In a recent blog, researchers from the European Central Bank (ECB) scrutinized the way that hedge funds have substantially increased their trading activity in euro area government bond and repo markets and evaluated how this plays out for market functioning and intermediation.
In recent years, euro area government bond (EGB) markets have witnessed a surge in the activity of hedge funds, and among foreign investors, hedge funds have assumed a prominent role in EGB markets.
Data from Tradeweb show that hedge funds roughly doubled their volumes of EGB transactions in secondary markets from 2018 to 2023. According to this data, hedge fund activity represented 56% of volumes in the secondary market in 2023, up from 26% in 2018. This trend appears to have coincided with a migration of experienced staff from banks and asset managers to hedge funds.
Hedge funds’ presence could be a double-edged sword for market functioning. On the one hand, hedge funds are frequently credited with enhancing market efficiency and liquidity. On the other hand, they could also act as potential amplifiers of volatility and market shocks.
Reassuringly, the concentration of banks’ exposure to hedge funds has gradually declined over time, although it remains elevated. Additionally, hedge funds account for only about 10% of outstanding repo volumes and banks’ exposures are diversified across approximately 200 hedge funds.
Looking ahead, hedge funds are likely to remain key players in EGB markets, backed by both substantial financial and also human capital. However, questions remain about the persistence and the reliability of hedge funds’ presence in this market segment, particularly under conditions of market stress. The scale of their activities underscores the potential amplification effects of rapid strategy reversals, which could lead to heightened volatility and pose challenges for the smooth functioning of government bond markets.