There is both the conventional leverage using the funds raised from the repo market and the synthetic leverage inherent in the futures market, where the margin to be deposited can be a fraction of the value of the position.
According to the BIS, the leverage in the contracts for five-year government bonds is about 70 times and in the ten-year bonds it is about 50 times. Since they use borrowed money to fund their long positions and synthetic leverage for the short positions, the total leverage required to convert micromargins into significant profits would be many times these numbers.
Basis trading has grown rapidly because as U.S. deficits and debt have risen dramatically in recent years, the supply of U.S. government securities that the market has to absorb has also increased.
US Federal Reserve Chairman Jerome Powell. The Fed can and would step in if everything goes wrong, but that’s part of the problem as hedge funds increase their risk appetite.Credit: Bloomberg
As asset managers seek exposure to the futures market, spreads between futures and the physical market have widened, making trading even more attractive.
The Bank of England’s interest in the US bond market would have been piqued by its own experience last year when it was forced to intervene to avert a foreign exchange and bond market crisis in the UK after a short-lived mini-budget was proposed by Prime Minister Liz Truss (whose term was also short-lived) and her chancellor Kwasi Kwarteng (ditto) sent British bond yields soaring and the pound plummeting.
The market turmoil exposed a derivatives trade that British pension funds were using to hedge their long-term liabilities.
As bond yields soared, they faced so-called margin calls and were forced to dump their physical bond holdings, triggering a destructive spiral that threatened the solvency of pension funds and inflicted huge losses on bond investors in general, according to Britain’s Homeland Der Credit market collapsed and threatened the stability of the entire British financial system.
Now regulators fear something similar could happen in the U.S. bond market, which has had its own problems recently.
In 2019, a spike in repo rates caused this market, which is crucial to the functioning of the U.S. system, to collapse.
In 2020, in the midst of the pandemic at the start of the pandemic, a similar collapse occurred when hedge funds with highly leveraged derivative positions in the Treasury market suddenly became forced sellers.
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In both cases, the Fed was forced to take emergency action, pumping liquidity into the system and acting as a buyer of last resort for Treasury bonds.
Regulators fear that a liquidity “event” like the one that occurred with the realization of the severity of the COVID-19 outbreaks could lead to volatility in the bond market, risk aversion by lenders to hedge funds and a surge that would force funds to increase their to reduce positions – what the BIS calls “margin deleveraging” – in a race to exit that could trigger a destructive cycle and destabilize the U.S. Treasury market.
The U.S. Treasury bond market is, of course, the heart of the global financial system. It is considered a global safe haven and its bond yields provide the benchmark for much of the world’s fixed income securities. The 10-year US bond is the world’s “risk-free” asset.
It is therefore not surprising that financial regulators are concerned about a possible threat to their stability.
It is a threat – if it is a threat – partly of their own making.
After the 2008 financial crisis, stricter capital and liquidity requirements were imposed on major banks that previously served as market makers and provided liquidity to the Treasury market. Now hedge funds and algorithmic traders are taking on much of that role, greasing the wheels of the US financial system.
The Bank of England had to intervene last year to avert a foreign exchange and bond market crisis in the UK after Prime Minister Liz Truss (pictured) and her Chancellor Kwasi Kwarteng proposed a short-term mini-Budget.Credit: Bloomberg
The hedge funds would argue that anything that diminishes their role by making basis trading less attractive – there are proposals for stricter margin requirements and/or limits on leverage, as well as enforcing greater transparency – would jeopardize the smooth functioning of the market.
Analysts at Goldman Sachs have also pointed out that after the 2019 and 2020 episodes, margin requirements for futures contracts and lower prices for bonds (as interest rates and yields rose in the wake of the Fed’s 18-month tightening of US monetary policy) bond prices have fallen. Leverage in the system is now lower than before.
Do hedge funds and basis trading pose a threat to systemic stability in the US and globally? Perhaps. Previous attacks on US financial markets have highlighted their vulnerability to the failure of these types of leveraged trades.
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However, these earlier episodes and the BoE’s interventions in the implosion of the UK bond market also make it clear that the safety net beneath the market is all unraveling.
The Fed can and would intervene, although that alone illustrates another problem, because knowing that the Fed is supporting them encourages hedge funds to take on extreme leverage and accept the risks, while at the same time protecting others in those markets and those transactions Reassured parties involved The Fed will always save them. This could of course be called a moral hazard.
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