The European Central Bank flagged on Wednesday that highly-leveraged trades by hedge funds in regional bond markets pose a risk to financial stability.
Hedge funds typically use leverage ratios of around 25 when exploiting small price differences between similar assets, such as bonds and equivalent futures contracts, according to the ECB's Financial Stability Review. While these basis trades can support liquidity, they risk worsening market swings during periods of stress.
The ECB said leveraged positions may need to be unwound quickly if bond prices react sharply to geopolitical or risk sentiment shocks. This could erode the stable funding base of European governments by amplifying price movements and increasing volatility.
The warning adds to concerns from global regulators about potential market disruptions related to bond market leverage. Officials worry that rapid liquidation of positions by hedge funds could cause large price moves affecting financing costs for governments, companies, and consumers.
The Financial Stability Board said in February that yield curve or duration trades were the most popular hedge fund strategies in European bonds, with cash-futures basis trades also prevalent. These trades may involve a hedge fund using short-term borrowing to buy a bond to profit from the small price difference between the security and its corresponding futures contract.
Hedge funds pursuing arbitrage strategies have become an increasingly important source of liquidity in European government bond markets, the ECB said. However, their expanding role comes as traditional buyers of long-dated debt, such as pension funds, retreat from the market. The ECB is also withdrawing as it reverses years of quantitative easing.
The growing presence of more price-sensitive investors like hedge funds in euro area sovereign bond markets could amplify any abrupt repricing of sovereign risk, the ECB said. This could also raise the risk of spillovers to the funding costs of corporates and banks.
