Regulators are finally starting to appreciate how much major government debt markets are being dominated by a handful of hedge funds. There’s a head of steam building around the issue; the Bank for International Settlements released an important analysis last week of the leverage involved, with the Bank of England's December Financial Stability Report also highlighting the risks to financial stability posed by the trading strategy. But we need to be careful about letting the air of out of this bubble.
What’s clear from both reports is that central bankers don’t have a coherent plan for reducing the leverage that’s metastasized in sovereign bonds in recent years. Asking nicely hasn’t worked; the dilemma is how to get hedge funds to suddenly reduce their market share without triggering a market meltdown, as I wrote in mid-November. A sudden withdrawal of liquidity, due to the imposition of overly onerous margins or forcing trades into centralized clearing houses, could usher in the next financial crisis rather than prevent it.
Understandably, hedge funds are pushing back, with the Alternative Investment Management Association and the Managed Funds Association — the two largest industry groups that represent hedge funds — both objecting to BOE plans for minimum margins on gilt repurchase agreements, according to letters sent to the central bank seen by Bloomberg News. While they’re acting out of self interest, ignoring their warnings would be a serious mistake. But the current policy vacuum can’t last much longer — it has to be filled with something.
Hopefully, conversations happening in the background reflect an appreciation of the perils of a too heavy-handed approach shown by Lee Foulger, the BOE’s director of financial stability, strategy and risk. In a Nov. 12 speech, Foulger said the central bank is “mindful that any measure or package of measures may have impacts on trading costs and market liquidity.”
Authorities are rightly paranoid about mitigating counterparty risk to avoid a repeat of the domino effect seen during the dark days of the global financial crisis, hence their eagerness to channel trades through a centralized clearing system. While that model works well in interest-rate swaps and other derivatives markets, it’s less suited to vanilla government bond and repurchase agreement markets.
One size really doesn’t fit all when it comes to financial plumbing. Many different types of trading function perfectly well with bilateral bank-to-client settlement; imposing third-party clearance would remove a profitable client-flow business for banks. But perhaps more importantly, repo trading provides significant real-time information for risk dissemination. Hauling clearing into one big collective warehouse may suit regulators who always want maximum clarity, but the unintended consequences on liquidity could be profound.
