BIS Chief Warns of Hedge Fund Leverage Risks in Bond Markets

In a recent address at the London School of Economics, Pablo Hernández de Cos, General Manager of the Bank for International Settlements (BIS), highlighted the escalating risks posed by hedge funds' increasing leverage in government bond markets. He emphasized the urgent need for regulatory intervention to safeguard financial stability.

De Cos pointed out that a significant portion of repurchase agreements (repos) involving hedge funds are conducted with zero haircuts—approximately 70% in U.S. dollars and 50% in euros—effectively permitting unlimited leverage. This practice, coupled with rising global public debt levels, introduces substantial financial stability risks. He advocated for policy measures such as implementing minimum collateral haircuts and expanding central clearing to impose consistent risk controls.

Hedge funds have increasingly engaged in leveraged strategies within government bond markets, notably through "relative value" trades like cash-futures basis trades. These strategies involve exploiting small price differences between bonds and their futures contracts. The prevalence of zero-haircut repos—where lenders do not require a discount on the collateral's value—has facilitated this high leverage. Specifically, around 70% of bilateral repos in U.S. dollars and 50% in euros involving hedge funds are conducted with zero haircuts.

The combination of high public debt levels and the growing role of non-bank financial institutions (NBFIs), such as hedge funds, in bond markets introduces new financial stability challenges. Highly leveraged positions can amplify market volatility, especially during periods of stress. For instance, margin calls on U.S. Treasury future trades in 2021 contributed to turmoil in the Treasury market.

To address these risks, de Cos proposed:

1. Implementing Minimum Collateral Haircuts: Establishing minimum haircuts on repos to limit excessive leverage.

2. Expanding Central Clearing: Increasing the use of central clearing to ensure consistent risk controls across market participants.

These measures aim to impose more consistent risk controls and mitigate the potential for market disruptions.

The concerns raised by de Cos are not unprecedented. In March 2020, the U.S. Treasury market experienced significant turmoil, partly due to the unwinding of leveraged positions by hedge funds. Similarly, in 2021, margin calls on Treasury futures trades led to market instability. These events underscore the potential systemic risks posed by high leverage in government bond markets.

The increasing leverage among hedge funds in government bond markets has broader implications:

• Market Volatility: Highly leveraged positions can lead to rapid and large-scale sell-offs, exacerbating market volatility.

• Financial System Stability: The interconnectedness of financial institutions means that instability in one sector can have cascading effects throughout the financial system.

• Public Debt Management: Rising public debt levels, projected to reach 170% of GDP in advanced economies by 2050, combined with leveraged trading strategies, could complicate debt management and increase borrowing costs.

The BIS's warning underscores the pressing need for regulatory measures to address the risks associated with hedge funds' leveraged activities in government bond markets. Implementing minimum collateral haircuts and expanding central clearing are critical steps toward ensuring financial stability in the face of rising global public debt and the growing influence of non-bank financial institutions.