Hedge Fund Leverage Needs Kid-Glove Handling by Regulators

Financial plumbing becoming news is rarely a bullish signal. The head of the New York Federal Reserve last week called in the big institutions for an unscheduled meeting prompted by spikes in its standing repo facility — the central bank’s money-market backstop. While that brainstorming put monetary liquidity in the spotlight, the unspoken concern was leverage, especially borrowing by hedge funds.

The proliferation of multi-pod hedge funds has brought about a major increase in their share of government bond trading globally. Their use of leverage and low regulatory oversight make them potentially unstable counterparties and so threaten the stability of the benchmark markets for all other financial assets. There’s been much hand-wringing over the scale of the US Treasury bond futures basis trade — a relative-value bet between a cash bond and its equivalent futures contract — but US authorities have done little to address it.

But there is a beacon of hope, and — importantly — nuance, emerging from one unlikely source: The Bank of England. The UK central bank seems to recognize whacking on more onerous regulations isn't the way to reduce systemic risk.

For example, the bank’s Financial Policy Committee notes five hedge funds constitute 80% of sterling interest-rate derivatives trading, which has an umbilical financing link to the repo market. That seems crazy, but the solution is not to slam on the brakes — it’s to let the trades gently unwind. Victoria Saporta, BOE executive director for markets, acknowledged in a speech on Nov. 7 in Frankfurt that hedge fund activity in the gilt market is putting upward pressure on repo rates. I warned about this in February, and it’s been a full year since the BOE's system-wide exploratory scenario was published. However, wheels are finally turning.

Lee Foulger, BOE director for financial stability, strategy and risk, made clear in a Nov. 12 speech that "more than half of the outstanding stock in the non-centrally cleared segment of the gilt repo market is conducted at zero haircuts." This means hedge funds can build up substantial levels of leverage at little cost. But instead of the usual pearl-clutching, Foulger announced an important shift on how the BOE monitors the dynamics of the gilt repo market — actively liaising with the major players on how reforms might work in the real world.

He focused on two initiatives to counteract hedge fund dominance: Mandatory centralized repo clearing and minimum haircuts (or margining) on repo trades that are settled bilaterally. The revelation was that clearing should be tailored specifically for differing risk profiles and liquidity needs. Furthermore, he implied a one-size-fits-all approach to haircuts could easily impair liquidity for no discernible benefit, just making trading more expensive.