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Margin leverage and vulnerabilities in US Treasury futures

Speculative positions by leveraged investors in US government bonds are back. In recent months, leveraged funds have accumulated approximately $600 billion in net short positions in U.S. Treasury futures (Graph A1.A), with more than 40% of net short sales concentrated in two-year contracts (Graph A1. B). .* These funds had experienced comparable levels of net short selling in the lead-up to the repo market turmoil in September 2019 (marker a) and the US Treasury market turmoil in March 2020 (marker b). This box examines current developments in light of these experiences. It focuses on the often overlooked leverage associated with futures trading and how sudden fluctuations in this “margin leverage” can lead to destabilizing margin spirals.symbol

Speculative positions in US Treasury futures rose despite higher initial margins

Back in September 2019 and March 2020, price differences between futures and the underlying cash bonds (the “cash futures “basis”) encouraged highly leveraged funds to engage in relative value trades. Recent evidence suggests that the same type of trading may be the cause of the current surge.symbol When Treasury futures are valued at a premium compared to cash bonds, a common relative value trading strategy is to sell futures forward (taking short positions in futures) while simultaneously buying bonds (going long on the cash market). Such trading generates profits as the futures and spot prices eventually converge on the futures contract expiration date. Because the basis is typically narrow, investors must increase their profits through very high leverage, meaning they use only a small amount of equity and borrow the rest. An important way to leverage is through long positions: investors borrow cash on the repo market (usually they have to roll it over daily) by putting up their US Treasury holdings as collateral.

A less discussed aspect of leverage in cash futures basis trading arises from the futures markets. When entering into a futures contract, traders are required to deposit an Initial Margin (IM), which is cash or highly liquid assets that the central counterparty (CCP) holds as collateral to protect against the counterparty's credit risk. The ratio of the futures contract value to the IM determines the allowable leverage. For example, if traders open a futures position for $100 with an IM of $20, they are effectively borrowing $80 and the leverage of the position is 5x (= 100 / 20). Leverage on actual U.S. Treasury futures was very high before the pandemic, averaging around 175x and 120x for five- and 10-year Treasuries, respectively (Graph A1.C). It has declined since 2021 as increased volatility in the U.S. Treasury market has led to greater demand for IMs, but is still elevated at around 70x and 50x, respectively. An increase in IM requirements automatically leads to deleveraging as traders must either provide additional cash to meet the IM requirements or close their positions.

The sudden closure of positions was preceded by large initial margin increases

In both September 2019 and March 2020, a disorderly decline in margin leverage exacerbated bond market distress. The two episodes were preceded by significant increases in IMs (Graph A1.C, declines before vertical markers), to which leveraged relative value traders appeared to respond, at least in part, by unwinding their positions. This was evident in the jump in the price of US Treasury futures on the day of the IM surge in early August 2019 (Graph A2.A). As cash bond prices rose faster than futures prices due to increased volatility, the basis reversed, further incentivizing trades to take place (Graph A2.B, red line). The resulting momentum exerted continued upward pressure on futures prices (Graph A2.A). Similar market dynamics were seen in March 2020, exacerbating increased volatility in U.S. Treasury markets caused by uncertainty and lockdowns (Graph A2.C).

Given this experience, the current build-up of leveraged short positions in U.S. Treasury futures represents a financial vulnerability that should be monitored as it could potentially trigger margin spirals. While this channel received widespread recognition in the March 2020 episode of Dash for Cash,symbol Other factors attracted more attention related to the stress in the repo market in September 2019.symbol But the reduction in margins in August 2019 could have been a harbinger of the disruptions in the financing market that followed a month later. Margin reduction, if done in a disorderly manner, could lead to disruption in the core fixed income markets.

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