Some sovereign debt chiefs are increasingly welcoming the expanding presence of hedge funds in government bond markets, viewing these investors as beneficial contributors rather than sources of risk.
Shift in Perspective
The heads of the Canadian, German, and Italian government debt offices stated that the more active role now played by hedge funds is enhancing liquidity and market functioning. These remarks were made at the FT Global Bond Summit in London on Tuesday, following recent warnings from various regulators about the financial stability risks posed by leveraged hedge fund strategies.
“A year or so ago, we were fairly concerned, but our views have evolved and they’re more nuanced now,” said Matt Emde, director general for funds management at the Government of Canada’s department of finance. “It’s added depth to our markets, and we’re getting better pricing interactions because these hedge funds have been bidding very aggressively, they want the volumes.”
Hedge Funds as Shadow Dealers
Emde noted that hedge funds currently account for 30 to 50 percent of demand in Canadian debt auctions. He compared their role to that of “shadow dealers,” as they often warehouse bonds before selling them in the secondary market, thereby boosting liquidity for other investors.
However, the increased involvement of such funds has prompted regulators from Canada to the U.K. to warn that it could amplify volatility or make markets more vulnerable to sudden selloffs. In the U.K., where hedge funds control over half of electronically traded gilts, Bank of England Governor Andrew Bailey said earlier this year that a small number of funds using borrowed money could risk destabilizing the market if they unwound their positions simultaneously.
Similar Role to Bank Prop Desks
Tammo Diemer, a member of the executive board at the German Finance Agency, told the conference that hedge funds are now playing a role similar to that of proprietary trading desks at banks, which have been scaled back due to regulatory changes. He added that the market benefits from certain strategies, such as relative value trades between different products and countries.
While Italy’s debt chief agreed that hedge funds perform useful functions, such as closing price arbitrages, he also sounded a note of caution. “It’s clear that they may also represent a social risk, especially in the context of market instability,” said Davide Iacovoni, director general for public debt for the Italian finance ministry.
Systemic Risks and Budget Pressures
With sovereign borrowing costs having surged after the pandemic and again due to the war in Iran, pressure on government budgets has led many to pay closer attention to potential systemic risks. In 2022, a historic rout in U.K. bonds led to the ouster of former Prime Minister Liz Truss.
Looking ahead, the officials emphasized the importance of better understanding how to interact with hedge funds and the different strategies they employ. “You can’t paint all hedge funds with the same brush. You have to get to know who they are,” said Emde. “The flip side is that not all central banks and these other institutions are safe hands.”
