London stocks slip as Bank of England flags AI-driven valuation risks

The Bank of England has warned of mounting risks in the gilt market stemming from a profitable hedge fund strategy known as the basis trade, urging market participants to strengthen risk management in order to avoid a disorderly unwinding that could ignite volatility in government bonds.

Hedge funds’ net gilt repo borrowing, in which cash is borrowed against gilts used as collateral, rose to almost £100bn in November, the BoE said on Tuesday. This is the highest level since data collection began and compares with an estimated £77bn in June.

The increase is linked to the cash futures basis trade, a relative value strategy that seeks to exploit small price differences between bonds and the corresponding futures contracts. Much of this activity is driven by funds based outside the UK, with hedge funds managed by US firms accounting for about 60% of positions.

“The small number of funds running crowded and heavily leveraged trades in the gilt repo market increases the potential risk of sharp moves as funds could need simultaneously to deleverage in response to a shock,” the BoE said. Market participants should “risk manage their positions to take account of potential shocks, including correlation shifts outside historical norms.”

Hedge fund involvement in government bond markets has become a growing concern for regulators as they seek to address risks accumulating in the non-bank financial sector. Repo markets are a key source of financing for a wide range of leveraged fixed income strategies, including the basis trade.

The BoE has previously warned that the expanding role of hedge funds in the gilt market increases the likelihood of fire sales. Its plan to introduce minimum haircuts on gilt repo transactions, which would limit the amount of leverage investors can assume, was criticised by industry groups last month, who said it would damage liquidity.

In the UK, the basis trade typically involves using repo financing to buy gilts and selling the corresponding gilt futures contracts to capture small price discrepancies.

On Tuesday, the BoE reiterated that a small group of hedge funds is responsible for more than 90% of net gilt repo borrowing and stated that the “opacity of parts of the gilt repo market” is hindering its supervisory work.

“Leveraged market participants can often serve a useful function by warehousing risk and intermediating between different types of market participants, thereby improving market liquidity and price discovery,” the BoE said. However, “forced or widespread deleveraging would have the result of amplifying initial moves and potentially triggering a feedback loop of further forced selling.”