The hedge fund industry has warned the Bank of England that proposed changes to the gilt repo market could have unintended consequences, potentially reducing liquidity and increasing funding risks during periods of market stress, according to a report by Reuters.

The Alternative Investment Management Association (AIMA), which represents the hedge fund industry, raised concerns in a letter to the central bank this month over plans to expand central clearing in the market for short-term financing secured against UK government bonds.

AIMA said the proposals could create “new vulnerabilities” and expose investors to greater volatility. The industry group had previously flagged what it described as significant structural concerns when responding to the BoE's initial proposals last year.

The central bank is consulting on measures designed to strengthen the resilience of the gilt repo market, including wider use of central clearing. Under such arrangements, a central counterparty stands between buyers and sellers and guarantees transactions.

The proposals also include minimum haircuts on repo transactions that are not centrally cleared. The measures are intended to provide greater protection for lenders and reduce the potential for forced asset sales during periods of market stress.

The BoE's plans follow the 2020 “Dash for Cash” episode and the 2022 liability-driven investment crisis, both of which highlighted vulnerabilities in leveraged financial markets and ultimately prompted central bank intervention.

AIMA's latest concerns focus in part on how expanded central clearing could affect hedge fund financing. The association said its members were concerned the changes could encourage funds to rely more heavily on daily repo financing rather than longer-duration arrangements, such as two-week deals.

That could leave funds more exposed to disruptions in short-term funding markets, AIMA said, warning that the proposed reforms could contribute to greater volatility during periods of market stress.

AIMA global head of markets Adam Jacobs-Dean also urged the BoE to wait for more evidence on the impact of similar reforms in the US before proceeding. The US is due to introduce mandatory central clearing for Treasury repo transactions next year.

The BoE has said its reforms are likely to take years to implement and has not yet decided which proposals will be adopted. The central bank reportedly declined to comment on AIMA's latest letter.