The Bank of England (BoE) has issued a warning about the rising influence of hedge funds in the UK government bond market, highlighting how their use of leverage could amplify financial system vulnerabilities, according to a report by the Financial Times.
Speaking on Monday, Deputy Governor Dave Ramsden emphasised that while hedge fund activity in the gilt market is not inherently problematic, it presents risks that require careful oversight. “Hedge fund leverage and concentration are specific examples of vulnerabilities that could lead to system-wide risks and warrant continued and careful monitoring,” Ramsden stated.
Hedge funds now account for almost 30% of gilt market transactions, nearly double their 15% share in 2018, according to Ramsden. This growth reflects a shift in the market dynamics as government debt levels outpace commercial bank balance sheet expansion and the BoE reduces its own bond holdings.
A significant portion of hedge fund activity is driven by multi-manager funds and computer-driven strategies that rely on significant leverage to boost returns. Multi-manager funds, which house numerous trading teams pursuing various strategies, can quickly adjust their market exposure in response to centralised risk management systems.
While these structures may improve efficiency during normal market conditions, Ramsden warned that their reliance on leverage could exacerbate market shocks, as seen in the past five years.
Ramsden pointed out that highly leveraged hedge funds have played a role in amplifying recent market shocks, though he stressed that there is no immediate dysfunction in gilt markets. For instance, the orderly rise and subsequent decline of 10-year gilt yields around the recent UK Budget underscored the market’s resilience.
However, the BoE’s simulations of a hypothetical hedge fund collapse revealed that such an event could trigger fire sales, spreading stress to pension funds, insurers, and other financial institutions.
To address potential risks, the BoE plans to launch a new funding facility in 2025 to provide emergency liquidity to non-bank financial institutions, including pension funds, insurers, and liability-driven investment (LDI) funds. These entities were at the centre of the 2022 pension market crisis.
The facility will be activated only during periods of market stress to prevent “fire sales” and broader financial instability. Borrowing through the facility will remain anonymous to avoid the stigma that might deter firms from seeking assistance.
The BoE’s measures aim to balance the benefits of hedge fund activity with the need to safeguard financial stability.
