The Financial Stability Board (FSB), a risk watchdog for the G20, issued a warning on Wednesday regarding elevated levels of leverage within certain segments of the $7 trillion hedge fund sector. The FSB highlighted that considerable data deficiencies hinder a comprehensive assessment of vulnerabilities within non-bank financial institutions (NBFI).
In a report, the FSB noted that many of the underlying issues observed in NBFI during the height of the COVID-19 pandemic in March 2020, which prompted central banks to infuse liquidity into markets, remained largely unresolved.
The FSB pointed out, “Limits on data collection and disclosure mean that certain aspects of NBFI leverage can be hidden.”
While insurance companies, pension funds, and investment funds collectively constitute two-thirds of NBFI assets, the FSB’s report emphasized that over 90% of on-balance sheet financial leverage is concentrated within “other financial intermediaries (OFIs),” encompassing entities such as broker-dealers, hedge funds, finance companies, holding companies, and securitization vehicles.
The FSB expressed particular concern about certain hedge funds, primarily those operating in the United States, Britain, and the European Union, which employ intricate strategies that could potentially harbor vulnerabilities difficult for counterparties and regulatory bodies to swiftly assess or disentangle.
The report stated, “Within the hedge fund sector, there is a group of funds, typically pursuing macro and relative value strategies, with very high levels of synthetic leverage.”
The FSB further suggested that future policy initiatives should explore the necessity for additional regulations pertaining to margin requirements and cash reserves that support derivatives and securities financing transactions, which establish connections between hedge funds and prime brokers.
It stated, “One area to explore is whether prime brokers’ risk management of exposures to leveraged non-bank entities could be enhanced.”
To address the primary data gaps, the FSB recommended enhancing the utilization of trade repositories designated for recording transactions, strengthening reporting obligations for non-bank entities exhibiting significant leverage, and expanding disclosure prerequisites.
Additionally, the FSB highlighted the potential for enhancing market resilience to shocks by increasing the accessibility and usage of central clearing for government bond markets, cash transactions, and repurchase agreements (repo).
The FSB has already put forth more stringent regulations to bolster the resilience of open-ended funds, a critical component of the NBFI sector, during market crises. However, these proposals have encountered significant opposition from industry stakeholders.
