A year ago, a small pocket of borrowed money on the fringes of Britain’s bond market imploded with enough force to topple the prime minister and force a bailout from the Bank of England.
Now, the world’s most influential regulator is stepping up scrutiny of growing potential risks in the UK gilt market’s bigger cousin: the $25 trillion U.S. government bond market.
Over the past month, both the Bank for International Settlements and the Federal Reserve, the world’s convening bodies for central banks, have noted a rapid increase in hedge fund bets in the Treasury market.
So-called basis trading involves pitting two very similar debt prices against each other – selling futures and buying bonds – and using borrowed funds to generate income from the tiny gap between the two.
Neither the protagonists nor the strategy itself are the same players as those involved in last year’s debt-driven investing collapse in the UK. But they all have one thing in common: high leverage colliding with sudden and unexpected market moves, and the speed with which they can cause potentially serious problems.
The magnitude of basis trade is difficult to determine. Even the Federal Reserve lacks accurate data. But leveraged funds’ short positions in the most liquid futures contracts hit a record high of nearly $900 billion in late August, according to data from the Commodity Futures Trading Commission.Even if it’s not all for basis trading, the Fed has explain The strategy created “financial stability vulnerabilities” and the Bank for International Settlements explain It has the potential to “messy” the transaction.
These risks are important because the U.S. Treasury market is the foundation of the global financial system. Federal government debt yields represent the so-called risk-free rate, which is a benchmark for every asset class. The brief but damaging UK market crisis a year ago highlighted how quickly markets can become disorderly when leverage is used – a key factor for investors looking at the accumulation of over a decade of ultra-low interest rates. Potential problems are an increasingly pressing concern for regulators.
Analysts, experts and investors believe that the Fed’s intervention in the Treasury market in places such as September 2019 and March 2020 has led to confidence that the Fed will intervene in any situation of extreme market instability, thus Covert support for speculative trading.
“I do think moral hazard is very real here,” said Morgan Ricks, a professor at Vanderbilt Law School who specializes in financial regulation. “So I think it’s reasonable that the Fed’s implicit support for this trade is encouraging more trade to happen.”
But hedge funds counter that they are now important providers of liquidity to the industry. “The market needs arbitrageurs,” said Philippe Jordan, president of Capital Fund Management, a $10 billion hedge fund. “Without them, it would be more expensive for governments to issue notes and transaction costs for pension funds to be higher. This ecosystem exists for a reason.”
back to basics
In recent years, hedge funds have played an increasingly important role in the operation of the Treasury market.
Primary dealers, the 24 banks that trade directly with the Treasury and facilitate transactions for investors, have exited their role since 2008 because it costs them more to hold bonds.
As the Treasury market has grown—from about $5 trillion in early 2008 to $25 trillion today—hedge funds and high-speed traders (who are less transparent and regulated than banks) have filled the void. They now play an important role, buying bonds and setting prices for other investors, partly through basis trading.
Basis trading has surged this year as the Federal Reserve raises interest rates and the Treasury market expands. Both factors have pushed yields higher, increasing demand for futures markets from asset managers looking to lock in returns; their long positions in some Treasury futures have hit record highs in recent weeks.
Basis trading works by exploiting the price gap between Treasury futures, which promise users to buy a bond at a specific price at a future date, and cash bonds. Hedge funds sell futures and buy cash bonds, which are delivered to the counterparty when the futures contract expires.
The difference between Treasury and futures prices is small, often just a few percentage points, so the returns are minimal. But hedge funds can amplify their bets that the gap will close by using borrowed money to fund trades.
Because Treasury securities are considered the highest quality collateral, the prime brokerage arms of major Wall Street banks are happy to provide loans against Treasury securities, often at their full face value rather than at a slight discount. In the repo market (short-term loans that facilitate trading of large amounts of Treasury securities), hedge funds invest only small amounts of cash based on their credit lines, sometimes increasing leverage by more than 100 times.
There is also a loan on the other side of the transaction. Futures are inherently leveraged products, and hedge funds only need to post a small amount of collateral to meet the margin requirements of futures exchanges. For example, 10-year Treasury futures offered by U.S. exchange group CME allow trading amounts up to 54 times cash margin.
By leveraging the borrowing power of both parties to a transaction, hedge funds can deploy enormous leverage. The head of the fund involved in the trade said traders used to be leveraged up to 500 times.
