The World’s Central Banks Are Fretting Hedge Funds’ Risky Bond Bets

(Photo by Dylan Calluy on Unsplash)

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If only we could hedge against hedge fund risk.

The Bank for International Settlements (BIS), a cooperative organization of 63 global central banks, warned in its quarterly report on Monday about the troubling rise of the so-called basis trade, in which hedge funds seek to profit off marginal differences between the prices of Treasury bonds and their facsimiles in futures markets. It’s just the latest red flag raised by regulatory bodies about hedge funds’ recent dalliances in the bond market.

Bonds, Treasury Bonds

It’s all very weedy, but US Treasuries constitute a $25 trillion market that acts as a benchmark for borrowing costs of US government debt no less, and one that saw roughly $750 billion of trades every day in August, according to data from the Securities Industry and Financial Markets Association reported by the Financial Times. The potential to, as the BIS delicately puts it,  ”dislocate” trading is noteworthy.

Basis trades use heavy borrowing in the repurchase market to leverage the price difference between a short bet on Treasury futures and a long position on Treasury cash. When it works, hedge funds make huge profits — with heavy leverage allowing them to put up precious little of their own cash. But if larger market corrections or movements act against highly leveraged futures positions, it can trigger various market selloffs. And because data from the Commodity Futures Trading Commission suggests a recent build-up in such trades, the BIS is officially worried.

That should sound familiar because it’s almost the exact same dynamic that played out in the early days of the pandemic:

  • Hedge funds built up similarly large basis trade positions in early 2020 — some of which were levered up to 50 times their own wagers, sources told Bloomberg at the time. But when the pandemic introduced massive market volatility, and hordes of investors rushed into the typically safe confines of Treasury futures, hedge funds making basis trades got crushed.
  • The ensuing volatility is at least in part responsible for convincing the Federal Reserve to unveil its money bazooka and blast some $5 trillion of cash to stabilize the markets.

2020 Redux: “The current build-up of leveraged short positions in US Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger,” the BIS wrote in its report. The concerns echo a recent paper published by the Fed highlighting the exact same warning signs, while the SEC has been monitoring hedge funds’ basis trade positions since this spring, according to a Bloomberg report in May. Then again, if systemic financial instability is the only 2020-era crisis to make a comeback, who are we to complain?