The hedge fund industry is likely to gain ground in the near future and this, in turn, is expected to lead to increased leverage, the European Central Bank said this week.

But the financial crisis showed that there are problems associated with hedge fund business models and they can add to financial market stress in turbulent times. "In the period ahead, the hedge fund sector is likely to continue to recover," the ECB said in its latest Financial Stability Review. "This, however, may also lead to higher levels of leverage and concomitant higher vulnerability to various leverage-related risks."

Hedge funds can make times of financial market turmoil worse by selling assets when they are already otherwise badly hit, adding to volatility, the stability review said.

"Overall, the crisis confirmed that certain features of the hedge fund model, namely the combination of leverage and unstable funding sources, may result in substantial position- unwinding pressures in times of stress and thereby exacerbate vicious cycles of liquidation and deleveraging," it said. "In this respect, the analysis conducted here provides some evidence that at the peak of the recent crisis, the amount of forced and voluntary asset sales by hedge funds may have been sufficiently large to have a non-negligible negative impact on market prices."

Leverage levels are, however, still relatively low, when compared with the levels reached in the first half of 2007, the report said, but added the data was limited.

Low interest rates and recovery in investor risk appetite have helped hedge funds pull in new capital recently. With recovering demand, the number of hedge fund launches has also reportedly picked up, the ECB said.