Hedge funds are fuelling a stock market bubble by using billions of dollars in debt to drive up AI valuations, the Bank of England has warned.
The Bank’s committee tasked with monitoring where the next financial crisis will come from warned that there has been a “significant rise” in hedge funds borrowing to invest in AI stocks.
In a new report, the Bank said: “Equity prices have increased especially for AI-related stocks.
“Rising equity prices have been driven, in part, by a narrow set of AI-related companies increasing market concentration in some global indices.
“There has been a significant rise in hedge fund leverage in equity markets, creating risks.”
Hedge funds can use the same stock as collateral many times over to carry out more trades, increasing the market jeopardy if share prices suddenly fall.
The Bank warned that the same hedge funds that are driving up AI valuations are also borrowing against gilts and other government debt.
The Bank said: “Current market expectations are that increases in growth driven by AI developments will support debt sustainability.
“Any negative change in expectations could have wider consequences for sovereign debt markets.
“In addition, many of these markets are characterised by a relatively high use of leverage by a small number of hedge funds pursuing similar trading strategies across jurisdictions.”
The warning underlines the fear that a correction in AI stocks could have cascading effects if hedge funds are forced to offload gilts to meet margin calls from borrowers.
Such an event could trigger a rise in borrowing costs for the UK Government.
The Bank noted that hedge funds offloading debts pushed up gilt yields during the Middle East crisis.
It also found that AI stocks were increasingly concentrated in specific regions, making up more than half of market capitalisation the US, South Korea and Taiwan.
This has increased volatility over the past year after AI stocks have swung wildly.
Separately, officials in Threadneedle Street warned that Britain faces a much greater risk of debilitating cyber-attacks against banks and the wider financial system from AI.
It comes after US tech giant Anthropic previously warned that its new system, Mythos, was too powerful for public release because of its ability to find weaknesses in cyber-defences.
Such technologies pose “a significant increase in risks” to financial stability, the Bank said.
It warned that if banks are unable to keep up with the pace of such innovation, they could be severely exposed to blackouts and attacks.
The Bank said in the report: “In a severe scenario, firms and key third-party providers could fail to keep pace, vulnerabilities could accumulate, and the risk of a systemic cyber event could rise materially.”
It added: “Even in more benign scenarios, a sustained increase in the volume and complexity of attack capabilities would require firms to identify, assess and remediate issues at much greater pace and magnitude.”