Hedge funds with 2,000% leverage catch EU watchdog's eye

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.

The funds predominantly are buyers in rising markets and sellers during a downturn, according to a report Jan. 30 by the European Securities and Markets Authority about the risk posed by leveraged alternative investment funds. It's an approach to trading that tends to compound market moves and can be an added source of instability.

The group represents as much as 15% of trading in the local mortgage-backed note market, the regulator said, without identifying which jurisdictions or specific funds. Their share has remained stable throughout recent episodes of stress, including the pandemic and Russia's invasion of Ukraine, the report added.

"Leverage for hedge funds remains very high, and this may pose a risk of market impact," ESMA said in its review of the broader hedge fund sector. Still, most funds are able to mitigate danger, with sufficient cash levels for potential margin calls to limit the risk during a selloff, the regulator said.

Hedge funds have come under increased scrutiny in Europe and the U.S., partly due to popular leveraged basis trades that almost blew up the Treasury market four years ago. The market turmoil in the U.K. of two years later, stemming from leveraged pension fund strategies, has also left regulators highly sensitive to liquidity risks.

ESMA's sample for its review comprised only 130 hedge funds, since the majority are neither substantially leveraged nor big enough, with less than €500 million ($542 million) in assets.

However, those included are among the most leveraged alternative investment funds, with a median commitment of more than 500%. Around a 10th of the funds have a leverage ratio of more than 2,048%, according to the report.

Separately, ESMA said it was monitoring the exposure of the bloc's hedge funds to Treasury futures given the scrutiny for basis trades in the U.S. The strategy exploits price discrepancies between bonds and futures tied to the same securities.

While the Bank of England has previously highlighted the build-up of large positions by hedge funds in U.S. Treasury futures, the European regulator said it has found no evidence of an increase in exposure last year.

In a separate report Wednesday, ESMA said markets are set to remain very sensitive, especially to the impact of higher-for-longer interest rates, the macro-financial outlook and geopolitical risks. It warned there's a high risk of corrections given fragile liquidity in equity, bond and crypto markets, highlighting particular concerns toward the valuation of real estate fund assets in a falling market.