A hedge fund industry group has warned the Bank of England that proposed reforms to the market for short-term lending secured against UK government bonds could create new vulnerabilities and reduce liquidity during periods of market stress.
The Alternative Investment Management Association (AIMA) raised the concerns in a letter sent to the Bank of England this month and reviewed by Reuters. The group said expanding central clearing in the gilt repo market could expose investors to greater volatility and potentially make funding markets less resilient during a crisis.
The warning represents a more direct challenge to the BoE’s proposed reforms than AIMA’s response to the central bank’s initial proposals last year, when the industry group highlighted what it described as “significant structural issues.”
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The dispute comes as the global bond market selloff has pushed government borrowing costs sharply higher. In Britain, the yield on 30-year government bonds, or gilts, rose to its highest level since 1998 earlier this month, increasing scrutiny of the functioning of the gilt market and the role played by leveraged investors.
Repo markets are important because they allow investors to obtain short-term cash by using securities such as government bonds as collateral. Hedge funds use the market extensively to finance leveraged positions and trade interest-rate movements, while other investors use repo transactions to turn bond holdings into temporary cash.
The BoE is consulting on measures designed to make the gilt repo market more resilient. The proposals include expanding central clearing, where a central counterparty stands between buyers and sellers and guarantees trades.
The central bank is also considering minimum haircuts on repo transactions that are not centrally cleared. A haircut requires the borrower to provide collateral worth more than the amount of cash received, providing additional protection to lenders if the value of the collateral falls.
The reforms were prompted in part by two episodes that exposed weaknesses in financial markets: the “Dash for Cash” during the market turmoil of 2020 and the 2022 liability-driven investment crisis, when stress in UK government bonds was amplified by leveraged pension strategies and ultimately required intervention by the central bank.
AIMA’s latest concerns center on how the proposed changes could alter the behavior of hedge funds.
In a letter signed by its global head of markets, Adam Jacobs-Dean, AIMA said members had raised new questions about further expansion of central clearing. The association noted that the changes could encourage hedge funds to rely more heavily on daily repo financing instead of the typical two-week transactions they currently use.
That shift could leave funds more exposed to sudden changes in funding conditions.
AIMA said the proposed reforms could result in “greater volatility during times of market stress,” although it did not directly link its warning to the latest global bond selloff.
The argument presents a potential trade-off for regulators. Central clearing is intended to strengthen the market by reducing counterparty risk and improving transparency. But AIMA’s position is that changing the economics and structure of repo financing could alter investor behavior in ways that create different forms of vulnerability.
The concern matters for hedge funds because their positions can require substantial short-term financing. If access to that financing becomes less stable during a market shock, funds may be forced to reduce positions or sell assets rapidly, potentially adding to market volatility.
BoE Faces Pressure to Move Carefully
AIMA’s letter was prompted by an article on the Bank of England’s website by Deputy Governor Sarah Breeden, who said similar reforms were being pursued internationally.
The United States is preparing to introduce mandatory central clearing for Treasury repo transactions from next year. AIMA argued that the BoE should wait to assess how the US clearing mandate operates before introducing an equivalent requirement in the UK.
The approach would allow UK authorities to observe whether central clearing improves market resilience as intended or produces unintended effects for liquidity and funding.
The central bank has not yet decided which proposals from its consultation will be taken forward and has said any reforms would likely take years rather than months to implement.
Breeden has nevertheless indicated that maintaining the existing framework without changes is not considered sufficient.
“Doing nothing is not an option,” she said in July, warning that banks could withdraw repo financing more aggressively during a severe market shock.
The regulatory concern reflects the growing importance of hedge funds in sovereign bond markets. The International Monetary Fund said on Tuesday that hedge funds had increased their presence in the market. At the same time, the BoE has previously warned that greater activity by leveraged hedge funds in the gilt market has introduced new risks.
According to BoE data, net borrowing in the gilt repo market stands at about £200 billion ($270 billion), with hedge funds accounting for approximately £85 billion. That scale means changes to repo financing could have implications beyond individual hedge funds. If financing conditions become more restrictive or expensive, the effects could spread into gilt trading, market liquidity and the cost of government borrowing.
The issue also highlights a broader regulatory challenge that emerged from the 2022 gilt crisis. Authorities want to prevent leveraged investors from becoming forced sellers during periods of market stress, but measures intended to reduce leverage or strengthen collateral arrangements can themselves change how investors finance positions.
Against that backdrop, the BoE faces a major concern about how the structure of the market would behave when liquidity is under the greatest pressure.
AIMA’s call to observe the US experience adds another consideration. With the US Treasury market preparing for its own central-clearing mandate, regulators will have an opportunity to gather evidence on how such reforms affect funding behavior, liquidity and market stability before making comparable changes in Britain.
The debate comes at a sensitive time for the gilt market, where long-term borrowing costs have risen sharply, and concerns over fiscal sustainability have intensified. The outcome of the BoE consultation is expected to influence not only how hedge funds finance their positions, but also the resilience of one of Britain’s most important financial markets during the next major bout of volatility.