(Bloomberg) — The government-bond trades of the world’s largest hedge funds are facing increased regulatory scrutiny, as officials mull policies that would cap the leverage — and profitability — of popular strategies.
In separate reports Tuesday, the Bank of England and the Basel-based Bank for International Settlements delved into the leverage such funds are accumulating through repurchase agreements, where investors borrow cash by pledging bonds as collateral. Both said borrowing by a small number of large hedge funds poses potential risks to financial stability.
The warnings are the latest salvo in a policy debate that could limit the amount of leverage that can be accumulated in so-called repo markets. Both the BOE and the global Financial Stability Board have floated minimum haircuts, a mandatory reduction on the valuation of collateral exchanged in repo trades — something the industry opposes.
At the core of the issue is whether hedge funds’ relative-value strategies pose excessive risks. The industry argues their activity improves liquidity, but the BOE warned a rapid unwind of their leveraged trades during market stress could trigger a “feedback loop” of forced sales.
“The gilt market is not unusual at all among government bond markets in seeing this big change in the structure of trading activity and position taking,” BOE Governor Andrew Bailey said at a press conference in London on Tuesday, referring to increasing hedge fund activity. “The reason we would come out with a conclusion to have haircuts and margining would be because of the risks in the system. We wouldn’t do it on a whim.”
Hedge fund activity in global bond markets has risen up the regulatory agenda as officials examine the risks from non-bank financial institutions. The BOE’s Financial Stability Report said Tuesday that hedge fund net gilt repo borrowing rose to a fresh record near £100 billion ($132 billion) in November. A “small number” of unnamed funds accounted for 90% of this leverage.
Overnight repo markets are a key source of financing for a variety of hedge fund strategies, including the basis trade. That typically involves a hedge fund using leverage from the repo market to purchase a bond in order to profit from the small price difference between the security and its corresponding futures contract.
In normal times, such a strategy should help correct market mispricings by narrowing the gap between cash bonds and futures. The risk regulators fear is hedge funds needing to unwind their positions quickly during periods of stress, triggering forced sales.
Alternative investment funds’ bond trading “enhances market liquidity, reduces volatility, and lowers government borrowing costs,” said Jillien Flores, the Managed Funds Association’s Chief Advocacy Officer. “Robust risk controls deployed by managers — as well as margining requirements imposed by counterparties — enables them to weather market shocks.”
Regulators frequently cite price action during the pandemic in March 2020, when the spread between futures and bonds widened as investors rushed into Treasury futures, triggering the unwind of basis trades. That fueled further selling pressures.
“If very short-term funding is being used that can generate zero haircuts, then you have to look at what strategies those things are funding,” said Bailey, who also chairs the Financial Stability Board. “What’s the risk if that funding doesn’t roll over?”
At the heart of regulators’ concern is that the bulk of repo trades by large hedge funds are conducted with minimal haircuts. The average reduction in collateral valuation applied by banks to the 10 largest hedge funds was close to zero, according to BIS research published Tuesday. That allows these funds to obtain “very high levels of leverage relative to their smaller peers,” it said.
“These large hedge funds are key clients of major dealers, giving rise to strong trading relationships that dealers appear to reward with more attractive haircut terms,” Felix Hermes, Maik Schmeling and Andreas Schrimpf wrote in the BIS paper.
Market participants argue that looking at haircut data alone is insufficient and regulators should take a more “holistic” approach. They say zero haircuts reflect what’s known in the industry as portfolio margining, where a bank makes decisions on collateral levels based on a counterparty’s entire trading exposure rather than just its repo transactions.
In any case, the regulatory debate on minimum haircuts is far from settled. A paper from Federal Reserve researchers this year found minimum haircuts “could decrease liquidity in repo and securities markets without offering a substantial increase in protection.”
It’s an issue that’s set to remain on the policy agenda given the importance of government bond markets to the global financial system, and the growing role of hedge funds as banks reduce their risk taking. The BOE’s consultation on repo reforms — which centered on minimum haircuts and greater central clearing of trades — closed last week.
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“The resilience of the gilt repo market is fundamental to the resilience of the sovereign bond market, which is the basis on which all financial-market activity in the UK takes place,” Sarah Breeden, the BOE’s deputy governor for financial stability, said. The central bank will respond to industry feedback on its repo proposals “soon,” she said.
–With assistance from Tom Rees and Laura Avetisyan.
(Updates with quote from MFA in ninth paragraph.)
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