The world’s biggest hedge funds are obtaining “substantially higher” leverage in bond markets than their smaller competitors, thanks to access to near-zero haircuts on repo transactions provided by major dealers, the Bank for International Settlements said in a report published Tuesday. The BIS findings add to growing regulatory concern about the buildup of risk in fixed-income strategies that rely heavily on borrowed money.
According to the report, the average haircut applied by banks to the 10 largest hedge funds was close to zero, enabling them to take on leverage at levels far beyond those achievable by smaller peers. Haircuts—reductions in the collateral value applied in repurchase agreements—play a crucial role in determining how much leverage hedge funds can access. Minimal haircuts significantly reduce borrowing constraints, effectively allowing some funds to magnify their positions at extremely low cost.
The analysis arrives as regulators intensify their examination of fixed-income trades such as the basis trade, where hedge funds use repo financing to capture small price discrepancies between a cash bond and its corresponding futures contract. Earlier Tuesday, the Bank of England urged market participants to scale back risk-taking to prevent disruptions, noting that hedge fund net gilt repo borrowing reached a record level near £100 billion in November. The BOE’s Financial Stability Report said a handful of large funds accounted for about 90% of that leverage.
“These large hedge funds are key clients of major dealers, giving rise to strong trading relationships that dealers appear to reward with more attractive haircut terms,” wrote BIS researchers Felix Hermes, Maik Schmeling and Andreas Schrimpf. The study identified a pronounced divergence in haircut pricing, with the largest hedge funds receiving consistently lower haircuts than smaller firms in both US dollar and euro markets.
Repo financing is essential to many hedge fund strategies, and the size of haircuts directly shapes the scale of leverage in the system. A haircut of 0.5% can allow a borrower to hold assets valued at 200 times their equity, while a zero haircut could theoretically permit “infinite leverage,” the BIS said. Understanding how these terms are set, the researchers argue, is critical for assessing vulnerabilities within global financial markets.
The heightened scrutiny has led to friction between regulators and the hedge fund industry. A BOE proposal to introduce minimum haircuts on repo transactions was met with resistance from trade groups, who warned that stricter requirements would undermine liquidity and reduce the appeal of UK government bonds.
The BIS’s findings are based on data from the euro area’s Securities Financing Transactions Data Store, a comprehensive repository that captures the entire euro-denominated repo market and a substantial portion of dollar-denominated activity, reflecting the prominence of European banks in US dollar repo markets.
The report also challenges a common industry explanation for zero haircuts. Some market participants argue that such practices stem from portfolio margining, in which banks set collateral requirements based on a client’s overall trading exposure rather than on individual repo deals. But the BIS said this does not change the conclusion that zero haircuts are widespread—and disproportionately benefit the largest hedge funds.
As leverage builds in key corners of global bond markets, the findings underscore the mounting concern among central banks that sudden unwinds could amplify volatility and threaten market stability.
