19 September, 2023 by Kate Duguid, Costas Mourselas and Ortenca Aliaj

One year ago, a pocket of borrowed money on the edge of UK bond markets imploded with enough force to topple a prime minister and draw the Bank of England into an emergency rescue.

Now the world’s most influential regulators are intensifying their scrutiny of a mounting potential risk to the gilt market’s much bigger cousin: the $25tn US government bond market.

Over the past month, the Bank for International Settlements, a convening body for the world’s central banks, and US Federal Reserve researchers have pointed to a rapid build-up in hedge fund bets in the Treasury market.

The so-called basis trade involves playing two very similar debt prices against each other — selling futures and buying bonds — and extracting gains from the small gap between the two using borrowed money.

Both the protagonists and the strategy itself are different from those involved in the UK’s liability-driven investment meltdown last year. But they have one thing in common: the collision of heavy leverage with sudden and unexpected market movements, and the speed with which that can cause potentially serious problems.

The scale of the basis trade is hard to pin down. Even the Fed lacks precise data. But leveraged funds’ short positions in the most liquid futures contracts reached an all-time high of almost $900bn in late August, according to Commodity Futures Trading Commission data. Even if not all of that is used for the basis trade, the Fed researchers said the strategy poses a “financial stability vulnerability” while the BIS said it had the potential to “dislocate” trading. 

Such risks matter because the US Treasury market underpins the global financial system. The yield on federal government debt represents the so-called risk-free rate that is the benchmark for every asset class. And the short but destructive UK market crisis a year ago highlighted how quickly markets can become disorderly when leverage has been employed — an increasingly pressing concern for regulators focusing on potential problems that accumulated during more than a decade of super-low interest rates.

Analysts, experts and investors argue that the Fed’s interventions in the Treasury market in September 2019 and March 2020, among others, have led to a belief that the Fed will intervene in any instance of extreme market instability, implicitly backstopping speculative trading. 

“I do think moral hazard is very real here,” says Morgan Ricks, a professor at Vanderbilt Law School, where he specialises in financial regulation. “So I don’t think it’s unreasonable to think that the Fed’s implicit backstop of this trade is encouraging more of the trade to happen.” But hedge funds retort that they are now vital providers of liquidity in this sector. “The market needs arbitrageurs,” says Philippe Jordan, president of Capital Fund Management, a hedge fund with $10bn in assets. “Without them it’s going to be more expensive for the government to issue paper, and more expensive for pension funds to trade. There is a reason this ecosystem exists.”

Back to basis

Hedge funds have been playing an increasingly important role in the functioning of the Treasury market in recent years.

Primary dealers, the 24 banks that transact directly with the Treasury department and facilitate trading for investors, have pulled back from their role since 2008, deterred by rules that have made it more expensive for them to hold bonds.

As the Treasury market has grown — from about $5tn at the start of 2008 to $25tn today — hedge funds and high-speed traders, which are less transparent and less tightly regulated than banks, have picked up the slack. They now play an essential role, buying bonds and making prices for other investors, partly through the basis trade.

Basis trades have proliferated this year as the Fed has raised interest rates and the size of the Treasury market has grown. Both factors have pushed yields higher, increasing demand in the futures market from asset managers looking to lock in returns; their long positions in some Treasury futures have reached record highs in recent weeks.

The basis trade works by exploiting the gap in prices between Treasury futures, which commit users to buying at a certain price on a future date, and on cash bonds. Hedge funds sell the futures and buy the cash bonds, which they can deliver to the counterparty when the futures contract comes due.

The difference between Treasury and futures prices is small, often just a few fractions of a percentage point, so the return is minuscule. But hedge funds can magnify their bets that the gap will close by using borrowed money to fund the trade.

Because Treasuries are considered the highest quality collateral, the prime brokerage divisions of major Wall Street banks are happy to lend against them, often at their full face value rather than a slight discount. In the repo market — short-term lending that facilitates a lot of Treasury trading — hedge funds need to post only small amounts of cash against their credit lines, sometimes levering up by more than 100 times. 

There is borrowing on the other side of the trade too; futures are inherently leveraged products and again, hedge funds need to put up only a small amount of collateral to satisfy the margin requirements of futures exchanges. Ten-year Treasury futures offered by US exchange group CME allow trades of up to 54 times the cash margin posted, for instance.

By taking advantage of the ability to borrow on both sides of the trade, hedge funds can deploy huge leverage. The head of one fund that has engaged in this trade says traders have in the past been able to lever up to 500 times.

The strategy has attracted different types of hedge funds. Traders say diversified groups such as Citadel, Millennium Management and Rokos Capital Management as well as specialists such as Symmetry Investments and Garda Capital Partners are among many that are routinely using the basis trade. The funds in question either declined to comment, or did not respond to requests for comment.

