Top monetary watchdog recommends limits on hedge fund leverage | USAEMALL.com

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Hedge funds and other non-bank groups could face limits on the amount of leverage they can use and may have to provide more disclosure to regulators about their borrowing, under plans put forward by the world’s financial stability watchdog.

The Financial Stability Board (FSB) said on Wednesday that its recommended measures — which follow a consultation announced late last year — were designed to tackle the build-up of leverage in non-banks, which “can be an important amplifier of stress. If not properly managed, it can create risks to financial stability.”

The plans highlight the belief among central bankers and regulators that hedge funds and other non-bank actors such as private credit funds, which often make heavy use of leverage but enjoy lighter regulation than banks, pose one of the biggest threats to the global financial system.

Regulators have warned about the so-called Treasury basis trade, a highly leveraged bet in which hedge funds short US government bond futures while borrowing money to take a cash position, hoping the two prices will converge. The unwinding of this trade was blamed for a sharp sell-off in bond markets in March 2020, while hedge funds were also widely seen as exacerbating Treasury market turbulence in April this year.

On Wednesday, the Bank of England said it would consult on ways to address vulnerabilities in UK repo markets, with hedge fund borrowing reaching a record high of £77bn. A “small number of hedge funds” accounted for 90 per cent of net gilt borrowing, the BoE said.

However, major hedge funds and private credit groups have criticised plans to restrict how much leverage they take on, setting up a stand-off between some of the world’s most powerful investors and top global regulators.

The measures recommended by the FSB, which was set up by the G20 group of countries after the 2008 crisis to co-ordinate global financial regulation, include requiring non-banks to disclose more data on leverage, making more transactions centrally cleared, imposing tougher rules on borrowing via refinancing markets and even setting outright limits on leverage levels for some funds.

It provided a range of options for national regulators to choose from to “help guide authorities in selecting, designing, and calibrating policy measures”, it added.

The non-bank sector — which includes hedge funds, private equity, insurers and pension funds — has grown to almost half of global financial assets over the past decade, with “business models and strategies continuously evolving and often using leverage”, the FSB said. 

It said the measures would allow national authorities to “identify financial stability risks created by non-bank financial intermediation leverage and have appropriate policy measures in place to address the risks that they identify”.

The FSB also announced the creation of a new task force to identify and address areas where it lacks sufficient data on the build-up of leverage outside of banks. 

The task force will be led by Andrew Bailey, who this month took on a three-year mandate as FSB chair alongside his role as Bank of England governor. It will start by conducting a test case on “leveraged trading strategies in sovereign bond markets”. 

The FSB said it had “identified several data challenges that have hindered the effective assessment of non-bank sector vulnerabilities by authorities”. It plans to publish a report on sovereign bond leveraged trading strategies by the middle of next year.

As well as bond market turmoil in the early stages of the coronavirus pandemic and earlier this year, regulators’ concerns intensified following the collapse of family office Archegos Capital Management four years ago, which left investment banks with $10bn of losses, and the UK gilt market crisis three years ago, which was triggered by derivative-linked strategies in pension funds.

The FSB said there was a positive side to non-bank leverage, which “can enhance efficiency and support liquidity in financial markets”.

But it added: “This is only feasible when leveraged entities maintain sufficient headroom to increase risk and leverage, including having sufficient liquidity.”