NextFin News - British banks are borrowing billions of pounds of cheap cash from the Bank of England and using it to buy government bonds, pocketing a spread of more than 150 basis points as long-dated gilt yields sit near multi-decade highs. The trade, made possible by the central bank's shift to a repo-led system for supplying liquidity, is working exactly as designed — and it is quietly reshaping how Britain's biggest lenders fund themselves.
The 10-year gilt yield stood at 5.37% on 23 September, while the Bank of England's policy rate remains at 3.75%, leaving a carry of roughly 162 basis points for any institution that can borrow at the policy rate and hold the bond. Through its weekly Short-Term Repo facility, which lends reserves at Bank Rate against pledged gilts, and its six-month Indexed Long-Term Repo facility, the central bank has become the marginal funder of that spread. The curve is steep enough that even shorter maturities pay for the trade: the five-year gilt yields just under 5%, the 30-year near 5.95%, and the 50-year above 5.25% — a ladder of positive carry against overnight funding that rewards anyone with access to cheap central-bank cash and the balance-sheet capacity to hold it.
The Trade: Borrow at 3.75%, Own a Bond at 5.37%
At its meeting ending 16 September, the Monetary Policy Committee voted 6-3 to hold Bank Rate at 3.75%, with three members pushing for a 25-basis-point increase to 4%. That decision left the shortest end of the yield curve anchored even as the long end climbed: the 10-year gilt yield rose 0.15 percentage points in a single session on 23 September and is 0.69 points higher than a year earlier. For a bank with access to the Bank of England's repo facilities, the arithmetic is straightforward — borrow cash at the policy rate, buy the bond, collect the difference.
The mechanics run through the Sterling Monetary Framework. The Short-Term Repo operation runs weekly, offers one-week reserves at Bank Rate on a full-allotment basis against Level A collateral, and is intended to keep money-market rates pinned to the policy rate. The Indexed Long-Term Repo offers the same reserves for six months, priced through a uniform-price auction at a spread over Bank Rate, against Level A, B and C collateral. Both facilities were built to replace the excess reserves that quantitative tightening is draining from the system: the Bank's bond stock has fallen from a peak of £895 billion in February 2022 to £488 billion in September 2026, a £70 billion reduction over the past year of which £21 billion came through active gilt sales.
Usage has followed the drain. The short-term repo facility, which drew only around £2 billion in early 2024, reached a record £100.9 billion in a single January 2026 operation and has repeatedly set new highs since. The long-term facility has been slower to catch on — weekly demand has historically run near £1 billion — but the Bank has been pushing lenders to use it routinely, raising the weekly capacity to £35 billion and telling banks they should be borrowing reserves as a matter of course rather than as an emergency measure. The message from Threadneedle Street is that the era of free excess reserves is over; the era of borrowed reserves has begun.
"Repo markets are the core plumbing of our financial system. When they work, they support financial stability and growth. When they fail, stress can spread fast."
Sarah Breeden, the Bank of England's Deputy Governor for Financial Stability, wrote in July. The current arrangement is, in that framing, the plumbing working as intended. But when the plumbing is also the cheapest source of funding for a leveraged bond trade, the line between liquidity insurance and carry trade blurs.
Why the Spread Exists — and Why It May Not Last
The gap between the 10-year gilt yield and Bank Rate is not an accident. It is the price the market demands for holding duration in an era of persistent inflation risk, heavy government issuance, and a central bank that is itself a net seller of bonds. The Debt Management Office plans to sell £179.6 billion of gilts via auction in 2026-27, and overseas investors — traditionally the marginal buyer — held 33.4% of the market at end-September 2025, down from the era when the Bank was the dominant purchaser. Insurance companies and pension funds held 21.1%, and the Bank's own asset-purchase facility still held 18.5%. With the natural buyer absent and the issuer present, someone has to be paid to hold the bonds. Right now, that someone is increasingly the banking system, funded by the central bank.
That is the cyclical leg of the trade. The spread is wide because the curve is steep, and the curve is steep because of forces that can turn: elevated energy prices, a fiscal programme that keeps supply coming, and an MPC that is split on whether the next move is up or down. None of these is permanent. The Bank's own September minutes project CPI inflation rising to around 3.75% in the fourth quarter of 2026 and slightly above 4% in the first quarter of 2027, based on energy prices as of mid-September — a backdrop that already pushed three MPC members to vote for a rate increase. If those inflation pressures force the Bank's hand, the short end rises and the carry compresses. If growth weakens and the long end rallies, the spread narrows from the other side. A carry trade built on a 162-basis-point gap is, by construction, a bet that the gap persists.
The structural leg is different. The Bank's transition to a repo-led, demand-driven framework for supplying reserves is a regime change, not a cycle. Under the old quantitative-easing regime, banks sat on excess reserves and did not need to borrow. Under the new regime, reserves are scarce by design, and the repo facilities are the intended source. That does not revert when the curve flattens. Banks will be routine borrowers from the central bank for the foreseeable future — the question is what they do with the cash.
