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Three years ago, investors learned that the mighty U.S. Treasury market wasn’t always as strong as it seemed. When the Covid-19 shock hit in March 2020, U.S. interest rates fluctuated, causing huge losses to hedge funds that swapped bonds for bonds through derivatives and repurchase agreements (“repurchase agreements”) against U.S. Treasuries made implicit, highly leveraged bets. cash.

The ensuing wave of forced selling caused the entire Treasury market to fail — until the Federal Reserve intervened on a record scale. Ouch.

Fast forward to 2023, and you might think those hedging strategies have learned their lesson. After all, U.S. interest rates have risen sharply since 2020 and could be volatile again in the year ahead; in particular, as Apollo analyst Torsten Sløk recently pointed out to clients, one-third of U.S. government debt (about $7.6 trillion) Must refinance in 2024.

Think again.Fed last week publish a report This suggests that this so-called hedge fund “basis trade” is re-emerging. After parsing data from the Commodity Futures Trading Commission, the Commission’s economists noted that “hedge fund repo borrowing increased by $120 billion between October 4, 2022 and May 9, 2023, as of May 2023.” The level on the 9th was higher than the previous peak in 2019.”

Yes, you read that right: Positioning today is decidedly more extreme than it was before the pandemic collapsed. This, they noted, “presents a financial stability vulnerability, as transactions are often highly leveraged and exposed to changes in futures margins and changes in repo spreads”. In short: If U.S. interest rates fluctuate wildly, be prepared for shocks.

There were also some red flags this week from the hawkish Financial Stability Board.in a new report Released ahead of the G20 meeting, the report warned that leverage among “non-bank financial intermediaries” such as hedge funds and family offices was soaring in ways that were difficult to track because it was “synthetic” (that is, based on derivatives).

The FSB is concerned about more than US Treasuries. But it clearly cares. “The March 2020 turmoil highlighted the need to strengthen NBFI resilience,” the report said, before explaining that excessive leverage could leave the financial system vulnerable to “further liquidity strains” in the event of a severe shock.

Now, dare I say it, some ordinary people — and politicians — might roll their eyes. Hedge funds are known for their penchant for high stakes. Few voters will shed a tear if these schemes fail and hurt their wealthy clients. There are similar feelings about the rapidly expanding field of family offices.

But the reason the FSB is sounding the alarm is that March 2020 demonstrated how the shockwaves from the NBFI deal could spread. What is particularly troubling at the moment is that structural fragilities in the Treasury market are not only exacerbating Treasury basis trade shocks, but may actually be getting worse.

Most notably, while banks used to act as market makers, lubricating the treasury and repo industries in a pinch, they stopped doing so after financial regulations tightened after the 2008 crisis. New entrants, such as algorithmic trading firms, do not play these roles.

In fact, Stanford professor Darrell Duffie wrote In a recent paper “Since 2007, the total size of primary dealer balance sheets has shrunk nearly fourfold per dollar of Treasury debt outstanding”. That ratio could worsen further as debt issuance increases, he warned. This is one of the most shocking statistics I’ve seen recently.

Since 2020, the Federal Reserve has made modest adjustments to the structure of the repo market. But the space lacks a centralized clearinghouse or official government backing that would guarantee that transactions always take place in times of austerity.

Thus, as Columbia Law School scholars Lev Menand and Joshua Younger argue in Another shocking paper. While investors have so far assumed that “Treasuries are almost equivalent to cash” because they can sell them “quickly, cheaply, and on a large scale” — an assumption “written into law in many places,” they wrote — But that claim seems increasingly patently false.

Is there any solution? There are a lot of suggestions floating around. The FSB wants more reporting on synthetic NBFI leverage and more caution from primary dealers extending such credit. SEC Chairman Gary Gensler is pushing for increased oversight The number of large market participants and more centralized clearing of repurchase agreements and treasuries.

Meanwhile, Duffy went further. In addition to central clearing, he suggested tweaking liquidity rules to allow traders to hold more Treasuries, taking steps to enable the Federal Reserve to act as a dealer of last resort and strengthening trade reporting.

These are all sensible things to do. Regrettably, however, Washington (or elsewhere) now has little political interest in enforcing these changes, and barring another shock, that is unlikely. Therefore, if the fund’s combined leverage ratio continues to rise, regulators’ unease will also increase. Do you have a feeling of deja vu?

gillian.tett@ft.com

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