The Bank for International Settlements (BIS) is urging policymakers to rein in hedge funds’ use of leverage in government bond markets. The call to action comes amid concerns about rapidly increasing public debt levels. Pablo Hernández de Cos, the new General Manager of the BIS, highlighted the combination of high debt and the growing role of non-bank financial institutions (NBFIs) as potential risks to financial stability. The Bank for International Settlements acts as an umbrella body for central banks, fostering international monetary and financial cooperation. The organisation also serves as a bank for central banks.
De Cos pointed specifically to leveraged “relative value” trades, such as cash-futures basis trades, which exploit minor price discrepancies between bonds and their futures contracts. These strategies, popular in the U.S. and other major economies, have drawn regulatory scrutiny following margin calls on U.S. Treasury future trades in 2021. He noted that a significant portion of bilateral repos taken out by hedge funds in both U.S. dollars and euros are offered at zero haircut, which allows for unrestricted leverage using government bonds.
With projections indicating that the debt-to-GDP ratio of advanced economies could reach 170% by 2050, driven by factors such as ageing populations and rising defence spending, de Cos emphasised that controlling NBFI leverage is a key policy priority. He suggested a combination of measures, including greater use of central clearing and the implementation of minimum haircuts on the value of bonds used as collateral by hedge funds. The BIS believes such targeted haircuts should be applied to limit leveraged plays.
De Cos also underscored the importance of central bank swap lines in stabilising the global financial system during times of distress. He added that maintaining low inflation and central bank independence are vital for supporting debt sustainability by reducing risk premia. He stated that credible monetary policy and central bank independence are crucial in the face of deteriorating sovereign creditworthiness.
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