Bank of Canada governor Tiff Macklem said military actions in Iran have increased volatility in energy and financial markets, with uncertainty about the duration and fallout from the conflict contributing to greater risks to global economic growth.

Adding to the risks — which are “tilted to the downside” — is the rapid growth of two activities outside, yet intersecting, with the heavily regulated banking and financial system:

private credit and leveraged trading by hedge funds in sovereign debt markets.

“Economic uncertainty is already high,” Macklem said in a speech on Wednesday at the Global Risk Institute in Toronto. “We cannot afford to add financial instability to the mix.”

Non-bank financial players have become central to how sovereign debt markets function, both globally and here at home, he said, adding that, in Canada, they account for up to 50 per cent of government bonds sold at market and are major players in the secondary market.

This adds liquidity and efficiency in good times, but the leveraged sovereign debt purchases pose risks in times of stress.

“The scale of these trades and speed at which they can unwind pose a systemic risk,” Macklem said.

“Short-term funding strains could cause severe dislocations in sovereign debt markets — the backbone of our financial system — and the cross-border nature of markets means that stress that begins in one jurisdiction or sector can quickly move to another.”

One scenario he worries about is a shock to markets that leads to a spike in global

interest rate volatility , which causes lenders to take haircuts on their investments or curtail funding.

“Higher funding costs or reduced access can force the positions to be unwound. Leverage can build quietly and then unwind very quickly when conditions change,” he said.

“If leveraged investors are forced to reduce their positions, they may need to sell sovereign bonds into already stressed markets. Prices fall. Liquidity deteriorates. And the stress feeds back on itself.”

Macklem said the dash for cash at the start of the pandemic, the U.K. gilt crisis in 2022 and stress in the U.S. Treasury market last spring after President

Donald Trump unleashed a torrent of tariffs around the world all shone a light on vulnerabilities in the sovereign debt market.

More recently, he said, vulnerabilities have been exposed in the now trillion-dollar private credit market, which also raise concerns about potential contagion to the banking sector and core of the financial system.

“Banks and insurers are linked to private credit through lending, sponsorship, warehousing and risk transfer,” he said. “That means weakness in private credit could spill back to the regulated sector, and because private credit is increasingly global, those spillovers could travel quickly across borders.”

Publicly traded private credit funds have been losing steam amid concerns over loans to software companies that could suffer from growing use of artificial intelligence. Firms such as Blackstone Inc. and Blue Owl Capital Inc. have faced withdrawals from investors concerned that default rates could rise sharply.

Though recent defaults appear to have been contained, they highlighted the risks in private credit and raised questions about the quality and transparency of underwriting, Macklem said.

“The opacity of private credit means investors may not have enough information about the quality of loans held in their funds,” he said. “A spike in defaults could prompt them to try to exit their positions quickly. This could cause severe strains, including spillovers to public credit markets.”

Private credit in Canada has not grown as quickly in Canada, but he said Canadian pension funds and insurers are active players in the market and have private credit exposure internationally.

Macklem said systemic risks didn’t disappear after the global financial crisis in 2008, they just migrated — and global surveillance and regulatory frameworks haven’t kept up.

“Our oversight was built for banking,” he said. “Non-bank players generally don’t have the same reporting requirements or level of monitoring. That gap poses a challenge for global standard-setters, national regulators and central banks.”

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Global organizations such as the Financial Stability Board are working to improve understanding and monitoring of private credit, Macklem said, adding that international cooperation across authorities and borders is required.

“We need to understand the interconnections between private credit and banks,” he said, adding that surveillance should be enhanced so risks can be monitored as this market grows.

“That includes tracking cross-border exposures, funding structures and the potential for correlated stress across institutions and jurisdictions.”

After his speech, Macklem said the basics of risk such as liquidity and leverage haven’t changed, but new players are making the system more complicated.

“It’s bringing benefits, it’s bringing diversification, it’s creating new access, but it’s also bringing new complexity. It’s also creating new interconnections,” he said. “And the reality is, as it becomes more complex and there’s more interconnections, it can be easier to hide leverage.”

As a result, protecting the financial system will rely, at least in part, on due diligence at non-bank financial firms.

“Make sure you really understand the risks that you’re taking. Think about not just how things are working in normal times, but about times of stress (and) what the knock-on effects could be,” Macklem said.