Hedge funds have “probably” increased their positions in highly leveraged Treasury basis trades, posing a risk to financial stability, according to a research paper published by the Federal Reserve.
(Bloomberg) — Hedge funds have “probably” increased their positions in highly leveraged Treasury basis trades, posing a risk to financial stability, according to a research paper published by the Federal Reserve.
Even the US central bank can only guess at the magnitude of basis trades — which exploit price differences between Treasury futures contracts and the notes and bonds eligible for delivery. However data on futures positioning and repo borrowing of deliverable securities “are consistent with hedge funds increasing their positions in the Treasury cash-futures basis trade,” researchers Daniel Barth, R. Jay Kahn and Robert Mann wrote in the paper published Wednesday.
Constrained by the lag due to quarterly hedge fund reporting, they measured growth from October 2022 through May both in sponsored repo borrowing and short positions in Treasury futures. Basis trades pair a short position in futures with a long position in a cash security, financed by borrowing in the repo market.
While “not enough to conclusively determine the scale of hedge fund basis trade activity,” conditions appear similar to those that prevailed in 2018 and 2019, when hedge fund basis trades grew rapidly as Fed interest-rate increases boosted hedging demand by asset managers, they wrote.
The need to unwind basis trades during the global flight to safety at the onset of the pandemic contributed to instability in the Treasury market, regulators have concluded. At the time, massive volatility in bond futures sparked margin calls and contributed to the Fed’s decision to pledge trillions in stimulus.
“Should these positions represent basis trades, sustained large exposures by hedge funds present a financial stability vulnerability,” the researchers wrote. The Treasury market “remains volatile,” and “cash-futures basis positions could again be exposed to stress during broader market corrections.”
Amid the persistent increase in hedge fund short positioning in Treasury futures, market watchers have long suspected a buildup in the basis trade. Still, the public acknowledgment by the Fed underscores the significant risk it poses, according to Ben Emons, a senior portfolio manager at NewEdge Wealth.
“The Treasury basis trade is large enough for the Fed to be aware that if it does overtighten by withdrawing too much liquidity, it could cause an accident in the system,” Emons wrote in a Thursday note to clients.
Regulators in recent months have increased their scrutiny of the trades, which in some cases have been levered 50-to-1. Officials at the US Securities and Exchange Commission and the Fed have questioned prime brokers about leveraged trading in government bonds by their hedge fund clients.
Hyun Song Shin, head of research at the Bank for International Settlements, also recently noted that the basis trade appears to have made a comeback, albeit in a “much smaller” size than during the periods leading to the March 2020 blowup.
In a recent an episode of the Bloomberg’s Odd Lots podcast, he urged regulators to monitor the strategy closely because of the high leverage it involves.
“So you are selling the futures and buying the bonds, but then if margins go up, you have to either come up with additional equity from somewhere,” Shin said. “That’s very difficult in stressed episodes. So you typically end up selling. And so this is another case where a safe asset can still be at the center of this kind of episode.”
–With assistance from Tracy Alloway.
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