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A build-up of leveraged bets has the potential to “dislocate” trading in the $25tn US Treasuries market, the umbrella group for central banks said, the latest high-profile warning over the potential for crowded hedge fund bets to sow instability.
The Bank for International Settlements issued a warning in its quarterly report released on Monday about the growth of the so-called basis trade — whereby hedge funds seek to exploit the tiny differences between the prices of Treasury bonds and their equivalents in the futures market.
“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 said in the report, which focuses in particular on leverage used in the futures market to post margin.
“Margin deleveraging, if disorderly, has the potential to dislocate core fixed-income markets,” it said.
The Treasury market is one of the world’s most closely watched as it sets borrowing costs for US government debt, with $750bn changing hands every day in August, according to data from Sifma.
The unwinding of leveraged Treasury positions in moments of stress such as in September 2019 as well as March 2020 during the coronavirus pandemic led to wild swings in the Treasury and repo markets that ultimately forced the Federal Reserve to step in.
As evidence of a build-up in the trade, the BIS cited data from the US Commodity Futures Trading Commission showing a rise of short positions in Treasury futures contracts to record levels in some maturities in recent weeks. The BIS values short positions in Treasury futures at about $600bn.
The bank is the third regulatory body in recent weeks to draw attention to the risks posed by the build-up of hedge fund bets in the bond market.
In August the Fed said there had been a rise in the volume of basis trades placed and warned about the financial stability risks that such a build-up posed.
The Financial Stability Board, which comprises the world’s top finance ministers, central bankers and regulators, this month warned that hedge funds with high levels of synthetic leverage — debt created by derivatives — were a potential source of market instability.
The basis trade is typically employed by hedge funds that use relative value strategies that involve a long position in the cash market and a short position in the futures market, funded by repurchase agreements. While there is no definitive data that shows the size of the basis trade, weekly figures from the CFTC showing short positions in Treasury futures are often watched as a proxy. Borrowing levels in the repo market are also monitored.
Because the difference between the cash and futures bonds tend to be small, hedge funds make large profits from these trades by leveraging them heavily, putting very little of their own cash upfront.
Much of that leverage is seen in the long positions in the cash market, but the BIS paper also highlighted leverage in futures positions. Leverage in futures is elevated — at 70 times in five-year Treasuries and 50 times in 10-year notes — though below levels seen just before the pandemic.
In futures, traders typically use margin to magnify the value of their positions and supply only a fraction of the value of the total trade. The BIS warned that if the market moved against highly leveraged futures investors, they may be forced to ditch their positions, triggering further market sell-offs.