The strategy attracts different types of hedge funds. Traders said basis trading is frequently used by diversified groups such as Citadel, Millennium Management and Rokos Capital Management, as well as specialist firms such as Symmetry Investments and Garda Capital Partners. The funds involved either declined to comment or did not respond to requests for comment.
What about the risks?
But central banks and regulators worry that the impact of sudden market disruptions could quickly escalate and create ugly feedback loops.
Several warning shots had been fired. The Fed said it believed pressure from such trades played a role in hitting Treasury prices when Covid-19 lockdowns began in the U.S. in March 2020, and was also credited with the September 2019 repo. A factor in the temporary stagnation of the market.
There are many ways to resolve trade issues. One is that banks can avoid risks when markets come under stress and cut the leverage they allow to deploy capital, or raise the cost of short-term loans.
Another reason is that clearinghouses that facilitate futures trading can increase the amount of collateral required for their trading positions. This happened when Silicon Valley Bank collapsed in March, and fears of contagion triggered a rapid surge in demand for the safety of U.S. government debt. In response, CME Clearing increased margins on 10-year Treasury futures by 15%.
Both would make trading less profitable and leave hedge funds with a choice: continue trading at higher costs, or close their positions, which could impact the broader market. The deal is also vulnerable to changes in repo rates, which could reduce the amount banks are willing to lend on hedge fund trades.
“If liquidity deteriorates, all of these strategies will face significant risks,” said a senior executive in the field at a major U.S. bank. “For example, if they are unable to roll over repo transactions, or the (cost) of those transactions increases.”
Regulators say it all adds up to a situation where the exit of just a few large companies could encourage or force others to do the same, quickly leading to a vicious cycle of unhealthy selling in the world’s most important asset market.
“My biggest concern is that if we ease up significantly on leveraged trading, it could really dry up liquidity in the Treasury market,” said Matthew Scott, head of rates trading at AllianceBernstein.
In this case, the Fed is unlikely to sit on its hands. “Our assumption is that the Fed will step in to rescue the repo market, just like they have done in the past, so my view is that if anything happens, they will step in again,” the executive at the large U.S. bank said. “
Interventions could involve bond purchases, undermining the central bank’s mission to tighten policy until inflation is defeated, akin to an official trade safety net.
Some companies say they are already starting to exit the industry. “There are so many people in the market right now and the influence is huge, so the concerns are not necessarily overblown,” said one executive at a major hedge fund.
But most hedge funds active in the space say the concerns are misplaced and that any restrictions could have severe knock-on effects.
A top executive at one of the world’s largest hedge funds says well-run entities don’t take on inappropriate risks. “This is not like an episode Billions. You’re talking about small profits on large positions,” the executive said. “If hedge funds stop buying Treasuries, I don’t know who is going to buy them.”
A fixed-income trader at another large hedge fund said basis trading “has been around for half a century and is very well collateralized by design.” If managed properly, “it plays a critical role in the healthy functioning of the U.S. Treasury market ecosystem.”
Funds also believe the market is better protected now that the Fed has established a standing repurchase facility, which will buy Treasury and agency mortgage-backed securities from banks in exchange for overnight cash loans. Although the tool is not available to hedge funds, it helps prevent sudden spikes in repo rates.
“Free insurance”
Vanderbilt Law School’s Ricks said the prospect of intervention amounts to “free insurance” if market conditions become unruly. “I think we should be concerned about rent extraction by the funds that are involved in this transaction, which are doing so with the support of the Fed.”
Executives at the major bank said that while basis trading was “overfished,” it was “likely to remain that way for quite some time because of this moral hazard.”
The Securities and Exchange Commission, led by Chairman Gary Gensler, has proposed several new regulations to curb hedge funds and high-speed traders in the Treasury market.
Under a rule, these types of market participants will be required to register as traders, which will increase oversight and transparency of their trading activities. But a final version of the rule has not yet been announced or implemented, and one Washington insider believes hedge funds will resist any highly restrictive dealer rules through litigation.
However, the clearest argument for hedge funds is not that trading is risk-free, but that in the current market environment it is critical to the functioning of the system.
“The U.S. national debt continues to grow, the deficit will persist, and the Fed is reducing the size of its balance sheet,” said Don Wilson, chief executive of DRW, one of the world’s largest proprietary trading firms.
“The need among leveraged market participants to facilitate the transition from cash to derivatives will continue to grow, and hindering this transition will have serious adverse consequences.”
Additional reporting by Katie Martin and Laura Noonan in London
data visualization Ian Both and Chris Campbell
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