BIS Chief Warns Rising Hedge Fund Leverage Could Strain Global Bond Markets

The head of the Bank for International Settlements says fast-growing hedge fund leverage in government bond markets poses emerging risks for financial stability as global debt levels continue to rise.

The Bank for International Settlements has issued a new warning about the growing use of highly leveraged hedge fund strategies in government bond markets, saying the trend could amplify volatility at a time when public debt across advanced economies is expanding at an unprecedented pace.

The organisation’s new General Manager, Pablo Hernández de Cos, highlighted the increasing involvement of non-bank financial institutions in sovereign debt trading and said their activities require close attention from regulators worldwide.

Speaking at the London School of Economics, he explained that hedge funds are taking on substantial leverage to execute “relative value” strategies that depend on exploiting small pricing gaps between government bonds and related futures contracts.

These trades have grown significantly in major economies, particularly in markets like U.S. Treasuries, where sudden stress events in recent years exposed vulnerabilities in the system.

The concern stems from the way many hedge funds are accessing leverage through bilateral repurchase agreements that allow them to borrow against government bonds with no haircut applied, leaving lenders with little protection.

He noted that a large share of dollar-denominated and euro-denominated repo agreements used by hedge funds now involve zero-haircut terms, enabling leverage to accumulate with minimal constraints.

This structure, he warned, creates conditions under which small market disruptions can rapidly translate into significant instability, especially when firms face margin calls or struggle to unwind positions quickly during turbulent periods.

Past episodes, including sudden dislocations in U.S. Treasury markets, have shown how leveraged trades can intensify volatility and spread stress more widely across the financial system.

The BIS chief said these risks are magnified by the long-term trend of rising government debt, which is expected to continue due to demographic pressures, higher defence spending, and limited progress on fiscal consolidation.

Projections indicate the debt-to-GDP ratio of advanced economies could climb to 170% by 2050 unless substantial adjustments are made, increasing the importance of ensuring stability in government bond markets.

He emphasised that addressing the issue of non-bank leverage should now be considered a key policy priority for central banks and regulators, given the growing share of sovereign debt held or intermediated by institutions outside the traditional banking sector.

The interaction between high debt levels and leveraged market plays, he said, represents a structural challenge that will require careful monitoring and targeted regulatory tools.

Among potential measures, he pointed to the wider adoption of central clearing in government bond trading, a move that would create more transparent and consistent risk management standards across market participants.

Central clearing, he explained, could help reduce uneven leverage practices while improving oversight of exposures that currently sit within bilateral arrangements.

He also highlighted the introduction of minimum haircuts on government bonds used as collateral as another effective tool to limit unchecked leverage in repo markets.

By requiring a small discount on collateral value, authorities could reduce the extent to which hedge funds can borrow against bonds without facing meaningful constraints on their positions.

He stressed that such measures would need to be calibrated carefully to avoid disrupting market functioning while still providing an important buffer against excessive leverage.

Targeting specific segments where risks are most concentrated, he said, would allow regulators to strengthen stability without imposing unnecessary restrictions on broader market activity.

Beyond leverage management, he reiterated that central bank swap lines remain a crucial mechanism for preventing liquidity crises in global financial markets, especially during periods of heightened stress.

These arrangements, which allow central banks to exchange currencies and provide liquidity support, have proven essential in past episodes of market turmoil.

He also underscored that maintaining control of inflation remains vital for supporting debt sustainability because stable prices help keep borrowing costs lower and reduce risk premiums on government debt.

At the same time, he said that preserving central bank independence is more important than ever in an environment where sovereign creditworthiness is facing growing pressure.

The BIS message reflects a broader shift among global policymakers as they adapt to a financial landscape where non-bank institutions play an increasingly central role in shaping market behaviour.

For regulators, the challenge will be to strengthen oversight of leveraged activities while ensuring that sovereign debt markets continue to operate smoothly and efficiently.