BIS Urges Action to Limit Hedge Fund Leverage

The Bank for International Settlements (BIS) is advocating for stricter controls on hedge funds’ leverage in government bond markets. This appeal arises from rising concerns over escalating public debt levels globally.

BIS Highlights Risks from Hedge Fund Leverage

Pablo Hernández de Cos, the newly appointed General Manager of the BIS, emphasized the potential dangers posed by high public debt combined with the expanding influence of non-bank financial institutions (NBFIs). These factors could threaten financial stability worldwide.

The BIS Role in Financial Stability

The BIS acts as a cooperative body for central banks, facilitating international monetary and financial collaboration. It also serves as a banking institution dedicated to central banks.

Concerns Over Leverage Strategies

• De Cos pointed out the risky nature of leveraged “relative value” trades.
• These trades often exploit small price differences between bonds and their associated futures contracts.
• They have gained popularity in the United States and other significant economies.

Regulatory concerns have intensified following margin calls on U.S. Treasury future trades in 2021. Additionally, hedge funds have been found to engage in bilateral repos in U.S. dollars and euros with zero haircuts, enabling excessive leverage on government bonds.

Future Debt Projections

Projections indicate that the debt-to-GDP ratio for advanced economies may soar to 170% by 2050. Factors contributing to this rise include:

• Aging populations
• Increasing defense expenditures

De Cos identified controlling NBFI leverage as an essential policy goal. He proposed several strategies for mitigating risks associated with hedge fund leverage.

Recommended Measures

• Enhance the use of central clearing systems.
• Implement minimum haircuts on bonds used as collateral by hedge funds.

The BIS believes these measures could effectively limit excessive leveraging activities in the market. De Cos also highlighted the significance of central bank swap lines in stabilizing global financial systems during crises.

The Importance of Stable Monetary Policy

Maintaining low inflation and ensuring central bank independence are critical for fostering debt sustainability. These efforts can lower risk premiums and stabilize sovereign creditworthiness. De Cos reaffirmed that credible monetary policy is foundational in navigating deteriorating financial conditions.