System” (Mar. 24, 2016). A recent report published by the European Securities and Markets Authority contains a section devoted to analyzing these risks in a regulatory enforcement context. This article highlights the key takeaways most relevant to hedge fund managers deploying, or considering using, synthetic leverage. For more on alternative methods by which hedge funds obtain leverage, see our three-part series on subscription credit and other financing facilities: “Needed Liquidity and Advance Planning” (Jun. 2, 2016); “Greater Flexibility” (Jun. 9, 2016); and “Operational Challenges” (Jun. 16, 2016). 

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