The £77bn trade that risks throwing Britain into a doom loop

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2 days ago

Thirty years after George Soros broke the Bank of England, foreign hedge funds are circling again. And this time they're eyeing up the Government's bond market.
It may sound like a boring trade, but investors are making huge profits by borrowing tens of billions of pounds against UK debt, known as gilts.
The aim? To profit from minute differences between the cash price of a bond today and what it may be worth several days, weeks or months from now.
This strategy, known as a 'basis trade', makes money by exploiting the tiny gap between the two prices – buying one for a lower price and selling another for a higher price in a good old fashioned game of arbitrage.
Such is the high risk, low reward nature of these types of trades, that they have been likened to 'picking up pennies in front of a steamroller'.
But these 'masters of the universe', as Tom Wolfe once wrote, are far smarter than that. To really make it worth their while, hedge funds borrow money from banks to juice up their returns – turning these fractional pennies into big bucks.
Yet such is the popularity of the strategy that regulators are now becoming increasingly alarmed about the dangers these funds pose to the British financial system.
In many ways, their involvement has been welcome. Hedge funds – which face less regulatory scrutiny than banks – are performing the role of linking buyers and sellers that used to be done by more traditional lenders.
Thriving in an environment of high volatility, hedge fund traders are able to let their hair down in a way that banks cannot.
However, as Richard Hughes, the chairman of the Office for Budget Responsibility recently highlighted, these 'fickle and flighty' investors are more likely to be looking for short-term gains than a long-term relationship.
'These overseas investors are, by their nature as comparison shoppers in the global debt market, likely to be more fickle and flighty than their domestic counterparts,' he warned last month.
Andreas Dombret, a former German central bank official, puts it more simply: 'They're the first to leave the party if things get rough.'
The Bank of England is also keeping a close eye on developments. Its latest Financial Stability Report (FSR) warned that the big global footprint of these funds 'increased the risk that stress in one market could spill over into others' – triggering huge fire sales in times looming financial chaos.
So what could go wrong?
The role of hedge funds in the bond market has grown significantly in recent years.
Earlier this year, Bank deputy governor Sir Dave Ramsden said that hedge fund involvement in the gilt market had almost doubled from 15pc of trades in 2018 to around 30pc today.
Historically, pension schemes had been the largest buyers of gilts, particularly long-term debt. But this demand has started to dry up, as the era of the final salary pension scheme comes to an end, at least for private sector workers.
Part of the reason for hedge funds' huge appetite for gilts is that they can be used as collateral to borrow more money from banks.
To juice up their returns on the 'basis trade', hedge funds raise money through so-called repurchase agreements – or repos – where investors can swap bonds for cash.Gilts are put up as collateral: if banks don't get paid back they get to keep the gilts. And they use this money to buy more debt. As of June, hedge funds had borrowed £77bn from banks to recycle back into gilts – the highest level since records began in 2016.
This also represents the largest increase in borrowing across the so-called shadow banking sector, according to Threadneedle Street.
But it doesn't take a genius to spot the risks involved. If hedge funds are using their gilts to borrow money to recycle into more gilts, then it only takes one small unexpected price movement for the house of cards to start wobbling.
The Bank is watching this explosive growth closely over fears it could create another doom-loop spiral.
It said growing holdings of gilts by hedge funds also raised the risk of a borrowing shock, with 90pc of net borrowing on the repo market concentrated among just a handful of hedge funds.
'This concentration means that a rapid unwind of leveraged positions by a few key players could amplify shocks during periods of high volatility,' the Bank warned.
Households and businesses at risk
It's not just investors that risk getting hurt. The Bank has warned that a wider leverage-fuelled sell-off could push up borrowing costs for households and businesses.
After all, the liability driven investment (LDI) crisis triggered by Liz Truss's mini-Budget pushed up mortgage costs for millions of borrowers.
Andrew Bailey's recent inaugural speech as head of the world's most powerful financial watchdog, the Financial Stability Board (FSB), saw him warn about the dangers of history repeating itself.
Reeling off a list of near misses in terms of financial meltdowns, he noted that American hedge funds were forced to unwind $90bn (£66bn) of their so-called 'basis trade' positions as they became largely loss-making.
'Public authorities had to intervene in unprecedented ways to prevent further market dysfunction and strain on the real economy,' said the Bank of England Governor, as he described the US bond market seizure triggered by Donald Trump's 'liberation day' tariffs as a 'near miss'.
However, a drive for more financial reporting and disclosure has met with resistance and has been watered down after a backlash from the industry.
Back in the UK, regulators are pressing ahead with proposals for more scrutiny, with a discussion paper in the works that could ultimately push more government bond trading towards central clearing houses, which charge a margin that effectively eats in to how much hedge funds can borrow.
Policymakers are also examining whether regulators can impose lower valuations lower than the market price on assets used to back a repo transaction, also removing the appeal of borrowing this way.
Changes in how the gilt market functions are likely to be permanent.
Regulators must now scramble to keep up as the risks continue to keep central bankers around the world awake at night.
Soros may have broken the Bank of England. But the Bank must be ready to make sure it doesn't happen again.
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