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Hedge funds are using leverage to build larger positions in UK government debt, creating potential new risks in the financial system, the Bank of England has warned.
Dave Ramsden, a BoE deputy governor, said in a speech on Monday that “hedge fund leverage and concentration are a specific example of the vulnerabilities that could lead to system-wide risks and warrants continued and careful monitoring”.
Giving details of a new funding window for non-banks that the BoE plans to offer in periods of financial stress, Ramsden said the vulnerabilities created by the increased leverage and concentration of hedge funds “can amplify shocks”.
The BoE executive, who has responsibility for markets and banking, said the proportion of overall gilt market transactions done by hedge funds had risen from close to 15 per cent in 2018 to almost 30 per cent this year.
This reflects how government debt levels have risen faster than commercial bank balance sheets, he said, while the BoE has started to shrink its own holdings of bonds — opening the door to hedge funds to take a greater share of gilt trading.
“There is nothing inherently wrong with the growth in hedge fund activity, indeed it is a trend that began well before 2024 and is not unique to the UK,” said Ramsden.
But he added: “Many of the hedge funds responsible for the increasing share of activity in the UK gilt trading use significant amounts of leverage to achieve higher returns.”
Hedge fund activity has become more concentrated among a small group of large firms, due to the “growth of ‘multi-manager’ funds”, he said, adding that such funds’ central oversight and risk management limits “can lead to quicker deleveraging in a stress”.
Multi-manager hedge funds house tens if not hundreds of trading teams running different strategies across equities, commodities, debt, foreign exchange and other markets. Such funds can quickly slash their exposure to certain assets if their central risk systems need to reduce or rebalance the overall level of risk.
Ramsden also pointed to the popularity of computer-driven hedge funds that bet on market trends.
“To be clear upfront, the developments do not suggest a fundamental issue in the functioning of gilt markets,” he said, adding that a rise in 10-year gilt yields at the time of the UK Budget and their subsequent decline showed markets had “operated in an orderly manner”.
But he said the risks of “highly leveraged non-bank participants” had been underlined by the way they had “amplified a number of shocks in the last five years”.
The BoE recently examined the impact of a market crisis, including the theoretical collapse of a hedge fund, on non-bank financial companies. It said last month that the stress was likely to be amplified by fire sales of assets at pension funds, insurers and other investors.
Ramsden also gave fresh details on the BoE’s planned funding window to be opened only in periods of stress to provide emergency liquidity to pension funds, insurers and liability-driven investment (LDI) funds that were at the heart of the 2022 crisis in the UK pension market.
He said firms accessing its funding would remain anonymous and it would only disclose their number and aggregate borrowing amount to avoid any “stigma” that could deter them from turning to the central bank in a crisis.
The facility, to be available from the start of 2025, will offer funding only when “tremors of dysfunction” in markets are “building into something that will lead to fire sales and material spillovers to other firms, which would threaten financial stability if they remained unchecked”.