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LONDON, Nov 27 (Reuters) – The new head of the Bank for International Settlements has said reining in hedge funds’ ability to make highly leveraged bets in government bond markets should be a key priority for policymakers given rapidly increasing public debt levels.

Pablo Hernández de Cos, who took over as General Manager of the umbrella body for central banks in July, said the combination of high debt and growing role of non-bank financial institutions (NBFIs) such as hedge funds in bond markets posed new financial stability risks.

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The worry is their use of leveraged “relative value” trades like cash-futures basis trades, which look to exploit small price differences between bonds and their futures contracts.

These strategies have boomed in the U.S. and other major economies but have been in the sights of regulators after margin calls on U.S. Treasury future trades in 2021 fuelled a bout of turmoil in the world’s biggest government bond market.

“Around 70% of bilateral repos taken out by hedge funds in U.S. dollars and 50% in bilateral repos in euros are offered at zero haircut, meaning that creditors are not imposing any constraint on leverage using government bonds,” de Cos said in a speech at the London School of Economics.

With ageing populations and rising defence spending projected to push the debt-to-GDP ratio of advanced economies to 170% by 2050 absent fiscal consolidation, de Cos said reining in NBFI leverage was a “key policy priority”.

He called for a “carefully selected combination of tools” but highlighted two specific measures as likely to be particularly effective.

One of those was the greater use of central clearing, so government bond market players are treated more equally. The other was for “minimum haircuts” – or discounts – to be applied to the value of the bonds hedge funds use as collateral, to limit their leveraged plays.

“The growing intermediation of record-high public debt levels by NBFIs introduces significant new financial stability challenges,” de Cos said, adding that haircuts should be applied in a targeted manner.

In the context of these new risks, he said central bank swap lines remained “critical” to stabilise the global financial system at times of acute distress.

Keeping inflation in check will remain the most effective way to support debt sustainability by reducing risk premia, while central bank independence remains vital too.

“Against the backdrop of rapidly deteriorating sovereign creditworthiness, the need for credible monetary policy and central bank independence is stronger than ever,” de Cos said.

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