The Second-Order Risk: The Funder Is Also the Regulator
Here is the tension the market is not pricing. The same institution providing the cheap funding is simultaneously trying to make the gilt repo market more resilient to the kind of leveraged positioning that funding enables. Breeden has said "doing nothing is not an option" on gilt repo regulation, and the Bank is consulting on minimum haircuts for non-centrally cleared repo and greater central clearing — reforms that would raise the cost of precisely this kind of intermediated leverage. The Bank has said it will publish a comprehensive update, including potential policy proposals, in early 2027. Until then, the system runs on the assumption that banks' use of central-bank funding for bond positions remains orderly.
The risk is not hypothetical. The Bank's own system-wide exploratory scenario exercise found that with hedge funds' repo borrowing at current levels, a stress scenario run today could produce an additional £5 billion of gilt sales — more than double the sales recorded in the original exercise — fully exhausting banks' market-making capacity. Hedge funds, which account for as much as 60% of secondary gilt trading volumes and hold £85 billion of net gilt repo borrowing, are the obvious leveraged player. But if banks are using central-bank funding to build their own bond books, they are no longer just the shock absorbers. They are also carrying the position.
The transmission channel is simple. A bank funds a gilt position with one-week repo from the Bank of England. The position is profitable as long as the gilt yield exceeds the funding cost and the bond does not fall in price. If yields rise, the bond loses value; if repo funding becomes scarce or expensive, the position must be unwound into a falling market. The Bank's Financial Stability Report noted that overnight gilt repo rates stayed close to Bank Rate through the first half of 2026, aside from predictable period-end spikes — but that stability is the precondition for the trade, not a guarantee. The moment the spread between repo rates and Bank Rate widens, the carry evaporates and the unwind begins.
There is a second transmission channel that runs through bank capital. A gilt bought with central-bank repo funding still consumes balance-sheet capacity — it counts against the leverage ratio even though the asset is nominally risk-free. That is why the Bank of England's proposed reforms matter: minimum haircuts and central clearing would reduce the balance-sheet cost of intermediating the trade, making it cheaper to run, but they would also make the funding chain more dependent on central counterparties and the Bank's own facilities. The reform intended to make the market safer could, perversely, deepen the very dependency it is meant to manage.
The Counter-Case: This Is a Feature, Not a Bug
The strongest argument against reading this as a vulnerability is that it is exactly what the Bank designed. The short-term repo facility is meant to be used freely; Bank officials have said the rising usage shows the facilities "are functioning as intended and have effectively provided reserves, smoothing the impact of the reduction of the bank's balance sheet." In that view, banks earning a carry is the point — it is the incentive that keeps them intermediating the gilt market as the central bank steps back. The trade is hedged, the positions are collateralised, and the repo rates remain anchored. A 162-basis-point spread on a hedged book is not a bubble; it is compensation for balance-sheet and capital costs in a market where the traditional buyer has left the building.
There is force in that argument. The alternative — banks unwilling to intermediate because funding is unreliable — is what produced the March 2020 "dash for cash" and the September 2022 LDI crisis. If the choice is between a carry trade that works smoothly and a market that freezes, the Bank will take the carry trade. And the reforms now under consultation — central clearing, minimum haircuts — are precisely the guardrails meant to ensure the trade can be unwound without contagion. The Bank's own research estimated that comprehensive central clearing during the dash for cash would have increased nettable repo by £81 billion, cutting UK dealers' exposures by 40% and lifting their average leverage ratio by 3 basis points — meaningful headroom in a stressed market.
But the guardrails are not yet in place, and the comparison with hedge funds cuts both ways. The Bank has spent years warning that non-bank leverage in gilts is the system's main vulnerability; the SWES exercise showed that hedge-fund repo borrowing could double forced gilt sales in a stress. If banks now run the same trade with the same cheap funding, the vulnerability is not removed — it is relocated onto institutions that also hold household deposits and provide payment services. That is a different kind of risk, and one that the current reform timetable does not address until 2027.
What to Watch
The trade rests on two pillars: the spread between gilt yields and Bank Rate, and the stability of repo funding. Watch the overnight gilt repo rate versus Bank Rate — if it trades persistently more than 25 basis points above the policy rate, the cheap-funding leg is breaking. Watch the 10-year gilt yield: a move back below 4.5% would compress the carry below 75 basis points and make the trade unattractive on a risk-adjusted basis. And watch Short-Term Repo usage: a sustained drop back below £10 billion a week would signal that banks no longer need — or want — the central bank's cash.
The MPC's next decision is due 5 November. With three members already voting to raise rates and CPI projected to reach around 3.75% in the fourth quarter, the short end of the curve is the most likely source of compression. In the base case, the spread narrows gradually as the cycle turns and the carry trade becomes less profitable, but the structural reliance on repo funding persists. In the downside case, a hot inflation print forces a larger-than-expected rate increase, the curve flattens aggressively, and positions funded at the short end are unwound into a volatile market. In the upside case, growth weakens, the long end rallies, and the spread compresses from the yield side rather than the funding side.
Across all three scenarios, one thing does not change: the Bank of England is no longer just setting the price of money. It is the source of the money itself, and the profitability of Britain's bond market now depends on the terms it offers. The carry trade works because the central bank wants it to work — and that is exactly why it will not work forever.
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