As funding demands rise and the European Central Bank pulls back, hedge funds are flooding the $10 trillion euro zone government bond market with capital, seeing possibilities.

Traders and authorities claim that the funds are acquiring a sizable portion of the government debt sales, offering a vital source of funding. Nonetheless, at a time when regulatory worry over their impact on the market is growing globally, investors with no regulatory experience frequently place their bets heavily in bank debt, linking their fortunes to lenders.

Hedge funds have grown more ingrained in the bloc’s debt market, according to information gathered specifically for Reuters by electronic platform Tradeweb and interviews with over a dozen people, including treasury officials and top dealers.

Up from 36% in 2020, hedge funds recorded a record 55% of European government bond trading activity on Tradeweb last year, forcing other financial institutions to make way for them as the dominant participants for the first time.

Hedge funds accounted for two-thirds of Italian debt trading volumes on Tradeweb, according to statistics compiled for Reuters, indicating that their influence was greatest in some of the most indebted countries in Europe.

Coalition Greenwich, a financial services research firm, ranks Tradeweb among the top three European government bond trading platforms, along with Bloomberg and MTS. Britain and other European markets, as well as those in the euro zone, are included in the statistics.

As the European Central Bank reduces its bond holdings, analysts at Barclays estimated in January that the euro zone debt market will need to take in a record 675 billion euros ($735 billion) of new bonds this year. This coincides with the government borrowing being driven by the pandemic and the war in Ukraine. Meanwhile, regulations put in place during the 2008 financial crisis limit the size of banks’ balance sheets.

The hedge funds have arrived, drawn in by the positive interest rates that have been there for nearly a decade.

The European market has become even more attractive because to the rapid rise of electronic trading, which has decreased the cost of buying and selling assets, especially when the pandemic struck in 2020. The region’s electronic trade has not kept up with that of the US.

Kenneth Tropin, the 30-year-old founder of Graham Capital Management, an investment firm that oversees $18 billion in assets, including government bonds, told Reuters that “these markets are very exciting and constructive to trade in.” One of the more established trend-following hedge funds is Graham.

According to four traders and treasury officials, Millennium, Citadel, and Haidar Capital collectively manage over $120 billion, making them some of the most active hedge funds in the euro zone bond market. Multi-strategy funds trade a wide range of assets across different strategies.

For this report, the three funds declined to comment.

Although hedge funds enhance market liquidity, former board member of the German Central Bank Andreas Dombret stated that the growing number of them makes the case for strengthening regulatory monitoring.

Hedge funds are not bound by the same statutory commitments that banks are, as so-called “primary dealers,” to purchase government bonds and engage in active trading of them in both good and bad times.

“They’re the first to leave the party if things get rough,” Dombret, who is currently employed by Oliver Wyman Consulting as a consultant to banks, said.

The $3.5 trillion hedge fund industry is less heavily regulated than the banking sector. It is made up of private investment vehicles that don’t publicly declare their profits or reveal how they make money—sometimes not even to their own investors.

To generate revenue for their clientele, which includes wealthy people, sovereign wealth funds, and pension funds, they speculate on both increasing and decreasing asset prices.

There were no comments available from a spokesperson for ESMA, the European Union securities watchdog, about the growing hedge fund activity in the bloc

Chair of ESMA Verena Ross stated during a conference that the agency pays close attention to “particular funds” that accumulate leverage.

An ECB representative stated that the bank is in favour of international initiatives to strengthen laws pertaining to hedge funds and investment funds.

With their ability to take advantage of unpredictable markets and their flexibility, hedge funds are becoming more and more prevalent as price swings become the new normal.

When the bloc’s inflation reached a height of more than 10% in 2022, benchmark German bond volatility shot to a record high and is still greater than it was prior to the inflation spike. In one of the two largest quarterly shifts since 2011, German rates increased 44 basis points in the third quarter of 2023 and then declined 80 bps the following.

According to two of the traders, the existence of hedge fund trading could also be a factor in price fluctuations.

According to Zoeb Sachee, head of euro linear rates trading at Citi, the main dealer for the governments in the bloc, “on both sides, there were some extreme moves, and that can happen if everyone is trying to chase the same trade and positioned the same way, and therefore have to step out.”

Researchers, including hedge funds, sold bonds during the pandemic’s peak in March 2020, while dealers took on more debt on their books, according to a new tab from the Financial Stability Board (FSB), an organisation that brings together officials, regulators, and central bankers from the G20 economies.

The extent of the selloff put financial and economic stability in jeopardy, which is why the ECB had to inject enormous stimulus into the market to stabilise it. The central bank is now taking a step back and getting rid of the stabilisers that lessen financial stress.

