Hedge funds: good or bad for market functioning? - European Central Bank

Hedge funds have substantially increased their trading activity in euro area government bond and repo markets, according to a blog post by ECB staff authors Federico Maria Ferrara, Tobias Linzert, Benoit Nguyen, Imène Rahmouni-Rousseau, Marta Skrzypińska and Lia Vaz Cruz published on 23 September 2024. The authors note that government bonds are central to financial markets as high-quality liquid assets and benchmarks for pricing other assets, so the smooth functioning of these markets is essential.

Data from one leading electronic bond trading platform show hedge funds roughly doubled their euro area government bond transaction volumes in secondary markets from 2018 to 2023. Hedge fund activity represented 56% of secondary-market volumes in 2023, up from 26% in 2018. The authors link this trend to a migration of experienced staff from banks and asset managers to hedge funds. The rise coincides with dealer banks facing higher balance sheet costs from post-crisis regulation and with the Eurosystem's balance sheet reduction, periods in which foreign investors have contributed significantly to absorbing net government bond supply.

Although hedge funds may not hold bonds for long, the ECB says their trading and participation in public debt auctions indirectly support absorption. An ad-hoc survey of large primary dealers by the ECB Bond Market Contact Group found hedge funds represent over 50% of requests dealers receive around auctions in Germany, France, Italy and Spain. The authors caution that a sudden withdrawal of hedge funds could strain dealer banks and create trading bottlenecks during stress.

On volatility, the authors find little evidence so far that hedge funds structurally amplify it. Using granular repo market data, they observe that hedge fund repo activity rose alongside bond market volatility before the ECB began raising rates in July 2022, but that correlation reversed once the tightening cycle started, including after the gradual run-off of the asset purchase portfolio began in March 2023. The authors do warn that interconnected hedge fund strategies, including pod structures, and reliance on leverage mean rapid unwinding of positions, whether from margin calls or strategic shifts, could add to volatility under stress.

Bank exposure remains a focus. Hedge funds partly rely on banks for funding, notably through repo, and five euro area banks account for 64% of repo borrowing from hedge funds. The authors describe this as a potential vulnerability, particularly if banks lack full visibility into hedge funds' positions, while noting that repo exposures are collateralised. The concentration has gradually declined but remains elevated. Hedge funds account for about 10% of outstanding repo volumes, and bank exposures are spread across roughly 200 hedge funds. The authors conclude that hedge funds are likely to remain key players in euro area government bond markets, but questions persist about the durability of their presence under market stress. The post notes that its views are those of the authors and not necessarily of the ECB or the Eurosystem.