Hedge funds grow in European bond and derivatives trading

IFR 2527 - 30 Mar 2024 - 05 Apr 2024
7 min read
Christopher Whittall

Hedge funds have materially increased their presence in European government bonds and derivatives in recent years, bringing about a revolution in the way these markets are traded and raising questions over whether this new-found prominence poses a threat to financial stability.

They now account for 55% of European government debt volumes and 42% of trading activity in euro and sterling interest rate swaps on Tradeweb, the electronic trading platform said. That compares with a roughly 28% share in those markets five years ago.

This growth comes at a time of flux for government bond markets. Central banks are reducing their presence after years of large-scale intervention while governments have been ramping up debt issuance to plug gaps in their budgets.

It has also coincided with a mass migration of bank traders to multi-strategy and macro-focused hedge funds, which have seen their assets swell in recent years. This shift in activity underscores the reduced sway banks now hold over fixed-income markets, having slashed their presence over the past decade in response to regulations that limit the size of their trading books.

“There’s no question that hedge funds are growing as a proportion of trading volumes, but in the context where others are retreating,” said Nicola Danese, co-head of international developed markets at Tradeweb, who highlighted reduced activity from central banks and pension funds.

"The [post-2008 financial crisis] regulatory journey for the most part was created and implemented during a period of incredibly accommodative monetary policy. Now that is changing. It is an interesting test for the market to see whether that regulatory framework is still appropriate now that monetary policy is so different,” Danese said.

Regulators have taken a keen interest in the health of government bond and related markets following a series of high-volatility episodes in recent years. That has intensified as central banks have started to reduce their bond holdings as part of a broader effort to tighten monetary policy, having exerted a calming presence on markets for much of the previous decade.

European politicians have long been wary of hedge funds trading their bonds after blaming them for exacerbating the eurozone sovereign debt crisis more than a decade ago. The cliche of heartless investors looking to make a quick buck contrasts with the stabilising influence that banks say they bring to these markets, where they are obliged to maintain a steady presence in their role as “primary dealers” underwriting and selling government debt.

This helps explain why the changing undercurrents in European fixed-income trading are starting to attract attention in regulatory circles, particularly when the amount of euro area government debt outstanding has ballooned 62% over the past 15 years to nearly US$12trn, according to the Bank for International Settlements.

“It’s not all negative but there are some concerns,” said Zoeb Sachee, head of European linear rates trading at Citigroup. “As a bank we’re committed to providing liquidity to clients and issuers and cannot just step away when markets get volatile, whereas hedge funds can and will. When liquidity is in short supply, you have the risk of people trying to get out of the door at the same time. We haven’t seen that in a major way, but it is a risk.”

Industry evolution

The growing prominence of hedge funds is partly a result of how the industry has evolved. Assets in multi-strategy funds, which make bets across markets, have increased by almost a quarter over the past four years to US$612bn, according to data provider Preqin.

Many of these investors have turned the traditional hedge fund operating model on its head, preferring to employ multiple “pods” – or small groups of traders – acting independently rather than relying on a handful of well-known managers making large wagers. That influx of trading manpower has led to materially higher volumes among these investors.

“The buyside is where the capacity is these days,” said a portfolio manager at a large macro fund. “It used to be four to five big hitters at the large funds, deciding when to buy. Now you’ve got 20 to 30 pods within a hedge fund trading all day, every day, often taking different positions to one another. This is where the liquidity is coming from.”

The growth of pod shops has created a near insatiable demand for macro traders, many of whom are coming from banks. No longer able to prop trade – make bets with the firm’s money – and constrained by regulations in how much risk they can take, more bank traders are finding themselves at home in hedge funds where such limits don’t exist.

“There’s been an ongoing [shift] of talent moving to the buyside. You have all these former market makers sitting in hedge funds with leverage and balance sheet and they’re trying to replicate what we’re doing in banks,” said a senior macro trader at a major bank.

Not all bad

In a notable example of their towering presence, hedge funds now account for more than two-thirds of trading in Italian government bonds, according to Tradeweb. However, not everyone thinks this should necessarily be a cause for concern. Danese said Italian bonds have performed strongly over the past year and half, undercutting the theory that increased hedge fund presence has a negative influence over markets.

"Hedge funds have a risk capacity that supplements a reduced capacity with the banks,” he said. “The ability of hedge funds to support primary and secondary markets is a healthy thing, especially at a time when government bond supply has been heavy and is set to increase.”

Sachee at Citigroup said it is not a bad thing if, on a day-to-day basis, hedge funds are more active and create more volume and interest in European markets.

“It’s really the same traders trading the same things. They’re obviously not providing liquidity, they’re demanding it. But, at the end of the day, they have a balance sheet allocation and they can warehouse risk, even though they’re doing it for just one reason: to make money,” Sachee said.