Gilts: the market the Bank of England wants to deleverage before the next accident

The Bank of England is not tackling a back-office detail. In seeking to frame hedge-fund leverage in the gilt market, it is putting its finger on a more general fragility: a heavier public debt, carried by shorter, more competitive intermediation more sensitive to margin calls. The risk is not a British default tomorrow morning. It is in the liquidity of a sovereign market reputed to be deep, but financed by positions that can shrink very fast.

In early July, the Financial Times and The Times report that the Bank of England is advancing on a mechanism to limit the leverage hedge funds can take in the gilt market, British sovereign bonds. The central path: impose minimum repo haircuts, in other words prevent a fund from borrowing almost the entire value of a security by pledging it as collateral.

The gilt market weighs close to £3 trillion per the orders of magnitude relayed by the financial press, and hedge funds reportedly account for about 30% of activity. Their role is useful: they take the other side of flows, arbitrage the gaps between cash bonds and derivatives, and smooth the market. But this liquidity is often financed by very short repo, sometimes with haircuts close to zero.

The leverage hidden in the haircut

A haircut is a safety discount. If an investor pledges 100 of gilts as collateral and the lender applies a 2% haircut, it lends only 98. If the haircut falls to zero, the same collateral finances almost the whole position. The gap looks tiny; its effect on leverage is not.

The Bank of England is targeting precisely this zone. Per the FT, the institution judges that competition between prime-brokerage banks and large clients can push funding conditions too far, notably through portfolio margining. A well-calibrated cross margin can reduce redundant margin calls. But in a systemic sovereign market, a zero haircut is not just a commercial price. It amounts to offering a lot of liquidity to a private trade.

The mechanism resembles the Treasury basis trade, already documented on l0g: a small price difference between cash and futures becomes a big position because it is financed very cheaply. As long as markets are calm, the arbitrage helps. When volatility rises, it can reverse its role: instead of absorbing the shock, it amplifies it.

Why the United Kingdom matters

The United Kingdom is not an exotic case. That is precisely why it is interesting. It has a secondary reserve currency, a large financial centre, high debt, a deep bond market, and a recent memory of crisis. The 2022 LDI episode was not the same trade, but it already showed the same mechanics: margin calls, forced gilt sales and a central bank obliged to intervene to prevent a market dysfunction.

The new episode is elsewhere, in hedge-fund repo. Per the elements relayed by the Guardian from the Bank of England’s December 2025 Financial Stability Report, net gilt repo borrowing approached £100 billion in November 2025. A small handful of funds represented more than 90% of this net borrowing, often at very short maturities and zero or near-zero haircuts. The risk is therefore not only size. It is the combination of concentration, short maturity and leverage.

The FT adds a more recent signal: during the sell-off tied to the war in Iran, the Bank of England observed a rapid deleveraging of about £19 billion, with a level remaining around £74 billion after the episode. This is not a collapse. It is a preview of the behaviour of a heavily financed trade when the market becomes less comfortable.

The BIS reading: public debt and NBFIs converge

The cleanest framework comes from the BIS Annual Economic Report 2026, published on 28 June. The Bank for International Settlements describes there a new link between fiscal risk and financial stability. In the old world, sovereign risk passed mainly through banks. In the new world, public-debt markets are more intermediated by NBFIs: hedge funds, open-ended funds, money market funds, insurers, market vehicles.

The BIS’s central figure is clear: in advanced economies, the NBFI share of sovereign-debt holding reportedly rose from 44% in 2021 to 53% in 2025. Over the same period, the share of domestic central banks in these holdings reportedly fell from 27% to 17%, and that of the foreign official sector from 15% to 13%. This shift does not say that every non-bank investor is fragile. It says the marginal buyer has become more private, more yield-sensitive, more dependent on funding conditions.

This reading explains why the BoE is acting now. When states issue more, they need markets able to absorb the volumes. If central banks shrink their balance sheets and banks limit their market intermediation, hedge funds take more space. Liquidity does not disappear; it changes carrier. And that carrier can be funded overnight.

The dilemma: more safety, less apparent liquidity

The regulatory project is delicate. Imposing minimum haircuts reduces maximum leverage, but makes certain trades more expensive. Encouraging central clearing can make exposures more transparent, but also concentrates risk in clearing houses and raises visible margin requirements. The market fears a simple consequence: fewer hedge funds, therefore less liquidity, therefore higher borrowing costs for the state.

This objection is serious. It is not enough to close the debate. A liquidity that exists only as long as haircuts stay at zero is not robust liquidity. The question is not whether hedge funds are useful. They are. The question is how much leverage a sovereign market can accept to obtain that usefulness.

The BIS frames the problem in broader terms: central-bank backstops must stay temporary, targeted and reversible, otherwise they risk encouraging the very leverage they will then have to rescue. If operators believe the central bank will always intervene, they can fund shorter and bigger. If the central bank promises never to intervene, a technical shock can become a macro shock. Between the two, you have to reduce the probability of needing the firefighter.

The signals to watch

Three signals matter now: the exact shape of the BoE’s proposals, the reaction of prime-brokerage banks, and the transatlantic treatment of the same problem. The United States already has its own project on central clearing of Treasuries and repo, in the continuation of the debate on the basis trade. Europe is also looking at margins on sovereign repos. This is therefore not a British story. It is the same problem in several currencies: how to finance more-indebted states with less-banked markets, without turning sovereign debt into a margin-call machine.

A gilt remains a British sovereign bond, not an exotic emerging debt. But modern risk is not always in the issuer. It is in the way the asset is financed, rehypothecated, arbitraged and sold when everyone reduces their balance sheet at the same time. The Bank of England is trying to remove a little leverage before the market does it itself. In one case, the deleveraging is negotiated. In the other, it arrives under margin call.

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Primary sources: Financial Times, “Bank of England to push ahead with plan to limit hedge fund leverage”, 2 July 2026; The Times, “Bank of England to limit debt that hedge funds can use to buy gilts”, 2 July 2026; BIS, Annual Economic Report 2026, 28 June 2026, chapters I and II on the fiscal-financial link, NBFIs and repo funding; The Guardian, summary of the Bank of England’s Financial Stability Report, 2 December 2025. Figures relayed with their perimeter: hedge-fund activity in gilts, net repo borrowing, deleveraging observed during the Iranian sell-off, BIS sovereign-holding shares. This is not investment advice.