What about the risks?

But central banks and regulators are fearful that the effect of any sudden dislocation in the market could quickly escalate and form ugly feedback loops.

Already there have been several warning shots. The Fed has said it believes stress on this trade played a role in hammering Treasury prices when Covid-19 lockdowns began in the US in March 2020, and it was also considered a factor in a brief seize-up in the repo market in September 2019.

There are several ways the trade can unravel. One is that banks can recoil from risk in moments of market stress, and cut back on the leverage they allow funds to deploy, or ramp up the cost of that short-term lending.

Another is that the clearing houses that facilitate futures trades can increase the amount of collateral they require against a trading position. This occurred when Silicon Valley Bank collapsed in March, with fears of contagion sparking a rapid surge in demand for the safety of US government bonds. In response, CME Clearing increased margins for 10-year Treasury note futures by 15 per cent.

Both make the trade less profitable and leave the hedge fund with a choice: keep the trade on for a higher cost or unwind it, potentially affecting broader markets. The trade is similarly vulnerable to a move in repo rates, which could reduce the amounts banks are willing to lend against hedge fund trades.

“My biggest concern is that if we get a big unwind in this leveraged trade, it could really cause liquidity to dry up in the Treasury market.”

Matthew Scott, head of rates trading at AllianceBernstein

“All these strategies are at significant risk if liquidity worsens,” says an executive in this space at a large US bank. “For instance, if they can’t roll their repo trades or the [costs of] those trades increase.” 

Regulators say this all adds up to a situation where just a few large firms getting out of their bets could potentially encourage or force others to do the same, quickly leading to a doom loop of distressed selling in the world’s most important asset market.

“My biggest concern is that if we get a big unwind in this leveraged trade, it could really cause liquidity to dry up in the Treasury market,” says Matthew Scott, head of rates trading at AllianceBernstein. 

In such a situation, it would be highly unlikely for the US central bank to simply stand back and watch. The executive at the large US bank says: “The assumption is that the Fed will step in to save the repo market, which they have in the past, so my view is that they will step in again if anything happens.”

Intervention could involve buying bonds, thus undermining the central bank’s mission to tighten policy until it defeats inflation, and resembles an official safety net for the trade.

Some firms say they have started pulling back from the trade. “This is pretty crowded right now and there’s a lot of weight in it, so the concerns out there are not necessarily overblown,” says one executive at a large hedge fund. 

But most hedge funds active in this space say fears are misdirected and that any clampdown could have grim knock-on effects.

A senior executive at one of the world’s largest hedge funds says well-run entities are not taking on undue risks. “It’s not like an episode of Billions. You’re talking tiny margins on big positions,” the executive says. “If hedge funds stopped buying Treasuries, I don’t know who would buy them.”

A fixed-income trader at another large hedge fund says the basis trade “has been around for half a century and is well collateralised by design”. Provided it is properly managed, “it plays an essential role in the healthy functioning of the US Treasury market ecosystem”. Funds also argue that the market is better protected thanks to the Fed’s creation of the standing repo facility, which will buy Treasuries and agency mortgage-backed securities from banks in exchange for overnight cash loans. Even though hedge funds do not have access to the facility, it helps prevent sudden spikes in repo rates. 

‘Free insurance’

The prospect of intervention if market conditions become unruly is tantamount to “free insurance,” says Ricks, of Vanderbilt Law School. “I think we should be worried about rent extraction by the funds that are engaged in this trade, who are piggybacking on a Fed backstop.”

The executive at the large bank says that while the basis trade is “overfished”, it could “go on for quite some time because of this moral hazard”.

It’s not like an episode of ‘Billions’. You’re talking tiny margins on big positions

A senior executive at one of the world’s largest hedge funds

The Securities and Exchange Commission, led by chair Gary Gensler, has proposed several new regulations that would constrain hedge funds and high-speed dealers in the Treasury market.

Under one rule, these types of market participants would be required to register as dealers, which would increase oversight of and transparency in their trading activity. But the final version of that rule has not yet been published or implemented and one Washington insider believes hedge funds will resist any highly restrictive dealer rule through litigation. 

The clearest argument made by hedge funds, however, is not that the trade is risk-free, but that in the current market environment it has become essential to the functioning of the system. 

“The total amount of US Treasury debt is growing and deficits are here to stay, just as the Fed is reducing the size of its balance sheet,” says Don Wilson, chief executive of DRW, one of the world’s largest proprietary trading firms.

“The need for leveraged market participants to facilitate that cash-to-derivative transformation will keep growing, and discouraging it will bring significant adverse consequences.”

Additional reporting by Katie Martin and Laura Noonan in London

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