FSB warns of risks posed by hedge funds’ ‘hidden leverage’

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Financial policymakers have singled out a group of hedge funds as a potential source of market instability in an escalation of existing concerns about the impact of their bets on bonds.

The Financial Stability Board, comprised of the world’s top finance ministers, central bankers and regulators, warned on Wednesday that some hedge funds had “very high levels of synthetic leverage”.

Synthetic leverage refers to debt created by the use of derivatives or other complex financial instruments that frequently does not show up on balance sheets.

The FSB did not name specific institutions, but referred to strategies related to recent market ructions, such as the default of Archegos Capital Management in 2021 and turmoil in the US Treasuries market this year.

Regulators find synthetic leverage more problematic to evaluate than outright borrowing because it is more difficult to measure institutions’ exposures and liabilities can rise quickly.

The policymakers also said hedge funds could have “hidden leverage” because they typically borrow from several prime brokers to increase the size of their bets.

“A few prime brokers dominate the provision of lending to hedge funds, and this concentration could amplify shocks and propagate them through the financial system,” it said.

The role played by hedge funds and other financial institutions such as asset managers and pension funds in bond markets has come under increased scrutiny since March 2020, when US government bond yields dramatically increased as demand evaporated.

The Archegos default also underlined how leverage could cascade through markets and the banking system when the fund’s series of highly concentrated bets on share price moves soured.

The FSB said markets remained “vulnerable” to “further liquidity strains” from so-called non-bank financial institutions.

“Within the hedge fund sector, there is a group of funds, typically pursuing macro and relative-value strategies, with very high levels of synthetic leverage,” it added.

Macro hedge funds take bets on direction of assets or interest rates. Relative-value ones aim to exploit market inefficiencies such as the difference between the price of futures contracts and the underlying asset.

Hedge funds’ leveraged bets on bonds were blamed in March this year for exacerbating turbulence in the US Treasuries market, prompting Securities and Exchange Commission chair Gary Gensler to tell the Financial Times that funds should face higher scrutiny.

However, even as regulators threatened greater oversight, exposures continued to grow in some areas of the market. A paper published by the US Federal Reserve last week showed that hedge funds’ notional short positions in five- and 10-year US Treasuries were above all-time highs as of May 9.

An executive at a firm that makes big bets on bond markets argued that hedge funds had “overfished” in the market, and warned that regulatory caps on the amount of leverage these funds could access through the repo market would be next.

The FSB has already begun work on leverage in non-banks and on Wednesday said the area would be a “key area of policy focus in 2024”.

It wants to address “the most salient data gaps” on the exposures of non-bank financial institutions, potentially by pulling in information from trade repositories and from the banks providing them with leverage.

It also wants measures to contain “excessive leverage behaviour”, which could include higher requirements for haircuts and margins on derivatives and securities financing transactions, as well as “measures to enhance prime brokers’ risk management and improve the liquidity preparedness of non-bank investors”.

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