The European Securities and Markets Authority (ESMA) published a report on the EU alternative investment funds (AIFs)’ market and an article on the risks posed by leveraged AIFs in the EU.
Looking at hedge fund strategies, the highest levels of leverage are observed for funds implementing commodity trading advisor (CTA) strategies: the median leverage was around 330% in 2022, a decline from 475% in 2021. Leverage stems almost exclusively from the use of derivatives (synthetic leverage) for CTA funds. Hedge funds pursuing relative value strategies (which includes trading the cash futures basis on US Treasuries) also had a high median leverage (257% of the NAV), which relies on repo borrowing (436% of the NAV for all relative value hedge funds).
Commenting n the build up of leveraged short term positions in US Treasuries needing to be monitored due to the potential for margin spirals, Jo Burnham, Risk and Margining subject matter expert at OpenGamma, said: “Institutional investor betting on yield spread fluctuations between US treasuries to make a fast buck faced ballooning margin costs last year, according to research that we carried out.
“The margin for one lot of 2-year listed treasury futures surged from $330 in November 2020 to a staggering $1,265 as of November 20 2023, reflecting an alarming 283% increase. Similarly, the margin for 10-year treasury futures witnessed a significant uptick, rising from $1,540 to $2,200 in the same time period, representing a significant 42% increase.
“This is likely to compound a desire to hold cash this year, which could affect the funding costs that face institutional investors looking to engage in the treasury basis trade, which involves taking positions in debt markets that seek to profit from changes in yield spreads between US treasuries and interest rate futures.”
“Institutional investors now face a more complex landscape as they navigate the trade-off between holding cash and using securities in a market characterized by higher interest rates. As the margin costs for treasury futures continue to rise, traders will likely seek new ways to adapt their approach to maintain profitability in an environment marked by shifting monetary policy dynamics.”
In the report, ESMA confirmed the risks posed by real estate (RE) funds, in a context of declining volumes of transactions and falling prices in several jurisdictions. Existing liquidity mismatches in AIFs are particularly heightened by the high share of open-ended RE funds, some of which offer daily liquidity. This vulnerability could be systemically relevant in jurisdictions where RE funds own a large share of the RE market.
Looking at the full sector and specifically at the risks posed by leveraged AIFs, ESMA finds that:
- the size of the sector declined slightly (-3%) to €6.8 trillion ($7.4tn) in 2022 and AIFs account for 36% of the EU fund industry,
- the fall in value was mainly driven by valuation losses for funds exposed to bonds and equities amid adverse market developments in 2022,
- RE funds face multiple risks related to leverage, market footprint, valuation discrepancies and liquidity mismatches
leverage for hedge funds remains very high, and this may pose a risk of market impact. However, most of them also dispose of large levels of cash to address potential margin calls, which limits the risk of fire sales, - National Competent Authorities (NCAs) have reported risks posed by the Liability-Driven Investment (LDI) funds, which gain leveraged exposures to the UK government bond market. Risks have remained elevated, and the limits set after the severe stress experienced in September 2022 remain appropriate.