Rising Systemic Risks in UK Gilts: The Hidden Dangers of Hedge Fund Leverage and Basis Trades

The UK gilt market, long a cornerstone of global fixed-income stability, is facing an emerging threat from concentrated leverage and speculative strategies employed by hedge funds. According to a Bloomberg report, net gilt repo borrowing by hedge funds has surged to nearly £100 billion as of November 2025-the highest level since data collection began-raising alarms among regulators about systemic vulnerabilities. This escalation is driven by the proliferation of basis trades, a strategy that exploits price discrepancies between gilts and their futures contracts. While these trades are not inherently destabilizing, their scale and the leverage deployed have created conditions ripe for volatility, particularly in times of market stress.

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The Mechanics of Leverage and Basis Trades

Basis trades involve borrowing gilts through repurchase agreements (repos) to short-sell them, profiting from narrowing spreads between cash bonds and futures. However, the current environment has incentivized excessive leverage. Data from Bloomberg indicates that over 60% of this borrowing is managed by U.S.-based hedge funds, with a handful of firms accounting for over 90% of net repo activity. This concentration amplifies risks: if a small number of participants face margin calls or unwind positions abruptly, the cascading effect could destabilize broader gilt markets.

Compounding the issue is the prevalence of zero haircuts on non-centrally cleared repo transactions, which allows hedge funds to borrow gilts with minimal collateral according to Bloomberg. This practice, while boosting liquidity in normal conditions, reduces buffers during downturns. As the Bank of England (BoE) has noted, such arrangements leave the system vulnerable to self-reinforcing sell-offs, where falling gilt prices trigger further deleveraging and downward spirals.

Regulatory Dilemmas and Market Competitiveness

The BoE is reportedly considering reforms to mitigate these risks, including imposing minimum haircuts and increasing central clearing of repo transactions according to Bloomberg. These measures aim to enhance resilience by reducing leverage and improving transparency. However, industry groups have pushed back, warning that such interventions could undermine the liquidity and global appeal of UK gilts. Hedge funds argue that stringent haircuts would raise capital costs, potentially driving trading activity to less-regulated markets or displacing smaller participants according to Bloomberg.

This tension reflects a broader challenge for regulators: balancing stability with market efficiency. While the BoE's concerns are valid-particularly given the crowded nature of current positions-the industry's counterarguments highlight the risk of overreach. A poorly calibrated regulatory response could inadvertently weaken the very liquidity the BoE seeks to protect.

Lessons for Systemic Risk Management

The current situation in UK gilts mirrors historical patterns where leveraged arbitrage strategies, when scaled excessively, have contributed to market fragility. Though specific precedents for gilt basis trades are limited, parallels can be drawn to the 2008 financial crisis, where concentrated leverage in mortgage-backed securities amplified contagion. The key takeaway is that regulators must act preemptively to address leverage imbalances without stifling functional market dynamics.

For now, the BoE's proposed reforms remain in the evaluation phase, with no clear timeline for implementation according to Bloomberg. Investors and policymakers alike must monitor developments closely. The gilt market's resilience has long been a source of confidence for global investors, but the growing reliance on leveraged basis trades threatens to erode that trust. A calibrated approach-combining targeted leverage limits with enhanced transparency-may be the only way to preserve both stability and liquidity in this critical asset class.