Global Regulators Sound Alarm on Hedge Fund Leverage
Prominent global financial authorities have raised concerns about a group of hedge funds posing a potential threat to financial market stability, particularly in the bond market.
The Financial Stability Board, comprising top finance officials and regulators, issued a warning about the high synthetic leverage within a segment of the hedge fund industry.
Since March 2020, when a sharp increase in US government bond yields occurred due to reduced demand, scrutiny has intensified on the involvement of hedge funds, asset managers, and pension funds in bond markets. The collapse of Archegos Capital Management in 2021 illustrated the market impact of excessive leverage in fund strategies.
The FSB highlighted the vulnerability of markets to potential liquidity strains from non-bank financial institutions without specifying particular entities. Some funds, mainly focused on macro and relative-value strategies, within the hedge fund sector, employ exceptionally high levels of synthetic leverage.
Synthetic leverage, often using complex off-balance-sheet financial instruments, is used to amplify returns or hedge positions, presenting challenges for regulators in assessing exposures and rapid liability escalation compared to traditional borrowing.
Macro hedge funds speculate on asset and interest rate directions, while relative-value funds target market inefficiencies, such as pricing differences between futures contracts and underlying assets.
In March 2023, hedge funds’ leveraged bond bets were blamed for turbulence in US Treasuries, prompting calls for increased regulatory scrutiny. Despite these concerns, some market segments continued to experience growth in exposures.
The FSB also emphasized the possibility of “hidden leverage” among hedge funds, as they commonly borrow from multiple prime brokers, potentially amplifying shocks and transmitting them through the financial system.
An executive in a similar industry argued that hedge funds have over-saturated the market, raising concerns about potential regulatory restrictions on leverage access through the repo market.
The Financial Stability Board has initiated efforts to address non-bank institution leverage and intends to focus on this area in 2024.
Their objectives include addressing data gaps in exposures, potentially through trade repositories and improved risk management by prime brokers, along with measures to limit excessive leverage behavior, including stricter requirements for derivatives and securities financing transactions. These efforts aim to enhance the readiness of non-bank investors in managing liquidity.