Hedge funds should face limits on leverage, global regulator recommends

By Tommy Reggiori Wilkes and Valentina Za

LONDON/MILAN (Reuters) -Regulators should consider limits on leverage used by non-bank financial firms such as hedge funds as well as measures to curb their size, the Financial Stability Board (FSB) said on Wednesday in a series of recommendations to make “shadow banking” safer.

Non-bank financial institutions, including hedge funds, private credit providers and insurers accounted for $218 trillion, or just under half, of the world’s financial assets in 2022, according to the G20’s FSB, a group comprising the world’s biggest financial regulators and authorities.

The sector’s rapid expansion is a growing priority for regulators, concerned about its lack of transparency and the risk its problems could threaten the resilience of broader financial markets.

Hedge funds, for example, have been blamed for exacerbating market chaos at the start of the COVID-19 pandemic in 2020 when they scrambled to unwind $90 billion of so-called basis trade positions in the U.S. Treasury market.

Presenting the report on Wednesday, FSB Chair Andrew Bailey said their actions contributed to “extreme illiquidity in government bond markets” and forced public authorities to intervene to protect markets and the real economy.

Other episodes of dysfunction cited in the report include the collapse of private investment firm Archegos in 2021, and the market turmoil caused by a hedging tool used by British pension funds that almost imploded large parts of the industry in 2022.

“The growth of leveraged strategies, along with concentration, and crowded positions in certain markets, is concerning,” Bailey, who is also the Bank of England governor, said. “These trends can amplify shocks and impact liquidity,” he said, noting hedge funds’ huge role in the U.S., Canadian and British government bond markets, and how shocks in one country could easily spill over to other markets.

“Implementing the report’s recommendations is therefore critical,” Bailey said.

Wednesday’s report, which is the culmination of several years’ work, calls for financial regulators to improve monitoring of the non-bank sector and to intervene directly, if needed, to make their financial systems safer.

Non-bank players have been critical of calls for more regulation, saying they play a vital role in markets functioning efficiently and in supporting liquidity.

Among the FSB’s recommendations is a call for supervisors to introduce, when needed, direct limits on leverage used by non-banks in core financial markets.

The report also recommends enhanced margin requirements in derivatives markets, curbs to limit the over-concentration of firms, the requirement for participants to report large positions and a call for improved regulatory co-ordination.

“The report’s recommendations on blunt entity-level caps and minimum haircut requirement are not appropriate tools to reduce risk in the financial system, and could have unintended, negative consequences for economic growth and financial stability,” said Bryan Corbett, President and CEO of MFA, a trade body representing hedge funds and private credit firms.

Collecting data on the role of non-banks to improve surveillance remains a key challenge, as does ensuring policies agreed internationally are implemented locally, Bailey said in a speech.

The FSB said it would now help authorities apply its recommendations, with members considering later this year whether more work was necessary for certain proposals.

(Reporting by Tommy Reggiori Wilkes and Valentina Za, Editing by Louise Heavens and Tomasz Janowski)

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