Hedge funds are facing increased scrutiny over their growing influence in European sovereign debt markets following a sharp sell-off in French government bonds that raised concerns over liquidity and systemic risk, according to a report by Reuters.

French 10-year government bond yields surged to 24-year highs in early October, while the premium investors demand to hold French debt over German bonds recorded its largest two-day increase since the euro zone debt crisis.

Although rising government debt, inflation and political uncertainty contributed to the sell-off, investors told Reuters that hedge funds' rapid unwinding of leveraged positions may have amplified market volatility.

Hedge funds now account for more than half of trading in Europe's roughly $13tn government bond market, up from 30% in 2020, according to European Central Bank estimates. The International Monetary Fund (IMF) says hedge fund exposure to sovereign debt has more than doubled since 2022.

"The hedge fund community has ballooned," said Lauréline Renaud-Chatelain, fixed income strategy lead at Pictet Wealth Management. "It's bringing a lot more volatility to the bond market and potentially explains why the (French) sell-off was severe in a context where we lacked a real catalyst."

The IMF has warned that leveraged and crowded hedge fund positions can amplify price dislocations and liquidity pressures during periods of market stress.

Strategies including cash-futures basis trades and leveraged carry trades are particularly sensitive to changes in bond prices and volatility, potentially forcing funds to unwind positions simultaneously.

Bruno Schneller, managing partner at Erlen Capital Management, said rapid deleveraging could create self-reinforcing market moves, although he cautioned against attributing the recent volatility solely to hedge funds.

The industry's growing presence also reflects the withdrawal of traditional sovereign debt buyers, including central banks, pension funds and banks, leaving hedge funds to provide an increasingly important source of market liquidity.

Jiri Krol, global head of government affairs at the Alternative Investment Management Association, defended the industry's role, warning against drawing broad conclusions about hedge funds' contribution to recent market movements based on anecdotal evidence.

However, Marion Le Morhedec, chief investment officer for fixed income at Fidelity International, said crowded positions and leverage could cause liquidity to disappear rapidly when hedge funds exit trades simultaneously.

Regulators are paying particular attention to repurchase agreement markets, where hedge funds borrow against government bond collateral to finance leveraged positions.

Bank of France data shows French government debt accounts for approximately €100bn of the €250bn in euro zone sovereign bonds pledged as collateral in repo markets.

In the UK, the Bank of England estimates hedge funds account for £85bn of the £200bn in net borrowing in gilt repo markets.

JPMorgan chief financial officer Jeremy Barnum also acknowledged the risks posed by hedge fund leverage this week, describing the industry as a longstanding source of systemic risk.

Despite the concerns, fund managers told Reuters that recent market volatility had not materially disrupted their strategies, with some investors using the sell-off to increase exposure to French bonds.

Michela Bariletti, chief credit officer at Standard Life, said the firm had selectively added French government debt during the sell-off as valuations became more attractive relative to credit risk.