The sell-off in US equities in early August showed that highly leveraged hedge funds operating in a low-liquidity environment could magnify market shocks, the Federal Reserve said on Friday. Financial markets fell sharply in the first week of August in what was seen then as a reflection of concerns over the US economy and rising interest rates in Japan, which turned against investors who had borrowed cheaply in yen in a popular trade known as the yen carry.
The central bank said sparse market liquidity, especially during times of stress, could also amplify volatility and exacerbate the fallout. Despite its warnings about indebted hedge funds, the Fed was sanguine about overall risks in the financial system, saying that in general banks “remained sound and resilient”.