Hedge Fund managers have been warned by the Bank Of England to increase investors lock-in periods, if they to join the shift to less liquid and transparent securities. Hedge funds are largely unregulated and trade in both debt and equities.

The warning cam in the Financial Stability Review. In particular, the warning was directed at managers that depend on fund of hedge funds for capital.

The has been a move in recent months for hedge funds to look for opportunities in longer horizons such as credit derivatives and distressed plays. Bigger funds have asked for guarantees from investors.

Reliance on funds of hedge funds as a source of capital was highlighted because funds are still offering monthly and quarterly liquidity to these groups.

"A combination of leverage, relatively illiquid assets, and in many cases, model based approaches may, in the event of material asset price shifts, exacerbate stressed conditions".

In other words, a potential Long Term Capital Management (LCTM) style crash. LCTM was the American fund that nearly brought the financial markets to its knees.

The Bank of England however does not see the amount of leverage at the same level as 1998. That was when LCTM used massive amounts, only to be undone by the defaulting Russians.

Increased lending to the Cayman Island banks was a crude indicator that the risk has slowly been building up. Others include borrowings of individual investors, funds and funds of hedge funds.

Indeed, in spite of poor performance much money is still flowing into hedge funds. Pension funds and other institutions have been jumping on the bandwagon.