Bank of England prepares curb on hedge fund leverage in the gilt market

The Bank of England is moving towards a more interventionist posture in one of the least glamorous but most consequential corners of modern finance: the repurchase agreement market that oils day to day trading in UK government bonds. Officials are drawing up proposals to limit how much short-term borrowing hedge funds can raise against gilts, seeking to damp the sort of forced selling that can turn a bout of volatility into a self-feeding rout.

At first glance, the target looks obscure. Repo, in essence, is collateralised borrowing. A firm sells a bond today and agrees to repurchase it shortly afterwards at a slightly higher price. The difference is the financing cost. In calm markets, repo is close to invisible, a plumbing system that keeps cash and collateral circulating smoothly between banks, asset managers, pension funds and trading firms. In stressed markets, it can become a pressure chamber, with margin calls, shrinking liquidity and positions being unwound at speed.

The Bank’s concern is not that hedge funds exist in the gilt market, but that they have become central to its functioning while relying on leverage that can amplify shocks. Policymakers have noted that hedge funds now account for roughly 30 per cent of transactions in the £3 trillion gilt market, a striking share for actors whose positions can be highly sensitive to short-term moves in yields and funding rates. Traditional long-horizon investors, particularly pension funds, are described by the Bank as less active than they once were. In other words, the balance of market-making and risk-taking has shifted towards institutions that may retreat precisely when stability is most needed.

This is not a moral critique so much as a structural one. Hedge funds often play the role of arbitrageurs: buying one gilt and selling another, exploiting small pricing differences between cash bonds and derivatives, or providing liquidity during routine trading. The model can be socially useful. Yet it depends on cheap, plentiful funding. When funding tightens, the same strategies can turn pro-cyclical, forcing funds to sell into falling markets to meet margin calls, thereby pushing prices down further and tightening conditions again.

Recent episodes have sharpened the Bank’s focus. Officials have pointed to sell-offs in bond markets triggered by geopolitical and political news, where leveraged positions were unwound rapidly. The war in Iran is cited by the Bank’s Financial Policy Committee as having sparked an unwinding of repo-linked contracts worth £19 billion. Even after that shake-out, gilt repo borrowing remained at a historically high level, around £74 billion. These numbers do not, on their own, prove fragility. They do, however, underline how large the short-term funding stack has become, and how quickly it can move when confidence wobbles.

The broader backdrop is a global environment in which government bond markets, once treated as the stable anchor of the financial system, have become more politically and geopolitically reactive. In the United States, policy shocks have been transmitted directly into Treasury yields; in Europe, inflation scares and fiscal questions have been repriced abruptly; in Britain, gilt yields have proved unusually sensitive to domestic political signals about borrowing and fiscal rules. In such a climate, a market structure that relies heavily on leveraged intermediaries carries an obvious hazard: the intermediaries may be compelled to sell precisely when the state needs its borrowing costs to be stable.

Britain has lived through this film before. The 2022 mini-budget crisis remains the defining modern example of gilt market dysfunction morphing into a systemic event. When the then government unveiled unfunded tax cuts and higher borrowing plans, yields on long-dated gilts surged at a pace not seen for decades. The Bank stepped in to buy government debt to calm the market, while also raising interest rates sharply. The immediate triggers were fiscal credibility and a sudden repricing of inflation and rate expectations. The mechanism that turned stress into a near crisis involved leverage, margin calls and forced selling, particularly in the pension fund strategies known as liability-driven investment. The lesson for regulators was not simply that politics can move markets, but that leverage can transform a price move into a liquidity scramble.

Since then, the Bank has been trying to stop the next shock from finding a new weak seam. With LDI partially rebuilt and banks generally better capitalised, attention has shifted to market-based finance, the network of non-bank institutions and funding chains that sit outside traditional deposit-taking. The repo market is a central artery in that system. When repo funding becomes scarce, traders de-risk, spreads widen, and the price of liquidity itself jumps. It is not difficult to imagine a scenario in which a sharp move in yields, driven by political uncertainty or global risk aversion, prompts a wave of margin calls, pushing leveraged funds to shed gilt exposure quickly, intensifying the sell-off and forcing other participants to pull back. At that point, what began as a repricing can look like a run.

The Bank’s intent, according to reporting that the Financial Times first surfaced and that the Bank is expected to detail further this month, is to impose restrictions on the amount of short-term borrowing that can be raised using gilts as collateral. The policy is still in development. Officials have stressed that no final decisions have been made on the precise measures, and any eventual approach will likely include timelines designed to give firms time to adapt. The Bank is expected to publish potential proposals early next year, suggesting a process of consultation and phased implementation rather than an abrupt clampdown.

Even so, the direction of travel is clear. Sarah Breeden, the deputy governor for financial stability, is due to outline the thinking in more detail. The intellectual case rests on a simple proposition: leverage can be efficient in normal times and destabilising in stressed ones, and it is the job of the central bank, as guardian of financial stability, to ensure the system does not rely on behaviours that vanish when most needed. In January, Sir Dave Ramsden, deputy governor for markets and banking, framed the matter in similar terms, arguing that the status quo is not a viable option and that something must change to ensure hedge funds’ role in the gilt repo market is safe.

The phrasing matters. When central bankers say the status quo is not an option, markets hear a warning that the regulatory perimeter is expanding. In effect, the Bank is signalling that non-bank leverage is no longer a peripheral issue but a core concern, and that it is prepared to use policy tools that shape how private actors fund themselves, not merely how banks hold capital. The question is what form those tools will take and how blunt they might be.

