Hedge fund control poses new risk for UK debt markets
Hedge funds are increasingly dominating debt-fueled bets on UK government bonds, a trend posing a potential risk to the gilts market, which serves as a barometer for borrowing costs in the country, according to investors and hedge fund sources. Bank of England Governor Andrew Bailey highlighted the impact of non-bank entities like hedge funds on UK financial markets in February, citing concerns about liquidity stress in the gilt market.
The surge in hedge fund trading activity in short-term lending markets, particularly for trades involving 10-year gilts, has raised eyebrows among market participants. Electronic trading platform Tradeweb data reveals that hedge funds represented 60% of UK government bond trading volumes in January and February, a significant increase from the previous year. David Aspell, a senior portfolio manager at a macro hedge fund, emphasized how hedge fund activity can lead to chaotic fluctuations in UK rates markets due to their substantial influence compared to other market participants.
With outstanding debt of around 2.5 trillion pounds in the gilts market, hedge funds have been leveraging repo financing for various bets against gilts. Capula Investment Management, Brevan Howard, Millennium Management, and Rokos Capital Management are among the key players using repo financing for their strategies. These funds utilize repo funding to support trades based on gilt prices, inflation expectations, and trend-following strategies. While these individual trades may seem small in isolation, their cumulative effect has raised concerns about market stability.
The Bank of England has warned about the potential risks associated with hedge funds’ increasing use of repo financing, particularly during times of market stress. The imbalance in repo borrowing poses a threat to the overall liquidity and functioning of the financial system, as banks may reduce lending to other market participants if hedge funds absorb a disproportionate amount of available funds. This situation could have repercussions for pension schemes, which rely on repo markets for financing and could face challenges in meeting their obligations if gilt yields rise sharply.
To mitigate these risks, the Bank of England has introduced a new liquidity facility for gilt holders, such as insurance companies and certain pension schemes, aimed at providing financial support during market disruptions. The upcoming release of official growth and borrowing forecasts on March 26 is expected to test market sentiment and potentially trigger significant volatility in the UK debt markets. Experts, like fixed income manager James Athey, have warned of potential disruptions if hedge funds rapidly unwind their positions in response to market shocks, underscoring the importance of maintaining stability in the face of changing market conditions.
