The trade that could blow up the financial system

Four of the world’s most significant financial regulators are warning of a particular risk lurking within the shadows of the financial system that could threaten the world’s most important market, the $US25 trillion ($39 trillion) US government bond market.

Only last week, in its latest quarterly review, the Bank for International Settlements warned that a build-up of leveraged hedge fund positions in the US Treasuries market had the potential to “dislocate” core fixed income markets.

The focus of the concerns is a trade that exploits tiny differences in the prices of US government securities in physical and futures markets.Credit: AP

Earlier this month, the US Federal Reserve Board and the Financial Stability Board echoed concerns expressed by the Bank of England in July about the potential for market turmoil latent in what is a routine and growing hedge fund trading strategy.

The focus of their concerns is a relative value or arbitrage trade – usually referred to as the basis trade – that exploits tiny differences in the prices of US government securities in physical and futures markets.

The hedge funds buy Treasuries (the most popular duration is the two-year note), borrow in the “repo” or short-term funding market using the notes as security and then take an equivalent short position in the futures market.

The trade works because the big asset managers and pension funds use the futures market to gain capital-light fixed interest exposures and hedge the interest rate risk on their own long-term liabilities. That has resulted in the futures prices being slightly – very slightly – higher than that of the bonds.

As contracts expire, the prices of the futures and the physical securities they’ve paid a fraction less for tend to converge, so when the hedge funds settle the trade by handing over the securities they crystallise a profit.

Because the differences are so marginal, it is leverage that makes the trade work for the hedge funds.

There’s both the conventional leverage in using the funds raised from the repo market and then there’s the synthetic leverage inherent in the futures market, where the margin they have to put up can be a fraction of the value of the position.

The BIS says leverage in the contracts for five-year Treasuries is about 70 times and about 50 times in the 10-year bonds. Because they are using borrowed money to fund their long positions and synthetic leverage for the short positions the overall leverage involved in turning micro margins into significant profits would be multiples of those numbers.

The basis trade has been growing rapidly because, as US deficits and debt has expanded dramatically over recent years, so has the supply of US government securities that market has to absorb.

US Fed chairman Jerome Powell. The Fed can and would step in if it all goes pear-shaped, but that is part of the problem, as hedge funds up their risk-taking.Credit: Bloomberg

With the asset managers looking for their exposure in the futures market, the spreads between futures and the physical market have widened, making the trade 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 proposed by prime minister Liz Truss (whose tenure was also short-lived) and her chancellor, Kwasi Kwarteng (ditto), caused UK bond yields to soar and the pound to plummet.

The market turmoil exposed a derivatives trade used by UK pension funds to hedge their long-term liabilities.

As bond yields soared they were hit with what were effectively margin calls and were being forced to dump their physical bond holdings, causing a destructive spiral that threatened the solvency of the pensions funds, was generating huge losses for bond investors generally, saw the UK home loan market seize up and threatened the stability of the entire UK financial system.

Now the regulators fear something similar could occur in the US bond market, which has had its own recent moments.

In 2019, a spike in repo rates caused that market – a key to the functioning of the US system, to seize up.

In 2020, amid the pandemic at the onset of the pandemic, there was a similar meltdown as hedge funds with highly leveraged derivatives positions in the Treasuries market suddenly became forced sellers.

In both instances, the Fed was forced into taking emergency measures, pumping liquidity into the system and acting as the buyer of last resort for Treasury securities.

The regulators are concerned that a liquidity “event” such as the one that hit with the realisation of the seriousness of COVID-19 could cause volatility in the bond market and risk-aversion from lenders to the hedge funds. They also fear a spike in margin requirements in the future market that would force the funds to dump their positions in a scramble for the exits that could destabilise the US Treasuries market.

The US Treasuries market is at the heart of the global financial system. It is regarded as the world’s financial safe haven and its bond yields provide the reference points for much of the world’s fixed interest securities. The US 10-year bond is the world’s “risk-free” asset.

It’s not surprising, therefore, that financial regulators are concerned about any potential threat to its stability.

It’s a threat – if it is a threat – partly of their own making.

After the 2008 financial crisis tougher capital and liquidity requirements were imposed on the big banks who used to be the market makers and supply the liquidity for the Treasuries market. Now the hedge funds and algorithmic traders perform much of that role, greasing the wheels of the US financial system.

The Bank of England was forced to intervene to avert a foreign exchange and bond market crisis in the UK last year after a short-lived mini budget proposed by the prime minister, Liz Truss (pictured) and her chancellor, Kwasi Kwarteng.Credit: Bloomberg

The hedge funds would argue that anything that diminishes their role by making the basis trade less attractive – there are suggestions of tougher margin requirements and/or restrictions on leverage, as well as enforced greater transparency – would jeopardise smooth functioning of the market.

Goldman Sachs analysts have also noted that, after the 2019 and 2020 episodes, margin requirements for futures contracts and lower prices for bonds (as interest rates and yields have risen over the Fed’s 18-month tightening of US monetary policy bond prices have fallen) mean there is now less leverage in the system than there was.

Do the hedge funds and the basis trade represent a threat to US and global systemic stability? Perhaps. The earlier seizures of US financial markets highlighted their vulnerability to any breakdown of these sorts of leveraged trades.

Those earlier episodes and the BoE’s interventions in the UK bond market implosion, however, also highlight the safety net under the market is all goes pear-shaped.

The Fed can and would step in, although that by itself underscores a different problem because the knowledge that the Fed is backstopping them encourages hedge funds to take on extreme leverage and accept the risks while comforting the other parties involved in these markets and these transactions that the Fed will always bail them out. This could, of course, be described as a moral hazard.

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