MNI INTERVIEW: Must Tackle Hedge Fund Debt Risk - BIS's Gelos

The growing dependence of sovereign borrowers on hedge funds risk liquidity shocks which could spill into FX swap markets and create “a dash for dollars” unless addressed by regulation, the head of financial stability at the Bank for International Settlements told MNI.

While sovereigns with heavy borrowing needs have benefitted from having hedge funds among their investor base, they are highly price-sensitive and can be hit by margin calls in times of stress, the BIS’s Gaston Gelos said in an interview, echoing calls by BIS General Manager Pablo Hernandez de Cos for minimum haircuts on borrowing and greater use of central clearing.

"The policy trade-off is between having slightly reduced liquidity in normal times, versus a more resilient system that is less prone to severe, and socially very costly, disruption when market stress arises," he said. "This is particularly important at the time of continued high sovereign debt issuance."

"So yes, it is important to preserve market efficiency, but we also are concerned about the evaporation of liquidity in stress episodes, the fragility of liquidity.”

DASH FOR CASH AND FX SWAPS AT RISK

Liquidity risks would not be limited to the sovereign debt market. Margin calls could trigger a "dash-for-cash" that could also create downward spirals in FX derivative markets. 

The interconnectedness of the FX swap and sovereign debt repo markets means that "stress in the repo market could quickly spread to the FX swap market or the other way around," Gelos said, because "if stress in the repo market lowers banks' risk-taking capacity, they're likely to retrench from the FX swap market as well."

 "Hedge funds would face margin calls on their leveraged positions, which would risk triggering a deleveraging spiral that could be destabilising, including in its international dimension with the dash-for-dollars that I was alluding to. The nature of FX swaps implies that if they're not rolled over, say, because the dealer banks are retrenching, that means that the investors, e.g. the asset managers or pension funds, will have to come up with the full notional amounts of the underlying contract ... that could cause a global scramble for dollars," he said.

 The interconnectedness of these markets mean that "we now have a broader connection between financial institutions and sovereign debt."

POLICY OPTIONS

In a speech in November at the LSE, the BIS’s Hernandez de Cos said reining in non-bank financial institutions’ leverage "should be a key policy priority.”

The Bank of England is undertaking a review of the gilt market. In response to a question from MNI at a recent event at King's College London, BOE Deputy Governor David Ramsden said "we don't think the status quo here is an option," but that neither greater use of central clearing nor minimum haircuts are reforms that you "can do overnight."

According to Gelos, enhancing the resilience of these markets "probably requires a multi-pronged approach.”

"Another key issue is data: understanding and monitoring the complex and constantly changing bank and NBFI leverage is one of the biggest challenges these days facing supervisors and regulators, but also private sector participants, and there are many blind spots."

The BIS could play a leading role in closing the data gap, Gelos said.

"Some of the current challenges stem from the trajectory of public finances in several economies, and addressing that is also a critical policy priority," he added. (See MNI INTERVIEW: UK Debt Stabilisation Insufficient - NIESR Head)

"International coordination could be helpful, given the global nature of sovereign debt markets and the growing role of internationally active NBFIs.”