Global financial regulators are intensifying their focus on the massive bond market trades executed by the world's largest hedge funds. Concerns are mounting that the extreme leverage these funds employ through repurchase agreements, or repos, could pose a significant threat to the stability of the financial system during periods of market stress.
Record Borrowing and Systemic Warnings
In a coordinated move, the Bank of England (BOE) and the Bank for International Settlements (BIS) issued separate reports on Tuesday, highlighting the risks. The BOE revealed that hedge fund net borrowing against UK government bonds, or gilts, via repos surged to a fresh record of nearly £100 billion (approximately $132 billion or ₹11,000 crore) in November. Alarmingly, a "small number" of unnamed funds were responsible for 90% of this leverage.
Both institutions warned that this concentrated borrowing creates potential vulnerabilities. "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," stated BOE Governor Andrew Bailey at a London press conference. He emphasised that any regulatory action would be driven by systemic risks, not taken "on a whim."
The Core Debate: Basis Trades and Haircuts
At the heart of the issue are popular hedge fund strategies like the "basis trade." This involves using cheap, short-term loans from the repo market to buy a bond while simultaneously selling a corresponding futures contract, aiming to profit from tiny price differences. While this activity can improve market liquidity in normal times, regulators fear a rapid unwinding of these positions during a crisis.
The primary tool being considered to curb risk is the imposition of minimum haircuts. A haircut is a mandatory reduction in the valuation of collateral (like bonds) pledged in a repo trade. It acts as a buffer against price falls. Research from the BIS found that the average haircut applied by banks to the ten largest hedge funds was close to zero, enabling "very high levels of leverage."
"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," cautioned Bailey, who also chairs the global Financial Stability Board. "What's the risk if that funding doesn't roll over?"
Industry Pushback and Unsettled Questions
The hedge fund industry strongly opposes blanket minimum haircuts. Jillien Flores, Chief Advocacy Officer at the Managed Funds Association, argued that these funds' trading "enhances market liquidity, reduces volatility, and lowers government borrowing costs." She pointed to the robust risk controls and margining requirements already imposed by banks.
Market participants contend that zero haircuts often reflect portfolio margining, where a bank assesses risk based on a client's entire book, not just repo trades. They urge a more "holistic" regulatory approach. A Federal Reserve paper this year also suggested minimum haircuts might "decrease liquidity in repo and securities markets without offering a substantial increase in protection."
Despite the debate, the issue remains a top policy priority. As banks retreat from risk, hedge funds' role in crucial government bond markets has expanded. The BOE's consultation on repo reforms, focusing on haircuts and central clearing, closed last week. Deputy Governor Sarah Breeden stated the bank will respond "soon," underscoring that the resilience of the gilt repo market is fundamental to the entire UK financial system.
