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A rise in leveraged bets could “disrupt” trading in the $25 trillion U.S. Treasury market, the central bank umbrella group said, in the latest high-profile warning about the destabilizing potential of hedge funds’ crowded bets.
The Bank for International Settlements warned in a quarterly report released on Monday about the growth of so-called basis trading, in which hedge funds seek to exploit tiny differences between the prices of Treasuries and their equivalents in the futures market.
“The current accumulation of leveraged short positions in U.S. Treasury futures is a financial vulnerability worth monitoring because it could trigger a margin spiral,” the Bank for International Settlements said in a report post-Margin.
“Margin deleveraging, if disorderly, has the potential to disrupt core fixed income markets,” the report said.
The U.S. Treasury market, one of the most closely watched markets in the world that determines the cost of borrowing U.S. government debt, saw $750 billion change hands every day in August, according to Sifma.
During stressful moments like the pandemic in September 2019 and March 2020, the unwinding of leveraged Treasury positions led to wild swings in the Treasury and repo markets, ultimately forcing the Federal Reserve to step in.
As evidence of increased trading, the BIS cited data from the U.S. Commodity Futures Trading Commission showing short positions in Treasury futures contracts of certain maturities have increased to record levels in recent weeks. The Bank for International Settlements (BIS) values short positions in Treasury futures at about $600 billion.
The bank is the third regulator in recent weeks to draw attention to the risks posed by increased hedge fund bets in bond markets.
In August, the Fed reported an increase in basis trading volumes and warned that financial stability risks Such accumulation constitutes.
The Financial Stability Board, a group of the world’s top finance ministers, central bankers and regulators, warned this month that hedge funds with high levels of synthetic leverage – debt created by derivatives – were a potential source of market instability.
Basis trading is typically employed by hedge funds using relative value strategies that involve long positions in the cash market and short positions in the futures market, funded by repurchase agreements. While there is no clear data showing the size of the basis trade, weekly data from the U.S. Commodity Futures Trading Commission (CFTC) showing short positions in Treasury futures is often viewed as an indicator. Borrowing levels in the repo market are also monitored.
Since the difference between cash bonds and futures bonds is often very small, hedge funds make huge profits from these trades through heavy leverage, while putting up little cash themselves.
Most leverage occurs in long positions in spot markets, but the BIS paper also highlights leverage in futures positions. Futures leverage has increased – 70x for the five-year note and 50x for the 10-year note – although below pre-pandemic levels.
In futures, traders typically use margin to amplify the value of their positions and provide only a small portion of the total trade value. The Bank for International Settlements warned that if market movements go against highly leveraged futures investors, they could be forced to abandon their positions, triggering further market selling.
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