The spectacular collapse of Wall Street in the last hour of trading shows that the world’s hedge fund industry is in a state of near panic and is being hit by mass redemptions.

And the removal of the ban on short selling yesterday has allowed them to suddenly and dramatically increase their short positions, with major effect.

Of course it is not just hedge funds dumping stocks. Long only investors are also slicing their profit forecasts for a long and deep US recession, and adjusting prices accordingly.

But the hedge funds are the marginal pricers in this market and a run on redemptions is underway that is producing dramatic volatility in a range of assets, including commodities, equities and foreign exchange.

Global hedge funds had their worst month for a decade in September – down 6.2 per cent according to the Hennessy Group’s flagship hedge fund index.

They were especially hurt by the ban of short selling that was introduced by the SEC half way through the month following the collapse of Lehman Brothers.

It was lifted on Wednesday at midnight, allowing a wave of short selling to hit the market last night. The funds kept their powder dry through most of the session, waiting to see the whites of long-only buyers’ eyes, and then hit them hard in the last hour.

A bad month is just a bad month: the big problem is the global rush to cash. Banks are hoarding the cash they are getting from central banks and investment funds and high net worth investors are trying to build up cash to prepare for the bargains of a lifetime.

Hedge funds are an obvious target but most have restrictions on redemptions. Some are quarterly, some once a year. Many funds can also put a cap on redemptions if things threaten to get out of hand.

Hedge funds are already building cash reserves to prepare for their annual redemption day, without having a clue what they might be asked to cough up.

And the investors in those hedge funds don’t know what their fellow investors are going to do either. Will the other partners in a fund redeem, so that I’m left holding scorched earth?

As a sidelight it’s worth noting that there will be a big cash transfer tomorrow when more than $US400 billion worth of Lehman Brothers and Washington Mutual credit default swaps have to pay out. There will be winners and losers out of this, but it could be a cathartic event for the stockmarket.

In some ways hedge funds are like banks: they get equity from investment funds and individuals looking to either spice up or stabilise their returns (depending on the hedge fund’s strategy and marketing offer) and then gear that equity up with short-term debt.

Hedge funds generally try to match the liquidity on both sides of their balance sheet by putting restrictions on redemptions and trading in highly liquid markets, but the problem is that markets have suddenly seized up and are no longer liquid, banks now want their debt back and the redemption dates do eventually roll around.

Will there be any hedge funds at all in a year’s time? I’m sure there will continue be hedge funds of some sort, but they’ll be smaller, they’ll have different, more conservative, trading strategies and many will be owned by someone else.

In the 1930s Floyd Odlum famously became very rich by buying 22 investment funds at prices well below the value of the securities they owned.

The funds in those days, by the way, were very similar to today’s hedge funds. They flourished during the late 1920s stockmarket bubble trading with borrowed money, paying their managers big performance bonuses, putting restrictions on redemptions and keeping their trading strategies secret.

The debacle of redemptions, collapse and forced selling in 1930 led to years of Congressional investigations and, eventually, to the Investment Company Act of 1940, which restricted their behaviour and ability to borrow. In essence they became mutual funds.

In the 1990s they emerged phoenix-like from the fossilised ashes of the 1920s and when the internet bubble burst, they just looked for other things to play with. In doing so the hedge funds helped foster the greatest boom in financial innovation the world has ever known.

The collapse of the hedge fund Long Term Capital Management in 1998 turned out to be a mere blip, the one-off explosions of some Nobel-prize smarty-pants who got caught. The fact that it was bailed out in a Fed-inspired rescue arguably led to a flowering of moral hazard and helped underpin a big expansion of risk.

From then on the rapidly growing hedge funds demanded, and got, the most incredible variety of derivatives with which they were able to narrow their bets to the tiniest slivers of risk in a particular security.

As the 2000s decade progressed, they traded credit default swaps and collateralised debt obligations based on the blossoming subprime mortgages that the ratings agencies were prepared to stamp AAA for some reason (but, hey, who are we to argue with Moody’s?).

The advent of more sophisticated stock lending, and the willingness of long-only funds to do it for a few basis points, allowed an explosion of short selling, which in turn allowed a big expansion in trading and arbitrage strategies.

As in the 1920s, the hedge funds kept their strategies to themselves and were able to persuade their fund clients that they were each doing something different, that the geniuses in each fund had discovered the secret of eternal absolute return and that all you had to do was sip from their cup for your performance to be magically reinvigorated.

Unfortunately it turns out they were all doing the same thing in the same securities, like a massive school of herring below the surface of the ocean.