Ken Griffin, founder and CEO of the $62bn US hedge funds Citadel, warned regulators to focus on banks instead of his industry, if they wanted to reduce the risks in the financial systems stemming from leveraged wagers on US Government debt.
The global regulators have warned of the growing risks associated with the so-called Treasury Basis Trade – selling Treasury futures and buying US government bonds, then extracting profits from the small difference between the two by borrowing money.
Griffin argued that they should instead focus on regulating the banks who lend to hedge funds to enable them to trade, and not the hedge funds themselves.
The US Securities and Exchange Commission (SEC), which regulates hedge fund, has proposed for the Treasury Market a new regime that would treat hedge funds as the broker-dealer arm of banks.
Griffin said that the SEC was looking for a problem. If regulators are truly concerned about the amount of the basis trade they can ask the banks to perform stress tests to determine if their counterparties have enough collateral.
In the week leading up to October 24, hedge fund bets on US Treasuries futures reached new heights, with net shorts reaching record levels against the two-year as well as five-year future. These bets, although not all of them, are in the basis trading.
Citadel, along with rival hedge funds Millennium Management & Rokos Capital Management is one of many who use the basis trade routinely.
Researchers at the US Federal Reserve and the Bank for International Settlements have both warned of the dangers of a rapid increase in hedge fund bets on the Treasury market. These risks are magnified because leverage levels can exceed 100-fold.
Regulators are concerned that if the trade goes against them, and hedge funds have to sell their Treasury Bonds at the same moment, it could cause a collapse in the most important bond markets of the world, which would have severe consequences for the financial system as a whole.
BIS blamed “an uncontrolled reduction in margin leverage” for the collapse of US Treasury markets in March 2020, at the beginning of the pandemic. In the Fed’s Financial Stability Report released last month, it was stated that the risks associated with the basis trade were “likely mitigated” by the tighter terms of financing applied by dealers to hedge funds over the past few quarters.
Prime brokerage divisions play a crucial role in the basis trade, as they lend money and use Treasury bonds to secure their loans. Banks will be expected to assess how hedge funds’ portfolios perform when subjected to various market stressors to ensure they have sufficient collateral to withstand market shocks.
Griffin said that he would not be opposed to regulations that limit the amount borrowed by hedge funds on the Treasury Market, as long as the proposals “were subject to sound economic analyses and were proposed for public comments”.
He said that hedge funds bought large amounts of Treasuries in order to match their short positions against the Treasuries.
He said that asset managers can invest their cash in corporate bonds, mortgages or other assets by gaining exposure to Treasuries efficiently through futures.
Futures are leveraged and require a fraction of cash as collateral in order to maintain a position. This is much cheaper than paying the full price for Treasury bonds now.
Griffin stated that “if the SEC recklessly undermines the basis trading, it will crowd out funding for Corporate America, increasing the cost of capital in order to build a factory or hire additional employees.” Griffin said that the SEC’s recklessness would increase the costs of new debts, which the US taxpayers will have to pay in the billions and tens billions each year.
Citadel’s founder, in addressing risks elsewhere in financial system said that “the risks are where there is a mismatch between assets & liabilities relative to leverage used”, pointing out the collapse of Silicon Valley Bank this year.
Because loan demand was low, the US lender used its $180bn of deposits to provide cheap funding for short-term. It also bought unhedged long-term bonds. However, rising interest rates led to devaluation of these bonds and a liquidity problem when customers tried withdrawing their money.
Griffin stated that “Silicon Valley Bank investing in long-dated Treasury bonds using the customer deposits is a profoundly different investment from a hedge funds buying a Treasury Bond and selling a contract for futures which can be settled by delivering a bond.”
Gary Gensler, the SEC’s chairman, has launched the biggest regulatory assault since the financial crises. One of the proposed regulations would increase oversight on hedge funds by requiring larger players to be registered as government securities dealers or broker-dealers.
Griffin stated that regulators should not require hedge funds to register as broker-dealers if they are going to participate in the Treasury Market at any reasonable level. Instead, they should focus their attention on the banks. This is a more cost-effective solution to any concerns the SEC, or other regulators might have.