Hedge Funds’ Leveraged Bond Trades Draw Regulatory Scrutiny

(Bloomberg) — Government bond trades by the world’s largest hedge funds are facing increased regulatory scrutiny as authorities mull policies that would limit the leverage and profitability of popular strategies.

In separate reports published Tuesday, the Bank of England and the Basel-based Bank for International Settlements investigated the leverage such funds accumulate through repurchase agreements, in which investors borrow cash by pledging bonds as collateral. Both said the 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 introduced minimum cuts, a mandatory reduction in the valuation of collateral exchanged in repo trading, that has been opposed by the industry.

The root of the issue is whether hedge funds’ relative value strategies pose excessive risk. The industry argues its activities increase liquidity, but the BOE has warned that rapid unwinding of leveraged transactions during market stress could trigger a “feedback loop” of forced sales.

“The gilt market is not at all unusual to see this major change in the nature of trading activity and positioning across government bond markets,” BOE Governor Andrew Bailey said at a news conference in London on Tuesday, referring to increased hedge fund activity. “It may be because of the risks in the system that we came to the conclusion of haircuts and marginalization. We wouldn’t do this on a whim.”

Hedge fund activity in global bond markets has been on the regulatory agenda as authorities examine risks from non-bank financial institutions. Hedge fund net gilt repo borrowing rose to a new record of around £100 billion ($132 billion) in November, the BOE’s Financial Stability Report said on Tuesday. 90% of this leverage was accounted for by a “small number” of anonymous funds.

Overnight repo markets are an important source of financing for a variety of hedge fund strategies, including basis trading. This usually involves a hedge fund using leverage in the repo market to buy a security in order to profit from the small price difference between the security and its corresponding futures contract.

In normal times, such a strategy would help correct market mispricings by narrowing the gap between cash bonds and futures. Risk regulators’ fear is that hedge funds will be forced to quickly unwind their positions during periods of stress, triggering forced sales.

Managed Funds Association Chief Advocate Jillien Flores said alternative investment funds’ bond trading “increases market liquidity, reduces volatility and lowers government borrowing costs.” “The robust risk controls implemented by managers and the margin requirements imposed by counterparties enable them to weather market shocks.”

Regulators frequently cite price movements during the outbreak in March 2020, when the spread between futures and bonds widened as investors rushed into Treasury futures, triggering an unwinding of underlying transactions. This further increased the sales pressure.

“If very short-term financing is being used that could create zero disruption, then you need to look at what strategies those things are funding,” said Bailey, who also chairs the Financial Stability Board. “What is the risk if this fund is not transferred?”

The basis for regulators’ concern is that most of the large hedge funds’ repo transactions are carried out with minimal disruptions. The average reduction in the valuation of collateral applied by banks to the 10 largest hedge funds was close to zero, according to BIS research published on Tuesday. This allows these funds to achieve “very high levels of leverage relative to their smaller peers,” it said.

“These large hedge funds are key customers of large dealers, leading to strong trading relationships that reward dealers with more attractive haircut conditions,” Felix Hermes, Maik Schmeling and Andreas Schrimpf wrote in the BIS article.

Market participants argue that looking at haircut data alone is insufficient and that regulators should take a more “holistic” approach. They say the zero deduction reflects a method known in the industry as portfolio margin; Here, a bank makes decisions regarding collateral levels based on the counterparty’s entire trading risk rather than just repo transactions.

In any case, the legislative debate on minimum haircuts is far from resolved. A paper by Federal Reserve researchers this year found that minimum cuts “could reduce liquidity in repo and securities markets without providing a significant increase in protection.”

Given the importance of government bond markets to the global financial system and the increasing role of hedge funds as banks reduce risk taking, this issue will remain on the policy agenda. The BOE’s consultation meeting on repo reforms, focusing on minimum cuts and more centralized trading clearings, ended last week.

Bloomberg Opinion: Hedge Fund Leverage Needs Kid Gloves: Marcus Ashworth

“The resilience of the gilt repo market is fundamental to the resilience of the government bond market, which underpins all financial market activity in the UK,” said Sarah Breeden, the BOE’s deputy governor for financial stability. He said the central bank would respond “soon” to industry feedback on repo offers.

–With help from Tom Rees and Laura Avetisyan.

(Updated by quoting MFA in the ninth paragraph.)

More stories like this available Bloomberg.com