The world’s top regulators are increasingly concerned about the potential risks posed by hedge fund bets in the $25tn US government bond market. The Bank for International Settlements and the US Federal Reserve have both highlighted a rapid build-up in hedge funds’ bets in the Treasury market, particularly the basis trade, which involves selling futures and buying bonds to profit from the small gap between the two using borrowed money. Despite the differences from the UK’s 2019 investment meltdown, both scenarios share the common element of heavy leverage paired with sudden market movements, which can lead to serious problems. The Fed and the BIS have warned that this strategy could cause financial instability and disrupt trading.
The US Treasury market is crucial to the global financial system, as the yield on US government debt is considered the risk-free rate and serves as the benchmark for all asset classes. Analysts and investors argue that the belief in the Fed’s interventions during times of extreme market instability has created moral hazard and encourages more speculative trading. However, hedge funds argue that they are essential providers of liquidity in the Treasury market and that without them, the government issuing new bonds and pension funds trading would become more expensive. Hedge funds and high-speed traders have played an increasingly important role in the Treasury market since the 2008 financial crisis when primary dealers reduced their involvement due to increased regulations and costs.
Regulators are concerned that any sudden dislocation in the market or a decrease in liquidity could have severe consequences and create a feedback loop. The Fed has already pointed out that stress related to the basis trade played a role in a drop in Treasury prices during the COVID-19 lockdowns in March 2020. Banks may also reduce leverage or increase the cost of short-term lending, and clearing houses may require more collateral against trading positions, which would make the trade less profitable. The trade is also vulnerable to changes in repo rates and the willingness of banks to lend against hedge fund trades. The fear is that a few large firms unwinding their bets could lead to distressed selling and trigger a downward spiral in the important US government bond market.