- BIS chief warns hedge funds' high leverage in bond markets risks triggering severe market volatility and systemic stress.
- Zero-haircut repos let hedge funds borrow with virtually no collateral buffer, amplifying potential rapid unwind effects.
- De Cos urges tighter monitoring, mandatory haircuts, and international coordination to curb non-bank leverage before crisis erupts.
As governments around the world pile on more debt to fund everything from infrastructure rebuilds to pandemic recoveries, a top global financial watchdog is warning that hedge funds’ aggressive borrowing tactics in bond markets could ignite the next big volatility storm.
Pablo Hernández de Cos, the freshly minted general manager of the Bank for International Settlements (BIS), didn’t mince words in a recent speech: it’s time for regulators to slam the brakes on this risky behavior before it spirals out of control.
Speaking at the London School of Economics earlier this week, de Cos laid out a stark picture of how non-bank financial institutions—like hedge funds—are muscling into government bond trading, often with leverage levels that make traditional banks look downright conservative.
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“Elevated public borrowing and the growing role of non-bank financial institutions in bond trading are creating fresh stability risks,” he said, according to a Reuters report that captured the essence of his address.
To understand why this matters, let’s rewind a bit.
Details Leading to the Analysis
Back in 2021, the U.S. Treasury market—long seen as the bedrock of global finance—experienced wild swings that caught even seasoned traders off guard.
Prices plummeted, liquidity dried up, and emergency interventions from the Federal Reserve were needed to steady the ship.
De Cos zeroed in on one culprit: the explosive rise of leveraged relative-value trades, particularly cash-futures basis strategies.
These are essentially bets on tiny pricing discrepancies between cash bonds and futures contracts, amplified by borrowed money to chase outsized returns.
When markets turn, though, those positions can unwind in a flash, exacerbating chaos rather than smoothing it.
But the BIS chief didn’t stop at historical anecdotes.
He drilled down into the mechanics of how hedge funds fuel this fire.
The Massive Risks Hedge Funds Create for the Markets
In a eye-opening detail, de Cos highlighted that around 70% of U.S. dollar bilateral repos—short-term loans backed by collateral—involving hedge funds are struck at a zero haircut.
For the uninitiated, a “haircut” is the discount applied to collateral to account for risk; zero means no buffer at all, allowing funds to borrow right up to the hilt without limits.
The situation is nearly as dire in euros, where half of these deals follow the same no-holds-barred approach.
“Effectively imposing no limits on leverage,” de Cos observed, painting a picture of a system teetering on the edge.
Zoom out, and the numbers get even more sobering. Advanced economies’ debt-to-GDP ratios are on track to balloon to 170% by 2050, driven by aging populations, climate investments, and yes, the lingering tab from COVID-19, according to HedgeWeek.
In this environment, any shock to bond markets—think interest rate surprises or geopolitical flare-ups—could ripple through everything from pension funds to everyday mortgage rates.
Hedge funds, with their nimble but highly leveraged playbooks, are increasingly at the center of it all, holding sway over trades that once dominated by slower-moving banks.
De Cos’s prescription? Make curbing leverage in non-bank financial institutions (NBFIs) a “key policy priority.”
He’s not calling for a full-throated overhaul overnight, but rather targeted tweaks: better monitoring of repo markets, perhaps mandatory haircuts on certain collateral, and international coordination to prevent regulatory arbitrage.
It’s a nod to the post-2008 reforms that tamed bank leverage, suggesting it’s high time for shadow banking to step into the light.
What Happens Now?
This isn’t just technocratic hand-wringing—it’s a timely intervention as central banks navigate a tricky landing from years of ultra-low rates.
The Federal Reserve, European Central Bank, and others are already grappling with bond market jitters; de Cos’s remarks add urgency to the debate.
Will policymakers listen, or will they wait for another 2021-style meltdown to force their hand?
For now, the BIS’s voice carries weight in the rarefied air of Basel, where global rules are forged.
As de Cos wraps up his first few months in the role—he took the helm in July—his focus on these under-the-radar risks signals a proactive stance.
In an era where public debt feels like an unstoppable force, tightening the reins on private leverage might just be the immovable object finance needs.
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