Introduction to Financial Stability
The new head of the Bank for International Settlements, Pablo Hernández de Cos, has emphasized the importance of regulating hedge funds’ ability to make highly leveraged bets in government bond markets. This concern arises from the rapidly increasing public debt levels and the growing role of non-bank financial institutions (NBFIs) such as hedge funds in bond markets.
The Risk of Leveraged Bets
The worry is that hedge funds are using leveraged "relative value" trades, which look to exploit small price differences between bonds and their futures contracts. These strategies have become popular in the U.S. and other major economies but have been in the sights of regulators after margin calls on U.S. Treasury future trades in 2021 fueled a bout of turmoil in the world’s biggest government bond market.
The Extent of the Problem
De Cos highlighted that around 70% of bilateral repos taken out by hedge funds in U.S. dollars and 50% in bilateral repos in euros are offered at zero haircut, meaning that creditors are not imposing any constraint on leverage using government bonds. This lack of constraint can lead to significant financial stability risks, especially considering that the debt-to-GDP ratio of advanced economies is projected to reach 170% by 2050 absent fiscal consolidation.
Proposed Solutions
To address this issue, de Cos suggested a "carefully selected combination of tools." He highlighted two specific measures as likely to be particularly effective: the greater use of central clearing, so government bond market players are treated more equally, and the application of "minimum haircuts" – or discounts – to the value of the bonds hedge funds use as collateral, to limit their leveraged plays.
The Importance of Central Bank Independence
De Cos also emphasized the importance of central bank independence in maintaining financial stability. He stated that keeping inflation in check will remain the most effective way to support debt sustainability by reducing risk premia. Additionally, he noted that central bank swap lines remain "critical" to stabilize the global financial system at times of acute distress.
Conclusion
In conclusion, the growing intermediation of record-high public debt levels by NBFIs introduces significant new financial stability challenges. To address these risks, policymakers must prioritize reining in NBFI leverage and consider implementing measures such as central clearing and minimum haircuts. By doing so, they can help maintain financial stability and support debt sustainability, ultimately ensuring the stability of the global financial system.
