Global hedge funds besiege Bank of England: Repo "haircut" rule will depress appeal of gilts

Global hedge funds are resisting a proposal from the Bank of England aimed at limiting the risk-taking of British bond traders, arguing that such controls or policies will harm liquidity and the attractiveness of the market for global investments. According to reports, the Alternative Investment Management Association and the Managed Funds Associationtwo major industry organizations representing global hedge fund institutionssent a letter to the Bank of England stating that they do not support the proposed plan to set a "minimum haircut" for repurchase agreements on so-called gilt-edged bonds (British government bonds). Such policies would effectively limit the amount of cash assets investors can borrow using gilt-edged bonds as collateral, thereby restricting the ability of hedge funds to accumulate leverage. While these groups support another proposal to direct more trades towards central clearinghouses, they expressed concerns in their submission to the Bank of England's consultation ending this Friday that mandatory clearing may be going too far given the current readiness of the market. The Bank of England has put forward these trading proposals in an effort to prevent a repeat of a market meltdown. British government bonds experienced record selloffs following former Prime Minister Liz Truss's 2022 "mini-budget," driven largely by leveraged British pension fund strategies being forced to unwind. "If the UK leads the way with minimum margin haircuts, we are concerned that some sophisticated traders may infer a higher risk to UK government debt," said Adam Jacobs-Dean, Global Head of Markets, Governance, and Innovation at the Alternative Investment Management Association, in a letter to the Bank of England. "This could weaken the attractiveness of gilt-edged bonds as an investment, reduce liquidity, and increase the borrowing costs for the UK government." Representatives from the Bank of England did not immediately respond to requests for comment. Their proposals are the latest efforts by the Bank of England to curb the risks of gilt-edged bond trading and mark the first time that the repurchase market has been targeted specifically. The Bank's System Wide Exploratory Scenario, a stress test on the UK financial system, highlighted some risks "significant enough to threaten financial stability and the real economy," as Sarah Breeden, Deputy Governor for Financial Stability at the Bank of England, stated in a speech in May. The repurchase market has already entered the forefront of global regulatory agendas, with officials from financial regulatory bodies eager to control the risks posed by non-bank financial institutions (NBFIs) leveraging up. In the United States, most repo agreements collateralized by US government bonds will have to undergo centralised clearing beginning in mid-2027. Hedge funds' views are crucial as their trading activity in the global gilt-edged bond market becomes increasingly active. According to a recent Financial Stability Report from the Bank of England, hedge funds' borrowing based on net repurchases has risen to 77 billion (approximately $102 billion) as of early June, the highest level since tracking began in 2016. The Bank of England stated that a few unnamed hedge funds accounted for about 90% of this figure. "In normal times, they play a valuable market-making role by intermediating between different types of market participants," the regulatory report said. However, "in periods of heightened volatility, a few key participants rapidly unwinding leveraged positions in gilt-edged bonds could amplify shocks." The most contentious policy is regarding haircuts, which refer to the difference between the market value of a bond and its cash valuation as collateral in a repo transaction. For example, if a bank lends 95 against a 100 bond, it equates to a 5% discount. Bank of England officials are concerned that due to fierce competition among dealers in offering cheap leverage to clients, many repo transactions do not include such discounts. Lee Foulger, Head of Financial Stability, Strategy, and Risk at the Bank of England, stated that over half of the gilt-edged bond repo transactions not cleared through central clearinghouses were conducted at zero discounts. "In repo transactions of gilt-edged bonds between dealers and clients, zero or near-zero haircutting means NBFIs can build up leverage almost costlessly," Foulger said in a speech earlier this month. He emphasized that this "could lead to significant or unexpected liquidity expansion demands that arise from collateral or margin calls, and could trigger forced sales and amplify market sell-off pressures." The image above shows that UK sovereign bond yields remain high, with borrowing costs in the country exceeding highs set in 2022 over multiple fluctuations. Market participantsincluding industry organizations representing hedge fundsessentially believe that observing only haircut data is not sufficient, and regulators should adopt a more "holistic" approach. They argue that zero haircuts reflect what the industry calls "portfolio margin, where banks determine collateral levels based on an entire trading counterparty's overall exposure rather than just their repo trades. "The lack of a haircut on a single trade does not imply that the position does not have an appropriate risk management framework," wrote Rob Hailey, Director of European, Middle Eastern, and African Government Affairs at the Managed Funds Association. In his latest remarks, Foulger invited institutions to provide "evidence" of such portfolio margin, so officials can assess how "this approach is specific to portfolio-level and to the entire market in both normal and stress periods." Another proposal from the Bank of England involves increasing the central clearing ratio for gilt-edged bond repo transactions. Industry organizations representing hedge funds urge regulators to provide incentives rather than take mandatory action as seen in the US. The Securities and Exchange Commission (SEC) in the US has already postponed its compliance deadline following industry complaints. "The market is not yet of a scale to compel a mandatory clearing at this time," said Hailey of the Managed Funds Association. "As the UK gilt-edged bond repo market grows, and the market infrastructure evolves, including broader market participants joining, the Bank of England could revisit this issue."