Hedge funds have placed a £100bn bet on UK government bonds, a move the Bank of England says leaves Britain dangerously exposed to a potential bond market meltdown.
Governor Andrew Bailey will face questions from MPs on the Treasury select committee this week after Threadneedle Street expressed alarm over trades that allow hedge funds to borrow huge amounts of cash from banks using gilts as collateral.
Bank officials have warned that volatility in the bond market is unavoidable. They are concerned that trading by hedge funds could pose risks to the financial system.
Hedge funds now participate in a third of all gilt trades, up from 15% a few years ago. While borrowing against government debt is a traditional form of secured lending, hedge funds are making huge profits by exploiting tiny differences between current and future bond prices.
They use the risk-free status of gilts to borrow massive amounts against them, sometimes leveraging themselves up to 100 times over.
Bank data show hedge funds had borrowed £99.9bn from banks to recycle back into gilts as of the end of November. This represents a tenfold increase compared with just over a year ago, when the figure was less than £10bn.
Chris Coghlan, a Liberal Democrat MP on the select committee, highlighted a Bank warning that a small number of predominantly US hedge funds were responsible for 90% of all net borrowing.
"The Bank of England is right to be looking at the small number of hedge funds leveraging up and buying up large amounts of UK government debt, as it could amplify the impact of a market shock," Mr Coghlan said.
Bank officials have warned a sudden economic or financial shock could trigger "fire sales" in gilts, plunging financial markets into turmoil.
Economists have compared the risks in the UK to the US, where hedge funds' exposure to US Treasuries increased by almost $1tn between 2017 and 2019.
A sudden unwinding of huge bets in March 2020 during the pandemic's onset was blamed for fueling violent reactions in what is considered the world's most liquid market. Hedge funds sold more than $200bn of Treasuries in days as they unwound leveraged bets, reducing their total exposure by $430bn.
This caused bond yields to surge even as the stock market collapsed, forcing the US Federal Reserve to step in and buy $1tn of US debt to stabilize the market.
Mr Bailey said "very profound changes" in bond trades had occurred over recent years. "We are living in a period of more volatile markets," he said last year.
Regulators are finalizing proposals to curb risk-taking by hedge funds, including pushing trades toward central clearing houses that charge margins reducing hedge fund profits. The US has adopted similar proposals set to take effect in 2027.
Policymakers are examining whether regulators can impose a valuation lower than market price—known as a haircut—on assets backing repo transactions, removing the appeal of such borrowing.
Hedge funds have opposed regulatory proposals to limit risk-taking on gilts, warning stricter rules could force them to shun UK debt and raise Treasury borrowing costs. The Alternative Investment Management Association and Managed Funds Association have criticized the plans in response to a Bank discussion paper.
Sir Dave Ramsden, the Bank's deputy governor, warned last week that changes were coming. "We don't think the status quo here is an option," he said at an event. "Something needs to be done."