From the book “Restoring Financial Stability: How to Repair a Failed System”. Section II: Financial Institutions
The available data show a remarkable diversity of management styles under the “hedge fund” banner. Hedge funds are major participants in the so-called shadow banking system, which runs parallel to the more standard banking system. Hedge funds have the ability to short sell assets, which allows them to use leverage, and leverage means that their equity value, absent limited liability, can go negative. Hedge funds add value to the financial system in a number of ways: (i) by providing liquidity to the market; (ii) by correcting fundamental mispricing in the market; (iii) through their trading, by increasing price discovery; and (iv) by providing investors access to leverage and to investment strategies that perform well.