A leveraged trade in US Treasury futures that has regained popularity with hedge funds poses a risk to global financial stability, according to the Bank of England.
(Bloomberg) — A leveraged trade in US Treasury futures that has regained popularity with hedge funds poses a risk to global financial stability, according to the Bank of England.
Known as the basis trade, the strategy typically involves exploiting small price differences between cash bonds and futures, and is attracting scrutiny from US regulators. On Wednesday, the BOE added its voice, saying the risks associated with these trades have mostly not been tackled by regulators.
The trade is particularly risky because returns are bolstered by borrowing money in the repo market. That tends to work well in a low-volatility environment but can backfire if the market moves fast — and can even disrupt the smooth functioning of the financial system. At the onset of the coronavirus pandemic in early 2020, as fund rushed to unwind their basis trades, liquidity dried up in Treasuries and other money markets.
Such risks “remain largely unaddressed and could resurface rapidly,” the BOE said. “In particular, the sharp transition to higher interest rates and currently high volatility increases the likelihood that market-based finance vulnerabilities crystallize and pose risks to financial stability.”
Read more: Notorious Hedge Fund Trade Puts Bond Bulls on Steepening Watch
The warning comes amid increased scrutiny of threats to financial stability posed by non-banks. That follows a historic rout in the UK bond market in September related to a leveraged strategy used by pension funds and the “dash-for-cash” in March 2020. The BOE released details last month on its expanded stress tests that now include hedge funds and pension firms.
“Alternative asset managers did not pose a systemic risk to the financial system during the market turmoil,” Bryan Corbett, president and CEO of Managed Funds Association, said in a statement, pointing to studies that found foreign entities were the primary sellers of Treasuries during the March 2020 market event.
Short positions in Treasury futures by leveraged investors have increased in recent months, the central bank said in its Financial Stability Report Wednesday. Market intelligence suggests these bets are “relative to bonds or swaps” and if prices were to move sharply, deleveraging the positions could further amplify stress, it said.
In the US, officials at the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about the basis trade, Bloomberg reported in May. Hedge funds active in the trade included Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, people familiar with the matter said at the time.
Treasuries positioning since then suggests leveraged traders have kept adding to their basis trade bets, in part facilitated by asset managers who’ve piled into the other side of the wager to hedge their interest-rate exposure.
“Further action is needed by international and domestic regulators to increase the resilience of market-based finance,” the BOE said. “Given the underlying risks remain significant and could resurface, completing this policy work and implementing it across jurisdictions is urgent.”
–With assistance from Ruth Carson.
(Adds comment from Managed Funds Association in sixth paragraph.)
More stories like this are available on bloomberg.com
©2023 Bloomberg L.P.