FSB warns of risks posed by hedge funds’ hidden leverage
by Laura Noonan and Costas Mourselas   /  September 6, 2023

“Financial policymakers have singled out a group of hedge funds as a potential source of market instability in an escalation of existing concerns about the impact of their bets on bonds. The Financial Stability Board, comprised of the world’s top finance ministers, central bankers and regulators, warned on Wednesday that some hedge funds had “very high levels of synthetic leverage”.

Synthetic leverage refers to debt created by the use of derivatives or other complex financial instruments that frequently does not show up on balance sheets. The FSB did not name specific institutions, but referred to strategies related to recent market ructions, such as the default of Archegos Capital Management in 2021 and turmoil in the US Treasuries market this year. Regulators find synthetic leverage more problematic to evaluate than outright borrowing because it is more difficult to measure institutions’ exposures and liabilities can rise quickly. The policymakers also said hedge funds could have “hidden leverage” because they typically borrow from several prime brokers to increase the size of their bets.

“A few prime brokers dominate the provision of lending to hedge funds, and this concentration could amplify shocks and propagate them through the financial system,” it said. The role played by hedge funds and other financial institutions such as asset managers and pension funds in bond markets has come under increased scrutiny since March 2020, when US government bond yields dramatically increased as demand evaporated. The Archegos default also underlined how leverage could cascade through markets and the banking system when the fund’s series of highly concentrated bets on share price moves soured.

The FSB said markets remained “vulnerable” to “further liquidity strains” from so-called non-bank financial institutions. “Within the hedge fund sector, there is a group of funds, typically pursuing macro and relative-value strategies, with very high levels of synthetic leverage,” it added. Macro hedge funds take bets on direction of assets or interest rates. Relative-value ones aim to exploit market inefficiencies such as the difference between the price of futures contracts and the underlying asset. Hedge funds’ leveraged bets on bonds were blamed in March this year for exacerbating turbulence in the US Treasuries market, prompting Securities and Exchange Commission chair Gary Gensler to tell the Financial Times that funds should face higher scrutiny.

However, even as regulators threatened greater oversight, exposures continued to grow in some areas of the market. A paper published by the US Federal Reserve last week showed that hedge funds’ notional short positions in five- and 10-year US Treasuries were above all-time highs as of May 9. An executive at a firm that makes big bets on bond markets argued that hedge funds had “overfished” in the market, and warned that regulatory caps on the amount of leverage these funds could access through the repo market would be next.

The FSB has already begun work on leverage in non-banks and on Wednesday said the area would be a “key area of policy focus in 2024”. It wants to address “the most salient data gaps” on the exposures of non-bank financial institutions, potentially by pulling in information from trade repositories and from the banks providing them with leverage. It also wants measures to contain “excessive leverage behaviour”, which could include higher requirements for haircuts and margins on derivatives and securities financing transactions, as well as “measures to enhance prime brokers’ risk management and improve the liquidity preparedness of non-bank investors”.

Top global regulator warns of ‘massive adjustment’ for financial system
by Hannah Brenton  /  April 28, 2023

“The world’s financial system needs a “massive adjustment” to cope with higher interest rates, and key rules will have to be revisited, according to a top global regulator. Klaas Knot, chair of the Financial Stability Board, an international standard-setting body, told POLITICO that rising interest rates fueled problems at several regional U.S. banks and similar losses may show up elsewhere. “The speed with which interest rates have changed, that, of course, implies a massive adjustment in the financial system,” the Dutchman said in an interview from his office in Amsterdam. He added it was unclear exactly where those losses would be. “In many, many places of the financial system, that adjustment will go well because it has been well-anticipated and has been well-managed.

But history teaches us that is not always the case everywhere.” The warning of potential trouble ahead echoes fears of other global officials and comes after the failure of Silicon Valley Bank, a $200 billion lender to the tech sector, sparked contagion across U.S. regional banks. The subsequent market panic contributed to bringing down Credit Suisse in Europe, forcing the Swiss government to hastily merge the lender with UBS. Any domino effect can have huge impacts for the economy, businesses and households. “We’ve seen the impact of rapidly changing interest rates manifest in the second tier of the regional U.S. banks,” Knot said. “But I would be very surprised if that was the only sub-sector of the financial system where you would have a significant impact.”

Despite the turmoil, Knot said he was more worried about risks stashed at “nonbanks” — a term that encompasses investment funds, insurers, private equity, pension funds and hedge funds — where authorities have less visibility on hidden losses. “If they are hidden for a very long period of time, sometimes the problem then grows so big, that it only becomes unhidden or visible when it’s too big to deal with,” he said. The FSB boss pointed to financial players that took the wrong side of a bet on interest-rates and may now be nursing losses. “I hope, of course, that this is well-dispersed over the financial sector,” he said. “Where we are worried is specific concentrations of such risk.”

In particular, he said, those losses could be amplified when there is a mismatch between hard-to-sell assets and easy withdrawals, and borrowed money is used to juice returns. That combination has worried authorities for some time — but Knot said this didn’t mean regulators are behind. For instance, the FSB, whose membership includes central bankers, financial regulators and finance ministries, will issue recommendations for open-ended investment funds in July. Under the plans, regulators would get more powers to trigger restrictions in a crisis, rather than leaving those decisions in the hands of the fund manager.

The financial rulebook will need to be revisited substantially in light of recent events, he said. “It’s a mistake to see the regulatory framework as something that is fixed, and something that should not be touched,” he said. “The financial industry is not at all fixed, it is continuously evolving. So, the regulatory framework should evolve with the evolving risks.” The Dutchman said this means revisiting assumptions about how quickly banks can sell assets to meet depositor withdrawals, the speed of those withdrawals in a digital era, and the reserves that have to be set aside to cover potential unrealized losses from interest-rate risks — all of which were factors in the U.S. bank collapses.”



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