By Phoebe Seers and Iain Withers
LONDON, Oct 7 (Reuters) - A hedge fund industry group has warned the Bank of England that proposed reforms to the market for short-term loans secured against UK government bonds, known as "repo", could backfire and reduce liquidity at times of market stress.
Industry body Alternative Investment Management Association wrote to the BoE this month in a letter, seen by Reuters, that implementing proposed central clearing in the market could create "new vulnerabilities"
and expose investors to more volatility.
It marks a more direct warning after the lobby's response last year to the central bank's initial proposals, which flagged "significant structural issues."
A global bond market selloff has put soaring borrowing costs in the spotlight, including in Britain, where 30-year yields on government bonds, or gilts, jumped to their highest since 1998 earlier this month.
Supervisors and financial authorities are watching closely the growing role of hedge funds in sovereign bond markets. The IMF said on Tuesday that hedge funds had grown their presence in the market, while the BoE has previously said that greater activity of leveraged hedge funds in the gilt market has introduced new risks.
The BoE is conducting a consultation on proposals aimed at making the gilt repo market more resilient, including by expanding central clearing, in which a central body stands between buyers and sellers and guarantees trades.
It also calls for minimum haircuts, or discounts on non-centrally cleared repo transactions, as a way of better protecting lenders and reducing the risk of asset fire sales during periods of market stress.
The proposed changes were in response to the 2020 "Dash for Cash" and the 2022 liability-driven investment crisis that exposed vulnerabilities that amplified market stress and ultimately required central bank intervention.
In a sign of growing concern, AIMA told the BoE this month that members had raised new questions about any further expansion of central clearing.
In a letter signed by its global head of markets Adam Jacobs-Dean, AIMA said the changes could encourage hedge funds to rely on shorter-term daily repo financing rather than typical two-week deals, which in turn could leave investors more exposed to disruption in funding markets.
AIMA did not directly reference the recent global selloff in bond markets but said the planned reforms could lead to “greater volatility during times of market stress”.
The letter was in response to an article on the BoE’s website by Deputy Governor Sarah Breeden that said similar initiatives were being pursued internationally, notably in the US Treasury market which will mandate central clearing for all Treasury repo borrowing from next year.
AIMA said that the BoE should wait to see how the US clearing mandate works before implementing it.
The BoE, which has said any reforms would likely take years, not months, declined to comment. The central bank has yet to decide on which proposals to take forward.
Breeden said in July that "doing nothing is not an option", warning that banks could pull repo financing more aggressively in a severe market shock.
Net borrowing in the gilt repo market — where traders seek to profit from moves in interest rates, and investors turn bond holdings into temporary cash — totals around £200 billion ($270 billion) according to BoE data, £85 billion of which is by hedge funds.
(Reporting by Phoebe Seers and Iain WithersEditing by Tommy Regiori-Wilkes and Tomasz Janowski)
