Hedge Funds: The New Wildcard in UK's Debt Markets

The UK's gilt market, a cornerstone of British borrowing costs, is facing a new threat: hedge funds. These financial heavyweights have crowded into debt-fueled bets on UK government bonds, increasing the potential for instability in a market already grappling with volatility. The Bank of England has warned that non-bank institutions like hedge funds can propagate liquidity stress in core UK financial markets, notably the gilt market. This is partly due to their activity in short-term lending markets, which can exacerbate market volatility.

The scale of hedge fund involvement is staggering. Data from electronic trading platform Tradeweb shows they accounted for 60% of UK government bond trading volumes in January and February 2025, up from around 53% at the end of 2023 and at least a five-year high. This dominance has led to chaotic trading conditions, with large hedge funds pushing the market around and sometimes with limited real money involvement relative to their activities.

One of the key risks is the potential for liquidity stress in core UK financial markets. Hedge funds use repo financing for three distinct bets against gilts: shorting the basis trade, betting on high UK inflation, and trend trading against 10-year gilts. These activities can lead to a disproportionate share of borrowing available in the UK repo market, a key part of the financial system's plumbing.

The Bank of England warned in November 2024 that hedge funds' rising share of repo borrowing could deprive other institutions of funding, especially if banks lend less during spells of market stress. Among those vulnerable to gilt selloffs are pension schemes, which borrow in repo markets to finance hedging positions. These derivatives contracts require more cash to secure them when gilt yields rise, which if the repo market is tight can trigger fire sales of liquid assets, including gilts, accelerating the selloff.

The impact of hedge funds' strategies on the broader financial system and other market participants is significant. Increased volatility, strain on the repo market, potential fire sales, and impacts on government borrowing costs are all potential consequences. The gilts market, with roughly 2.5 trillion pounds ($3.2 trillion) of debt outstanding, is a benchmark for borrowing costs in Britain, including mortgages. Volatility in bond markets affects government borrowing costs and credit conditions for households and businesses.

To mitigate these risks, several measures can be taken. Increased regulatory oversight, diversification of participants, stress testing and scenario analysis, enhanced transparency, and coordination with other financial institutions can help ensure the stability and liquidity of the gilt market. The Bank of England and UK regulators are already eyeing how hedge funds use repo markets to position in gilts, and increased oversight can help ensure that hedge funds do not use repo financing in a way that deprives other institutions of funding, especially during spells of market stress.

In conclusion, the increased participation of hedge funds in the UK gilt market poses significant risks to the overall stability and liquidity of the market. While hedge funds can provide liquidity and help reduce the cost of UK government borrowing, their activities can also lead to increased volatility and potential instability. It is crucial for regulators and policymakers to take proactive measures to mitigate these risks and ensure the stability of the gilt market.