"Action this Day" on a red sticker was how Winston Churchill prioritised initiatives during World War II. Bank of England Governor Andrew Bailey might consider channeling his inner Winston to counteract the outsized hedge fund leverage he has repeatedly warned is a growing financial-stability risk.
Bailey earlier this month in a speech at the University of Chicago Booth School of Business campus in London
reiterated the undeniable fact that the footprint of hedge funds and non-bank market makers has grown substantially in recent years. It's “putting some pressure on what we perceive of the limits of prime brokerage capacity,” he said — by which he meant investment banks earning fat fees lending to hedge funds. Full marks for identifying the problem; zero for results.
The risk of doing nothing is sleepwalking into another crisis fueled by the BOE allowing more promiscuous lending in repo markets than other central banks. It needs to put some guardrails in place to ensure it’s functioning as intended. Bailey put it bluntly: "Multi-manager funds can make individual ‘pods’ deleverage rapidly in stress conditions, which can exaggerate market moves." Yet his conclusion was dispiriting - "Interventions may not always need to be more regulation...They can be liquidity facilities...We should approach the response to vulnerabilities with an open mind."
With these multi-pod hedge funds using leverage to turbocharge their bets, I don’t think it’s a coincidence that gilts have been the worst-performing major global asset class in dollar terms, according to Deutsche Bank AG analysts, falling in value by 28% the past five years.
I warned during the January gilt market wobble about the growing excesses in the repo markets. Hedge funds are morphing into primary dealers. This problem could be sorted in an afternoon the old-fashioned way by calling those involved in for a "chat." Banks rent out their balance sheets with too little recourse but raising capital requirements on risk-weighted assets could be too blunt an instrument — unintended consequences need to be avoided.
The BOE itself is to blame for providing a borrow-all-you-want short-term repo facility. It's even put in place a safety net for insurers, pension funds and “liability-driven investing" funds who get into distress. Great to have protection in place for when the next crisis happens but what about doing more to prevent it?
The real solution is to hit leveraged players in the pocket by requiring the banks that facilitate them to impose greater "haircuts" (a risk charge) on gilt repo financing. The dirty secret of lots of bilateral bank-to-hedge fund borrowing is that haircuts are effectively zero. The BOE guidelines say “Banks should (my emphasis) also ensure that collateral haircuts. . .reflect the underlying risks of the counterparty and riskiness of the exposure and applied consistently across similar products.” There is a lot of hope embedded in that.
Bank profits may suffer — but financial stability for all is the greater goal. Investment banks follow the money, but it’s simple to make it more expensive for the riskier leveraged stuff.
Three recent debacles scream out for tightening up oversight. First, the collapse of Bill Hwang's Archegos in March 2021. After the resultant implosion of Credit Suisse AG this did see some tightening up on prime brokers in the US. Unfortunately, this lesson hasn't traveled across the Atlantic.
Second, the UK's very own gilt crisis in late 2022 was precipitated by a self-immolation of the pension sector that utilised high levels of leverage to mitigate low gilt yields. According to the BOE's own analysis this hidden leverage was responsible for two-thirds of the gilt selloff.
Finally, Chancellor Rachel Reeves’ January mini-crisis when gilt yields accelerated higher quicker than other global bond markets. All the subsequent rhetoric was about apportioning blame elsewhere. Vanishingly little was said about how the UK's vulnerability was exploited so rapidly. Simply put, access to borrowing gilts to take short positions, in vast scale, is too readily available for swift-acting leveraged hedge fund players. We are our own worst enemy.
The BOE has a dual mandate not just for controlling inflation but also ensuring financial stability. Deputy Governor Dave Ramsden has been forthright on this. The Bank has even explored a system-wide exploratory scenario. The BOE’s Financial Policy Committee has released papers going back to July 2023 noting five hedge funds constitute 80% of sterling interest-rate derivatives trading, yet all we have is consultation documents.
The Prudential Regulation Authority does a widely praised job of overseeing banks and building societies. But it all stops dead at the oversight of the leveraged community. Until we wake up on this, the only solution is to charge more for those who do business direct with the hedge fund client base.
When I asked the BOE what action it’s taking, I was pointed to this Financial Stability Board consultation. As the June 2024 FPC minutes show, it's an international approach the BOE wants to follow first. While there’s undeniable logic to a coordinated global approach, why isn’t the UK solving its own pressing problems — and being clear to the markets what it’s going to do and when? Unless perhaps there’s a major global regulator crackdown on hedge funds in the works. Oh for those halcyon days when the bank governor could lift an eyebrow and banks scrambled to avoid the opprobrium.
Credit: Bloomberg
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