Hedge funds exploit debt crisis through basis trading: sources

Featured Sponsor

table {
width: 100%;
border-collapse: collapse;
}
th, td {
padding: 10px;
text-align: left;
border-bottom: 1px solid #006699;
}
th {
background-color: #006699;
color: #FCB900;
}
.image-container {
width: 100px;
height: auto;
}

Officials with the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about leveraged trading in government bonds by their fast-money customers, according to people familiar with the matter, who asked not to be named, citing the confidential nature of the talks . The dangers have increased as political risk-taking around the debt ceiling threatened to plunge the US into default and unleash chaos in financial markets.

Several of the hedge funds that have recently engaged in so-called basic trading have also been active in 2020 as the outbreak of the pandemic turned the Treasury market upside down, catching them on the wrong foot until Fed officials stepped in to restore normalcy . The list includes Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, according to people familiar with the matter.

The opaque and risky strategy has long frightened the watchdogs. It involves borrowing heavily in the buyback market and using that leverage to exploit the price gap between Treasury futures and the underlying spot market. In some cases, trades were leveraged by a ratio of 50 to 1, according to two respondents. The strategy’s continued popularity is particularly alarming for SEC Chairman Gary Gensler, whose goal is to impose stricter regulations on large speculators.

“There is a risk in our capital markets today that there may be relatively low-margin or even zero-margin financing available to large macro hedge funds,” Gensler said in response to a Bloomberg News inquiry about the rise of the investment style.

The New York Fed said in a statement that it “regularly contacts a wide range of market participants to gather information about developments in financial markets, and this outreach is consistent with typical market intelligence gathering.”

Officials asked about current margin requirements and how a US default or credit rating downgrade would affect market activity, including the value of collateral, the people said.

Regulatory interest in the issue isn’t entirely new – some officials have been eyeing it since the last blast – but the possibility of US bankruptcy has added a new and worrying element. Financial regulators are under pressure after being repeatedly caught off guard by bond market instability since the outbreak of the pandemic.

Fed officials expressed concern at the monetary policy meeting earlier this month about the risks lurking outside the banking system in light of the recent financial crises. protocol The study, published on Wednesday, highlighted “hedge funds that tend to use significant leverage and may hold concentrated positions in some assets with little or no margin.”

memories of the Itinerary 2020 are fresh. Back then, massive volatility in Treasury futures triggered margin calls and contributed to the Fed’s decision to commit trillions in stimulus packages. ExodusPoint and Capula got caught, while Millennium shut down several so-called trading pods during the crisis. The Citadel had less of an impact. The company’s current positioning in the industry is not the greatest in history, said one of the respondents.

Representatives from Citadel, Millennium, ExodusPoint and Capula declined to comment on their latest revelations.

This time the setup is in Short futures positions of funds using leverage has reached record levels. This is a sign that speculators are looking to take advantage of a price differential between Treasury futures and the spot market. Because the strategy typically yields low returns, hedge funds borrow in the repo market to boost profits.

Much of this business is done on a bilateral basis – that is, transactions take place between two companies without a central clearing house serving as backup. The Treasury Department’s Office of Financial Research has said it views bilateral repurchase agreements, the most common of all buyback activity, as a regulatory vulnerability. Post-2008 banking rules have also been enacted repo activity more expensive and less attractive for dealers – that gives life new market entrants most of which operate outside the reach of financial regulators.

The SEC was seek to channel more treasury transactions from hedge funds to central clearinghouses. The agency also drafted a rule that would do so require Private funds can report major losses, sudden increases in margins or other significant events within 72 hours at most – or possibly sooner. However, this regulation will not come into force for another six months.

Meanwhile, the clock is ticking for debt negotiators in Washington. Traders assume that if the worst came to the worst, the Treasury would prioritize interest and principal payments on publicly held bonds. But even if a last-minute deal is reached, continued fiscal risk could cause repo rates to rise – and undermine unilateral deals in a bond market that has dealt a severe blow to a multitude of wealth managers over the past year, while also affecting regional banking boosts crisis.

To be clear, not everyone finds positioning in the bond market alarming. For Meghan Swiber, a US interest rates strategist at Bank of America Corp., hedge funds typically take the other side of the trade when money managers take massive long positions in futures. And to hedge, the quick buck continues to buy bonds in the spot market, which Swiber says is helpful at a time when the Fed is trimming its bond portfolio.

“The money manager community is seeing such high demand for government bonds that someone needs to provide liquidity to these money managers,” she said.

As the time to avert a default tightens, Republican and White House negotiators are reportedly getting closer to an agreement to raise the debt ceiling and cap federal spending for two years. House Speaker Kevin McCarthy will resume talks on Friday. However, the details are preliminary and no final agreement has been reached yet.

Should the US actually default on some commitments over the next month, Gensler warned that market funding and liquidity would be particularly problematic alongside the many concerns.

“It would be a huge mess,” he said at a recent press conference.

–Featuring Hannah Levitt, Christopher Condon, Katanga Johnson, Kate Davidson, Ye Xie, Edward Bolingbroke and Jenny Surane.