Global Market: Hedge fund group warns BoE repo reforms could worsen market stress

A hedge fund industry group has warned the Bank of England that proposed reforms to the market for short-term loans secured against UK government bonds could backfire, potentially reducing liquidity and increasing volatility during periods of market stress.

The Alternative Investment Management Association (AIMA) raised concerns in a letter to the BoE this month, seen by Reuters, about plans to expand central clearing in the gilt repo market. The industry body said the proposed changes could create new vulnerabilities, leaving investors more exposed to funding-market disruptions.

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The warning marks a more direct response from AIMA after the group raised significant structural concerns in its response to the BoE's initial proposals last year.

The concerns come as a global selloff in government bonds has pushed borrowing costs higher. In Britain, 30-year gilt yields rose to their highest level since 1998 earlier this month, highlighting renewed concerns about liquidity and stability in government bond markets.

Regulators are also closely monitoring the growing role of hedge funds in sovereign bond markets. The International Monetary Fund said on Tuesday that hedge funds had increased their presence in the market, while the BoE has previously warned that greater activity by leveraged hedge funds in the gilt market has introduced additional risks.

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The BoE is consulting on measures intended to make the gilt repo market more resilient, including expanding central clearing. Under such arrangements, a central counterparty stands between buyers and sellers and guarantees trades, helping to reduce counterparty risk.

The proposals also include minimum haircuts on non-centrally cleared repo transactions. These discounts are intended to better protect lenders and reduce the risk of forced asset sales during periods of market stress.

According to Reuters, the proposed reforms were prompted in part by the 2020 "Dash for Cash" episode and the 2022 liability-driven investment crisis, both of which exposed weaknesses in financial markets that amplified stress and ultimately required central bank intervention.

AIMA told the BoE this month that its members had raised fresh concerns about any further expansion of central clearing. The group warned that the proposed reforms could encourage hedge funds to rely more heavily on shorter-term daily repo financing rather than typical two-week arrangements.

Such a shift could leave investors more vulnerable to funding disruptions, particularly during periods of market stress.

AIMA's concerns came in response to an article on the BoE's website by Deputy Governor Sarah Breeden, who noted that similar initiatives were being pursued internationally. The United States is preparing to introduce mandatory central clearing for Treasury repo transactions from next year.

AIMA has urged the BoE to wait and assess how the US clearing mandate works before implementing similar measures in Britain.

The BoE, which has said any reforms would likely take years rather than months to implement, declined to comment. The central bank has yet to decide which proposals it will ultimately take forward.

Breeden said in July that authorities could not simply leave the existing framework unchanged, warning that banks could withdraw repo financing more aggressively during a severe market shock.

The gilt repo market is an important source of short-term funding and liquidity. Traders use it to finance positions linked to interest-rate movements, while investors can use their government bond holdings to raise temporary cash.

BoE data shows that net borrowing in the gilt repo market stands at around £200 billion ($270 billion), with hedge funds accounting for about £85 billion of that amount.

(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times.)
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