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The Bank of England is pushing ahead with its plan to restrict how much debt hedge funds may use when trading UK government bonds, despite warnings that it will raise borrowing costs and reduce liquidity in the nearly £3tn gilt market.
Hedge funds have become an increasingly important part of gilt trading, accounting for about 30 per cent of transactions in the market, which determines borrowing costs for the government and, by extension, for business and consumers across the economy.
Popular hedge fund strategies, such as trades targeting the difference in price between a gilt and a derivative of the same maturity, are leveraged up through borrowing in the so-called repo market, in which investors sell bonds and promise to repurchase them a short time later.
But an unwinding of such strategies has been blamed for exacerbating recent sharp sell-offs in bond markets, such as the post “liberation day” sell-off in Treasuries last April and the Iran war sell-off earlier this year.
The BoE aims to make gilt markets more resilient in a crisis by restricting how much short-term borrowing hedge funds can raise by using gilts as collateral.
Officials plan to impose a minimum “haircut” on gilt repos to create more of a buffer against market volatility. Haircuts, or discounts, to the collateral against which hedge funds can borrow provide downside protection for lenders but also raise funding costs for investors.
Sarah Breeden, BoE deputy governor for financial stability, is preparing to provide more detail about the plans in a blog later this month, according to people familiar with the situation. She is expected to argue that concerns that they will increase overall funding costs for hedge funds and other investors are misplaced.
Speaking at an event for market participants last month, Breeden downplayed these fears, saying: “Any design of potential minimum haircuts will take account of portfolio-level approaches. A well-calibrated approach need not increase overall margin costs.”
Investment banks are able to provide hedge fund clients with near-zero haircuts on gilt repos by taking into account offsetting positions within their portfolios in a “cross-margined” approach to the amount of upfront cash they require.
Yet the BoE believes that fierce competition between banks to win business from large hedge funds is also pushing them to offer excessive levels of leverage.
“To be clear, I agree that well risk-managed portfolio margining can be a good thing,” Breeden said last month. “However, zero haircuts may also reflect competitive pressures from powerful clients,” she added.
“Even if portfolios are cross-margined, it’s not obvious to me that within that gilt repo haircuts — given the systemic importance of this market — should be at zero,” she said.
In April, the BoE warned such repo borrowing had rapidly unwound by £19bn at the start of the Iran war sell-off, as an example of how it could feed broader market volatility when popular trades come under pressure. Repo borrowing after the deleveraging remained elevated compared with historical levels, at £74bn.
The idea of imposing minimum haircuts on gilt repo was first raised by the BoE in a discussion paper last year. It also proposed encouraging more of the market to be centrally cleared rather than traded bilaterally, which would be another way to limit leverage. The central bank aims to present its plans early next year.
Most respondents to its proposals have warned that such measures could “raise funding costs and potentially divert activity into other markets or instruments, reducing gilt market liquidity and price efficiencies”, the BoE said in the summary of feedback it received.
Some market participants warn restricting gilt repo will hit other investors beyond the small number of large hedge funds, many based in the US, that the BoE is targeting.
“Repo markets play an extremely broad and essential role in financial markets way beyond providing leverage,” said Bryan Pascoe, chief executive of the International Capital Market Association, a trade body.
“To avoid detrimental market disruption and deal with risk effectively, regulatory initiatives should be carefully targeted rather than carried out through blunt approaches,” he said.
Regulators in other parts of the world are also seeking to restrict hedge fund leverage in government bond trading, while trying to avoid spurning an investor group that indebted countries have become increasingly reliant on to fund borrowing needs.
The US Securities and Exchange Commission will require all Treasury repo borrowing to be centrally cleared from July 2027. EU regulators recently called for the European Commission to consider introducing margin requirements on government bond repo trading.
Some in the market are sceptical that extra costs from minimum haircuts or central clearing will drive hedge funds out of government bond markets. “They won’t go elsewhere, because this is plumbing,” said one market participant. Some big hedge funds believe they may actually benefit as higher funding costs squeeze smaller rivals out of the market.