Hedge funds are currently contributing positively in light of the stable markets, according to Francesco Papadia, who oversaw market operations at the European Central Bank during the early 2010s euro zone debt crisis. However, Papadia added that this should not be taken for granted.

Papadia, a senior scholar at the Brussels-based think tank Bruegel, stated that hedge funds “could lead the move towards more difficult conditions for both issuers and investors should prospects worsen” and that they might become “bond vigilantes.”

That’s a word used to describe investors that want larger returns on loans to governments they consider to be financially irresponsible.

Governments primarily use the financial markets to finance themselves through the issuance of bonds. The banks designated as primary dealers purchase the bonds at auctions and subsequently sell them to other investors. That is primarily how that occurs.

The head of Belgium’s debt management, Maric Post, admits that if hedge funds pull out of large trades or withdraw from the market, volatility may increase.

However, he tells Reuters in an interview this month that hedge funds’ demand for Belgian bonds has “quite well” smoothed out debt sales, so for the time being he’s not concerned.

According to three traders, hedge funds have occasionally purchased 20% to over 50% of auctions. Another trader, who wished to remain anonymous, stated that hedge funds now typically purchase about 35% of auction items, up from about 20% five years prior.

The amount that hedge funds wish to pass along to them is a determining factor in how much they purchase. Due to restrictions imposed after 2008, primary dealers are no longer able to maintain substantial bond holdings for extended periods of time, such as weeks following an auction.

The involvement of hedge funds, according to Bruno Benchimol, head of Credit Agricole’s euro zone government bond trading, smoothes the debt sales process by extending the period of time that longer-term investors, such as pension funds and insurers, must purchase the new bonds.

A popular tactic employed by funds that engage in price swing trading involves capitalising on a consistent trend in which bond prices often decline before to auctions as markets get ready to absorb the supply, then generally rise after the sale is finished.

According to three of the traders, hedge funds who employ that tactic typically unload the government bonds before of the auction, taking a short position in the event that values decline.

Hedge funds purchase fresh debt at auction as bond prices drop, then sell it to investors over the course of the following few days or weeks to lock in profits.

Additionally, traders indicated that hedge funds utilise the auctions to purchase bonds for larger relative value or macro strategies, or they set up relative value trades that capture how outstanding bonds—from various maturities or issuers—move against each other during debt sales.

In a report released this month, the International Capital Markets Association (ICMA), a trade association that represents financial institutions, identified relative value techniques as a key trading source. The report also issues a warning regarding the possible consequences of abruptly withdrawing hedge funds from the market.

“There isn’t a one or two type strategy that’s repeated over and over. There’s a large, diverse set of activities that are being deployed,” said Kal El-Wahab, head of EMEA linear rates trading at BofA, whose clients include hedge funds.

Hedge funds’ impact on bond market pricing is difficult to evaluate due to the diversity of their tactics, particularly when there is a general strong demand for the asset class.

The risk premium that Italy usually pays over Germany, which is a good indicator of market stress, just dropped to its lowest level in more than two years.

Trading volumes in European government bonds have reached all-time highs, bolstered by the interest of hedge funds. This is good news for investment banks benefiting from the boom.

It also lessens the strain from pricey primary dealerships that have seen a decline in profitability over time as a result of stricter guidelines governing banks’ use of capital.

Banks have been leaving dealerships in large numbers. According to trade group AFME, the average number of dealers employed by European governments has decreased from 20 in 2015 to 17.

However, there are drawbacks to hedge funds’ growth as well.

Hedge funds have taken roughly one-third of bank’s euro rates traders since 2021, according to two recruiters who wished to remain anonymous. There are less regulations, particularly around compensation, for hedge funds.

Furthermore, as hedge funds primarily rely on Wall Street firms for funding their wagers, the exposure of those banks to those firms poses a possible danger to financial stability, as the Bank of International Settlements (BIS) noted in a report earlier this month. opens new tab.

The largest, according to the BIS, are Goldman Sachs, Morgan Stanley, JPMorgan, UBS, Barclays, and BNP Paribas.

Record bond sales ultimately leave governments with few options. According to a trader and a treasury official, longer-term investors such as pension funds would need larger returns in order to participate in regular auctions, which would raise the cost of borrowing.

According to Julian Baker, co-head of euro linear rates trading at JPMorgan, these investors “tend to participate more when they have tangible needs at that particular point in time, whereas hedge funds will participate to the extent there’s an opportunity.”

(Adapted from Reuters.com)

Categories: Economy & Finance, Geopolitics, Strategy