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HomeBusinessUS Treasury Gaming by Hedge Funds: Alarm Sounded by Fed Economists (Reuters)

US Treasury Gaming by Hedge Funds: Alarm Sounded by Fed Economists (Reuters)

Federal Reserve economists have raised concerns about the potential for disruptions in the U.S. Treasuries market due to a popular hedge fund trading strategy. This trading strategy, known as basis trades, involves shorting Treasuries futures contracts and buying them back with repurchase agreement (repo) funding. The Fed economists have warned that these trades could expose cash-futures basis positions to stress during market corrections and pose financial vulnerability risks, especially in a volatile bond market with higher interest rates and uncertainties in monetary policy.

The researchers at the Fed have emphasized the need for continued and diligent monitoring of these trades, particularly due to the risk of a rapid unwind in case of higher repo funding costs. They have expressed concerns that such an unwind could amplify market stress and increase volatility in the Treasury, futures, and repo markets. Leveraged funds’ net shorts on Treasuries futures have reached near-record highs recently, indicating widespread usage of basis trades. While the Fed does not have direct regulatory oversight over hedge funds, there are expectations that they may eventually take action to address the accumulation of basis positions.

There are worries that a repeat of the illiquidity seen in the Treasuries market in March 2020 could occur if basis trades unwind. Increased margin costs on futures shorts and higher financing costs on cash long positions could make these trades vulnerable. If financing costs rise in the repo market, the spread between futures contracts and underlying cash Treasuries would need to increase to maintain profitability, potentially leading to market turmoil. The Fed is keen to prevent such a scenario and may take measures to mitigate the risks associated with basis trades.

In summary, the Fed economists have issued warnings about the potential disruptions in the U.S. Treasuries market caused by the resurgence of a popular hedge fund trading strategy known as basis trades. These trades, which involve shorting Treasuries futures contracts and using repo funding to buy them back, have reached record highs, raising concerns about financial vulnerability risks. The Fed is concerned that the cash-futures basis positions could be exposed to stress during market corrections and that a rapid unwind of basis trade positions could exacerbate market volatility. There are worries that a repeat of the illiquidity experienced in the Treasuries market in March 2020 could occur if financing costs in the repo market increase. The Fed may take action to prevent such market turmoil.

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