The Bank of England (BoE) published its latest financial stability report, which sets out its Financial Policy Committee’s (FPC’s) view of the outlook for UK financial stability, including its assessment of the resilience of the UK financial system and the main risks to UK financial stability, and the action it is taking to remove or reduce those risks.
The FPC noted that leveraged borrowing by hedge funds in gilt repo markets remains elevated, reaching close to £100 billion ($132.2bn) in November. Data suggests this activity is related, at least in part, to the popularity of the cash-futures basis trade. A small number of hedge funds account for more than 90% of net gilt repo borrowing, with trades often transacted at zero or near-zero collateral haircuts and at very short maturities and so require regular refinancing.
These vulnerabilities, in the context of compressed risk premia in a highly uncertain global environment, increase the risk of sharp moves. Funds could need to deleverage simultaneously in response to a shock if funding conditions tightened to the extent that refinancing became unavailable or prohibitively expensive. This reinforces the need for market participants to ensure the risk management of their positions takes account of potential shocks, including correlation shifts outside historical norms.
In September, the Bank, in close consultation with the UK Financial Conduct Authority (FCA), and with input from HM Treasury and the UK Debt Management Office (DMO), published a discussion paper evaluating the effectiveness and impact of a range of potential reforms to enhance the resilience of the gilt repo market; such as, greater central clearing of gilt repo and minimum margin requirements on non-centrally cleared gilt repo transactions. Any structural reforms identified through this work will take time to implement, which underscores the importance of market participants ensuring their own preparedness for shocks.
In addition, the FPC said it will review the implementation of the leverage ratio in the UK to ensure that it functions as intended and announced that there will be a private markets stress test.