The world\u2019s largest hedge funds are accumulating \u201csubstantially higher\u201d leverage in the bond market than smaller rivals thanks to their close relationships with dealers, according to the Bank for International Settlements.<\/p>\n
The average haircut \u2014 a reduction on the value of collateral in a repurchase agreement transaction \u2014 applied by banks to the 10 largest hedge funds was close to zero, according to BIS research published Tuesday. Such minimal haircuts allow these funds to obtain \u201cvery high levels of leverage relative to their smaller peers,\u201d it said.<\/p>\n
The BIS finding is the latest scrutiny into highly profitable fixed-income strategies such as the basis trade, as regulators seek to tame the risks from such leverage being unwound in a selloff. Earlier Tuesday, the Bank of England called on participants to manage their risk-taking to avoid market disruption.<\/p>\n
\u201cThese large hedge funds are key clients of major dealers, giving rise to strong trading relationships that dealers appear to reward with more attractive haircut terms,\u201d Felix Hermes, Maik Schmeling and Andreas Schrimpf wrote in the BIS paper.<\/p>\n
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Hedge fund activity in global repo markets has risen up the regulatory agenda as officials examine the risks from non-bank financial institutions. The BOE\u2019s Financial Stability Report said Tuesday that hedge fund net gilt repo borrowing \u2014 where they borrow cash by pledging gilts as collateral \u2014 rose to a fresh record near \u00a3100 billion ($132 billion) in November, with a \u201csmall number\u201d of unnamed funds accounting for 90% of the leverage.<\/p>\n
Repo markets are a key source of financing for a variety of hedge fund strategies, including the basis trade. That typically involves a hedge fund using leverage from the repo market to purchase a bond in order to profit from the small price difference between the security and its corresponding futures contract.<\/p>\n
Haircuts are pivotal in determining the leverage they and other investors can achieve via repo markets. In theory, a small haircut of 0.5% enables a borrower to hold assets worth 200 times their equity, while a zero haircut could even lead to \u201cinfinite leverage,\u201d the BIS report said.<\/p>\n
\u201cUnderstanding the factors influencing haircut settings and their implications for leverage is therefore critical for evaluating vulnerabilities in the financial system,\u201d the researchers said.<\/p>\n
The scrutiny has sparked tension between regulators and the industry. A BOE proposal to impose minimum haircuts on repo transactions was opposed by lobby groups, who warned it would harm liquidity.<\/p>\n
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While minimum haircuts \u201ccould limit leverage build-up, they risk favouring cash lenders at the expense of collateral lenders\u2019 ability to secure the return of their collateral assets,\u201d the BIS paper said. \u201cThus, a careful design of such tools that takes into account market practices across different segments seems warranted.\u201d<\/p>\n
The BIS\u2019s analysis is based on the euro area\u2019s Securities Financing Transactions Data Store. The database captures the entirety of the euro repo market as well as a \u201csubstantial volume of repo activity in US dollars, owing to the significant presence of European banks in dollar repo markets,\u201d the report said.<\/p>\n
The researchers also pushed back against one defence of zero haircuts: that they reflect what\u2019s known in the industry as portfolio margining. That\u2019s where a bank makes decisions on collateral levels based on a counterparty\u2019s entire trading exposure rather than individual repo transactions.<\/p>\n
\u201cAccounting for haircuts set at the portfolio level rather than for individual repo transactions does not alter conclusions on the prevalence of zero repo haircuts,\u201d the BIS researchers said.<\/p>\n
\u00a9 2025 Bloomberg<\/p>\n
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