(Bloomberg) — A small group of funds has accumulated such large short bets in the Treasury market that they could destabilize the entire financial system during times of stress, according to the International Monetary Fund.
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“A concentration of vulnerability has developed, as a handful of highly leveraged funds account for most short positions in Treasury futures,” the IMF said in its Global Financial Stability Report released this week. “Some of these funds may have become systemically important to the Treasury and repo markets, and the stresses they face could affect the financial system as a whole.”
The IMF’s comments come in a section discussing the so-called basis swap, which contributed to turmoil in the world’s largest bond market during the pandemic outbreak in 2020.
In this area, hedge funds exploit the tiny differences between the prices of spot Treasuries and those of futures contracts, using large sums of money borrowed from the repo market to amplify returns. Because of this leverage and reliance on short-term funding, this bet is facing increasing scrutiny from regulators. And now the IMF is highlighting another risk: concentrated positions.
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As of December, about half of the two-year Treasury short positions in the futures market were held by eight or fewer traders, according to the IMF. It was at a similar level at the end of 2019, just before a rise in funding costs at the start of the pandemic prompted traders to unwind their positions, which helped increase bond volatility at a time of upheaval in financial markets.
The IMF did not cite specific funds, but Bloomberg reported in December that firms including ExodusPoint Capital Management, Millennium Management and Citadel had made the bet.
The IMF has recognized that basis transactions are useful in ensuring market liquidity under “normal” conditions. But he also expressed concern that rapid growth in trade has increased the leverage of the financial system.
The popularity of basis trading has increased with interest rate hikes from the Federal Reserve, which could make the strategy more profitable by widening the price spread between the spot and futures markets.
Read more: What is basic trading? Why does this worry regulators? :QuickTake
A Fed study last month estimated that hedge funds have amassed at least $317 billion in Treasury securities linked to core trading since the first quarter of 2022, although that size is “considerably” smaller than what she had estimated previously.
The Securities and Exchange Commission has worked to curb basic trading and increase transparency of hedge funds’ exposure to the strategy. In December, the SEC required funds and brokerages to centrally clear more of their trades in U.S. Treasuries, a move aimed at strengthening oversight of core transactions.
Since then, there have been signs that use of the trade may be declining: Commodity Futures Trading Commission data shows a decline in leveraged funds’ short positions in bond futures.
The concentration of these bets has also decreased. On two-year futures contracts, net short positions controlled by eight or fewer traders fell to about 38% of total open interest, from 50% in early January, according to CFTC data compiled by Bloomberg.
Despite this outcome, the IMF noted that leveraged funds’ short positions remain significant, meaning they can still pose a risk.
As the Fed reduces its holdings of Treasuries, a process known as quantitative tightening, it could also reduce liquidity in the financial system, potentially triggering higher funding costs and leading to the collapse of securities trading. basis, the IMF said.
“Investors in the basis trade rely on low haircuts and repo rates to leverage their positions and increase the profitability of the basis trade,” the report said. “A rise in repo rates – triggered, for example, by unexpected quantitative tightening – can make trading unprofitable and could trigger forced selling of Treasury securities and rapid unwinding of futures positions as funds seek to get out of debt quickly. »
–With assistance from Liz Capo McCormick and Edward Bolingbroke.
(Adds IMF comment to seventh paragraph.)
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