The umbrella group of central banks warned that a buildup of leveraged betting could “dislocate”, or disrupt, trading on the US Treasury market worth $25tn. This is the latest warning about the possibility for hedge fund bets crowded with too many bets, to cause instability.
In its quarterly report, released on Monday, the Bank for International Settlements warned about the rise of the basis trade. Hedge funds are attempting to take advantage of the small differences in prices between Treasury Bonds and the equivalents of these bonds in the futures markets.
The BIS report, which is focused on the leverage used to post margin in the futures markets, states that “the current buildup of leveraged positions short in US Treasury futures could trigger a margin spiral.”
It said that “if margin deleveraging is disorderly, it could cause a dislocation of the core fixed income markets.”
Sifma data shows that $750 billion changed hands each day in August on the Treasury market, which sets borrowing rates for US government bonds.
In times of stress, such as September 2019 and March 2020 when the coronavirus pandemic was raging, the unwindings of leveraged Treasury positions led to wild swings on the Treasury and Repo markets. This forced the Federal Reserve into action.
The BIS used data from the US Commodity Futures Trading Commission to show that short positions in Treasury Futures contracts had reached record levels for some maturities over the past few weeks. BIS estimates short positions in Treasury Futures at around $600bn.
In recent weeks, the bank is the third regulator to call attention to the dangers posed by hedge fund bets on the bond market.
The Fed warned in August that the number of basis trades had increased and the risks posed by such an accumulation.
The Financial Stability Board (FSB), which is composed of the world’s leading finance ministers, regulators and central banks, warned this month that hedge funds that have high levels of synthetic debt — created by derivatives – were a source of potential market instability .
Basis trades are typically used by hedge funds who use relative value strategies. These involve taking a long or short position on the cash market while also taking a position in futures markets, all funded through repurchase agreements. Although there are no definitive figures that show the size of the basis trading, the CFTC’s weekly data on short positions in Treasury Futures is often used as a proxy. The repo market is also closely monitored for borrowing levels.
Hedge funds can make large profits by using leverage to trade these futures bonds, and putting little cash up front.
The BIS paper highlights leverage in both cash and futures markets. The leverage in futures market is high — 70 times for five-year Treasuries, and 50 times for 10-year notes. This is still below the levels just before pandemic.
Futures traders use margin to increase the value and size of their trades. They only supply a small fraction of the overall value. The BIS warned futures investors that they could be forced to abandon their positions if the market moves against them. This would lead to further market declines.