Non-bank financial intermediaries

Hedge funds have continued to increase their repo borrowing. While their activity supports market efficiency and liquidity, it could leave fixed‑income markets more vulnerable to the risk of a sudden sell‑off.

Non‑bank financial intermediaries—including pension funds, insurance companies, hedge funds, mutual funds and other asset managers—are important investors in financial markets. However, their activities may create vulnerabilities for the financial system if not properly managed.

Over the past 12 months, hedge funds have further increased their use of repurchase‑agreement (repo) borrowing to fund trading positions in government bonds. This supports market liquidity and price efficiency in normal times.

But if hedge funds were forced to quickly unwind their positions—for example, due to a loss of access to repo funding—it could amplify price movements and lead to dysfunction in government bond markets. It could also contribute to broader liquidity strains. These risks have increased since the previous Report because of heightened economic and geopolitical uncertainty.

Another area of non‑bank financial intermediation that warrants attention is private credit. This market has expanded rapidly at the global level and has recently shown signs of strain (see In focus: Rapid growth in private credit has created vulnerabilities).

Asset manager vulnerabilities

Asset managers’ repo leverage has continued to increase

Over the past five years, total repo borrowing by asset managers has roughly doubled to around $300 billion (Chart 14). Because repos are widely used to finance the purchase of government debt securities, this increase partly reflects higher issuance and, more generally, the overall growth of the Government of Canada bond market in recent years.

Over the past 12 months, repo borrowing by asset managers has increased by about 8%, or $22 billion.1 Hedge funds account for most of the growth, while repo borrowing by pension funds—the largest users of repos overall—has declined slightly. Pension funds tend to borrow for longer terms and at lower levels of leverage than hedge funds.

A sudden unwinding of repo leverage could affect market liquidity and functioning

Leveraged asset managers typically have robust risk management practices to meet sudden liquidity demands. However, these safeguards can come under strain during periods of severe market stress.

The risk of sudden liquidity demand has increased over the past 12 months. Volatility in fixed‑income markets has risen, and the stock of sovereign debt continues to grow globally. Episodes of market stress, such as the start of the war in the Middle East, have already led some hedge funds to scale back their repo positions in certain markets. This highlights the vulnerability of core markets to sudden changes in asset managers’ behaviour.

If asset managers need to suddenly raise liquidity or reduce their leverage, it could have significant implications for financial markets. A sharp pullback in hedge fund activity in government debt markets, for example, could negatively affect the liquidity and functioning of these and other fixed‑income markets. This, in turn, could generate broader financial system stress.

Endnotes