The world’s leading financial stability watchdog – the Financial Stability Board (FSB) – is ramping up oversight of hedge fund leverage and shadow banking risks, launching a task force to assess potential systemic threats, according to a report by Bloomberg.
The report cites FSB Chair Klaas Knot as confirming that the carry trade and basis trade, two popular but highly leveraged strategies, will be key areas of focus. Both strategies, which are used to exploit interest rate differentials and bond price discrepancies, have ballooned in scale, prompting regulators to assess their potential to trigger broader market instability.
Recent reports underscore the growing risks associated with these macro trades. A European Securities and Markets Authority (ESMA) study found that some hedge funds are leveraging their positions up to 18 times, with market bets totalling $220bn. This extreme financial gearing raises concerns about margin calls, forced liquidations, and potential ripple effects on the banking system.
The basis trade, once infamous for trillion-dollar wagers on US Treasuries, has gained traction in China, amplifying worries about borrowings-fuelled blowups. Meanwhile, the carry trade — where investors borrow in low-yield currencies like the Japanese yen to invest in higher-yielding assets — has grown increasingly volatile due to unpredictable US economic policies.
For instance, in August 2024, hedge funds shorting the yen and going long on US equity futures faced margin calls, triggering forced position closures. Such unwinding of trades in volatile markets can deepen losses, affecting broader financial stability.
The FSB has struggled to map risk exposures across different regulators, with data gaps limiting its ability to detect vulnerabilities in real time and Knot has emphasised the need for stronger national supervision to ensure regulators have the necessary data.
“A lot of data is either not available to regulators at all, or only available with a delay,” he said.
The FSB aims to enhance global data sharing, exploring whether real-time risk disclosures should be made public. Knot suggested that the task force would have a “powerful chair” and aims to make significant progress by 2025.
While regulators see increased scrutiny as necessary, the hedge fund industry has pushed back. Jillien Flores, Head of Global Government Affairs at the Managed Funds Association, defended market-based finance, has stated: “Market-based finance is essential for economic growth, providing diverse sources of capital, improving market efficiency, and supporting businesses and investors, including pensions.”
