European regulators are closely following a group of hedge funds with exposure to mortgage bonds and average gross leverage in excess of 2,000%, a position so large it risks impacting markets

European regulators are closely following a group of hedge funds with exposure to mortgage bonds and average gross leverage in excess of 2,000%, a position so large it risks impacting markets, per Bloomberg.


A recent report by the European Securities and Markets Authority (ESMA) sheds light on the risk posed by leveraged alternative investment funds, which primarily function as buyers in rising markets and sellers during downturns. This trading approach tends to amplify market movements and can be an additional source of instability. According to the report released on Tuesday, this group constitutes as much as 15% of trading in the local mortgage-backed note market, although the report did not disclose specific jurisdictions or funds. Notably, their share has remained stable during various episodes of stress, including the COVID-19 pandemic and Russia's invasion of Ukraine.

ESMA's review of the broader hedge fund sector emphasized that hedge funds, particularly those employing leverage, exhibit high levels of risk. However, the majority of these funds are reportedly equipped to mitigate these risks by maintaining sufficient cash levels to address potential margin calls during market downturns. While the report included a sample of 130 hedge funds, as many are neither substantially leveraged nor large enough, with assets less than €500 million ($542 million), it focused on those with a higher degree of leverage. The median commitment for these leveraged alternative investment funds exceeded 500%, and approximately 10% of the funds demonstrated a leverage ratio exceeding 2,048%, according to the report.

In a separate announcement, ESMA revealed that it is closely monitoring the exposure of the European Union's hedge funds to Treasury futures, reflecting the heightened scrutiny surrounding basis trades in the United States. Basis trades involve exploiting price discrepancies between bonds and futures tied to the same securities. Although the Bank of England had previously highlighted concerns about hedge funds accumulating large positions in US Treasury futures, ESMA reported no evidence of a significant increase in exposure in the past year.

In a broader assessment released on Wednesday, ESMA cautioned that markets are likely to remain highly sensitive, particularly in response to the impact of prolonged higher interest rates, the macro-financial outlook, and geopolitical risks. The report warned of a high risk of corrections, citing fragile liquidity in equity, bond, and cryptocurrency markets. ESMA highlighted specific concerns regarding the valuation of real estate fund assets in a declining market.