One possible route is to impose minimum haircuts, effectively requiring borrowers to post more collateral for the same amount of cash, reducing the maximum leverage available. Another is to place limits on the amount of borrowing that can be raised against certain forms of collateral, or to set expectations for how prime brokers and banks extend repo financing to leveraged clients. Each option comes with trade-offs. Tighter requirements can reduce the likelihood of fire sales, but they can also reduce market liquidity and raise the cost of trading gilts, potentially feeding into higher borrowing costs for the government at the margin.

That is the essence of the political economy dilemma: stability is a public good, but liquidity is also a public good in government bond markets, and the two can come into tension. Hedge funds argue, with some justification, that they are often the marginal buyer and seller that keeps prices aligned and enables other investors to transact efficiently. If their financing becomes more expensive or constrained, the market could become thinner, spreads could widen, and volatility could rise in ordinary trading. The paradox is that a policy designed to reduce volatility in crises could increase volatility day to day, at least during the transition.

The Investment Association, representing asset managers and insurers, has already warned that imposing borrowing limits could be a distorting intervention with uncertain benefit, characterising the approach as overly broad for what might be narrower issues of leverage and liquidity management. In its response to the Bank’s consultation work, the association urged policymakers to consider how the repo market interacts with the broader system during margin calls and to look for other ways to address liquidity pressures. This is the polite language of a trade body signalling that the central bank is at risk of solving one problem by creating another.

There is also a deeper question about where risk truly sits. If hedge funds are levered through repo, the immediate counterparties are typically banks or prime brokers. Those institutions may argue they are protected by collateral and margining. Yet in a stress event, collateral values can move sharply, liquidity can evaporate, and the operational reality of managing defaults, rehypothecation chains and settlement can become messy. The Bank’s concern appears to be less about any single counterparty’s exposure and more about system dynamics: the speed at which positions can be forced to unwind, and the feedback loop between price moves and funding constraints.

Political events have added a domestic flavour to these dynamics. In recent months, gilt yields have moved on signals about fiscal policy and leadership. After local elections in May, yields on ten-year and 30-year gilts rose materially, a move interpreted by some economists as the market pricing a greater uncertainty about future borrowing. The subsequent calming of yields when it was reported that a leading contender for prime minister would not alter the fiscal framework was a reminder that credibility, even in rumour form, can shift the cost of debt. This sensitivity is not unique to Britain, but the UK’s recent history, and the memory of 2022, have arguably made investors quicker to respond to perceived drift from fiscal constraints.

In such a setting, the gilt market has become both a barometer and a transmission mechanism. It reflects confidence in the state’s finances, and it also sets the benchmark for borrowing costs across the economy, from mortgages to corporate debt. When gilt yields jump, it is not only the Treasury that feels it. Households, businesses and pension funds do too. For the Bank, whose mandate includes financial stability and whose interest rate decisions shape the economy, preventing disorderly gilt market moves is not a matter of protecting traders, but of limiting a channel through which market stress can spill into the real economy.

Critics will nonetheless argue that the Bank risks overreach. If the central bank leans too heavily into micro-managing market structure, it may end up acting as a perpetual stabiliser, encouraging private actors to take risks in the expectation that volatility will be capped. This is the familiar moral hazard critique. Yet the Bank’s counter is equally familiar: it is not offering a guarantee, but attempting to reduce the probability that it will be forced to intervene in extremis, as it was in 2022. Pre-emptive constraints on leverage are, in this view, a way to reduce the chance that the central bank must later act as buyer of last resort.

There is also an international dimension. Regulators globally have been wrestling with the growth of non-bank financial intermediation, particularly the use of leverage in relatively safe assets. US policymakers have debated the resilience of the Treasury market, where hedge funds play a major role in so-called basis trades. International standard setters have looked at minimum haircut frameworks for securities financing transactions. The Bank’s push on gilt repo fits into this broader reappraisal of the assumption that government bond markets are inherently stable.

The immediate practical question for market participants is how quickly the Bank intends to move and how stringent any limits will be. If the framework is phased and targeted, the industry may adapt without drama, shifting towards less levered strategies, longer-term funding, or more robust liquidity buffers. If the measures are blunt, the transition could itself generate volatility, as positions are unwound and financing terms reset. The Bank appears conscious of this risk, hence the emphasis on implementation timelines and on publishing proposals for consultation rather than springing rules without warning.

Still, the message to the market is unmistakable: the era in which leverage migrated from banks to the shadowier reaches of finance without a commensurate regulatory response is drawing to a close, at least in the gilt market. The Bank is effectively asserting that if hedge funds are to occupy such a large share of trading activity in a market that underpins the UK’s financial system, then the resilience of their funding model is no longer a private matter.

The debate will turn on calibration. Too little, and the Bank risks leaving a known vulnerability in place. Too much, and it risks sapping liquidity from a market the government relies on to finance itself cheaply and smoothly. The Bank has an advantage, though not a guarantee, in that it is acting from a position of relative calm rather than mid-crisis. That gives it the space to consult, to test assumptions, and to build a regime that targets the destabilising features of leverage without choking off the useful market-making that keeps gilt trading functional.

What is certain is that gilts, once considered the most straightforward of assets, are now at the centre of a wider argument about how modern finance works, who provides liquidity, and what happens when that liquidity depends on borrowed money. The Bank’s proposed limits are a sign that financial stability policy is moving beyond bank balance sheets and into the plumbing of markets themselves, where the next crisis is as likely to begin as the last.