Nov 29 (Reuters) – In recent weeks, senior U.S. officials have raised concerns about hedge fund trading profiting from tiny price differences in Treasury bonds, fearing it could pose a risk to financial stability. However, no one knows how big this trade really is.
Researchers at the Federal Reserve and the Office of Financial Research (OFR) wrote in late August that there were signs that so-called basis trading had increased this year amid rising interest rates and was approaching levels last seen in 2019.
The trading, which is inherently risky because hedge funds borrow heavily to make profits, is believed to have worsened market tensions at the height of the pandemic in March 2020.
To conclude that basis trading had once again skyrocketed, researchers had to rely on a series of incomplete proxies rather than data that could tell them directly about it. This data does not exist.
Two market sources, one at a major bank and one at a hedge fund, said they did not see the trade as large on their own books.
Therein lies a problem that plagues the foundation of global finance: Some key segments of the $26 trillion government bond market operate in the shadows. The lack of transparency makes policymaking more difficult and contentious, leaving regulators sometimes with incomplete understanding and blunt tools that many in the industry argue can create new problems.
The problem has not been lost on officials, who launched a major review of the market in 2021 to improve its resilience and transparency. Their efforts to collect more data are now converging.
The next big milestone is expected early next year, with the OFR planning to finalize a rule to collect data on the largest segment of the short-term funding markets underlying government bonds. They currently have no data on transactions that take place bilaterally between brokers and their customers, such as hedge funds, repurchase agreements or repos.
Together with other steps, this will represent a major step forward in improving regulators’ visibility in the market, but there will still be some gaps.
“It’s a question of the level of transparency,” said Darrell Duffie, a finance professor at Stanford University who has studied the market extensively.
Duffie said more could be done, but added that “Treasury’s official sector market data sets are now far more comprehensive than they were a few years ago”.
An industry executive familiar with these issues described the work as fundamental but added that “it doesn’t solve all the problems.” Officials would have more information about transactions, but would have no idea what motivations lie behind all the different types of deals.
For example, you would have much better estimates of the base trade, but you still wouldn’t know exactly how big it is.
A Treasury official said authorities have plenty of data to assess financial market resilience and inform policy and are working to obtain more.
Efforts to bolster market resilience are broad-based and long-term, rather than just focused on specific positions such as base trading, the official added.
BASIC TRADES
To understand the progression and limitations, take the case of basis trades. In trading, hedge funds exploit the difference between a Treasury security and its derivative in the futures market.
The funds purchase the government bond on the secondary market and finance the purchase by taking out repo loans, using the bond as collateral.
At the same time, they short the corresponding Treasury futures contract and sell that bond in the future at a higher price than they paid to purchase it.
In their analysis, Fed researchers used data vignettes from different branches of this trading and stitched together information from various regulators.
For example, the Commodity Futures Trading Commission (CFTC) has data on hedge fund positions in futures markets. The OFR collects information about repo trading that is cleared through a third party called central clearing. The data contains information about the type of collateral used, which can provide an indication of whether the trade could be a basis trade.
The data sources have limitations that the researchers acknowledged. The CFTC data includes other trades hedge funds enter into that involve shorting Treasury futures, the two industry sources said. And centrally cleared trades account for only a small portion of this hedge fund borrowing, with most taking place in the bilateral repo market.
Thanks to their efforts, regulators will have more information in the coming months as these rules are finalized and implemented. The OFR data will provide valuable insights into the bilateral market. This includes the amount of debt or leverage that hedge funds use for trades and outstanding positions. The Securities and Exchange Commission also collects more information about hedge fund positions.
But the improvements will be limited. Regulators still won’t see all the trading, two industry sources said. To do this, they need to obtain more information from market participants that allows them to link the various transactions of complex positions such as basic transactions.
Meanwhile, some market participants fear the policy may be flawed. Concerns about debt have led to debate over proposals that hedge funds say could lead to fewer intermediaries and increase the government’s debt costs.
At a major Treasury market conference earlier this month, officials underscored the importance of good data.
“‘Without clay I can’t make bricks,'” New York Fed President John Williams said at the conference, quoting from a Sherlock Holmes novel. “He understood that he had to first gather the facts before he could flesh out the case.”
Reporting by Paritosh Bansal; Edited by Anna Driver
Our standards: The Thomson Reuters Trust Principles.
Comments are closed.