Key Points
- The head of the BIS is warning about financial stability risks posed by hedge funds.
- The main concern is their use of massive leverage (borrowed money) to bet on government bonds.
- Government debt is rising to record highs, amplifying the danger of these risky trades.
- A key problem is that lenders allow hedge funds to borrow with “zero haircut,” fueling the leverage.
The new head of the Bank for International Settlements (BIS) is sounding the alarm about the growing risks posed by hedge funds in government bond markets. In a major speech, Pablo Hernández de Cos said regulators must make it a top priority to limit these firms’ ability to make highly leveraged bets.
De Cos, who leads the influential umbrella body for the world’s central banks, warned of a dangerous mix: governments are piling on record levels of debt, and at the same time, non-bank players like hedge funds are playing a bigger and bigger role in trading that debt.
The main concern centers on “relative value” trades, in which hedge funds use large amounts of borrowed money to profit from small differences between the price of a government bond and its futures contract.
These strategies have exploded in popularity but have also been blamed for fueling market turmoil, as seen in the U.S. Treasury market in 2021.
De Cos pointed out a critical weakness: lenders often require “zero haircut” from hedge funds, meaning they don’t discount the value of the bonds used as collateral. This practice allows hedge funds to borrow massive sums against their holdings, creating extreme leverage.
With government debt in advanced economies projected to soar in the coming decades, de Cos said this situation poses a significant threat to financial stability. He called for specific solutions, primarily requiring lenders to apply “minimum haircuts” to the collateral posted by hedge funds. This simple move would directly limit their borrowing power and curb their riskiest plays.
