Hedge funds dominate UK debt markets, raising stability concerns

Hedge funds are increasingly becoming a major player in the UK government bond market, known as the gilt market. This trend raises concerns about potential instability in a market vital for government borrowing, including mortgages. In recent months, hedge funds accounted for 60% of gilt trading volumes, an increase from 53% at the end of 2023. Bank of England chief Andrew Bailey highlighted the risks from non-bank institutions, such as hedge funds, underscoring their role in creating liquidity issues in main UK financial markets. Analysts note that hedge funds add volatility to the market, sometimes leading to chaotic trading conditions. The UK gilt market is much smaller than the U.S. Treasury bond market, affecting borrowing costs for the government and, consequently, for households and businesses. Regulators are watching how hedge funds operate in repo markets, which help them fund their gilt positions. Repo markets allow institutions to borrow money against their bonds. A group of hedge funds, including major players like Brevan Howard and Millennium Management, are using repos to make several bets against UK bonds. These bets include speculating on the relation between 10-year gilt prices and their futures, anticipating that UK inflation will remain high, and betting against 10-year gilts in a recent market trend. The collective actions of hedge funds could strain the repo market, critical for other institutions like pension schemes, which rely on it for financial stability, especially during volatile times. The Bank of England has created a new liquidity facility aimed at mitigating risks for gilt holders, but access is limited to those holding significant amounts of UK bonds. As the release of official growth forecasts approaches, experts warn that quick sell-offs by hedge funds during market shocks could lead to broader instability in the financial system.