The Bank of International Settlements (BIS) warned financial markets that hedge funds could disrupt the all-important US Treasury market because of massive size of their leveraged bets against it.
In total, hedge funds hold a $600 billion short position against the $25 trillion US Treasury market, created using contracts to bet on the future price of the asset, according to a BIS research note from economists Fernando Avalos and Vladyslav Sushko.
This has the BIS, which manages funds for central banks and encourages financial cooperation between countries, worried that if hedge funds dependent on borrowed money are suddenly forced to put up more collateral, then bond markets could see an damaging sell-off, similar to what markets faced during the onset of the pandemic in 2020.
The BIS has raised concerns about a specific strategy known as the relative value trade. This strategy comes into play when there’s a noticeable difference between an asset’s current price, and its future contract price. In such scenarios, investors typically buy the cheaper asset and sell the pricier one.
Right now, Treasury futures trade at a slightly higher value than actual government debt because they require less up-front cash when purchased by long-term asset managers. A hedge fund pursuing a relative value trade takes advantage of this dynamic by buying actual Treasurys, while selling Treasury futures contracts at the higher price. When the time comes to fulfill the contract, the trader can deliver the actual bond they bought and pocket the difference between the two prices.
The actual differences in value between Treasurys and future contracts are quite small, so hedge funds typically need to borrow a lot of money to make this strategy profitable, according to the BIS. Hedge funds often finance their investments with overnight borrowing on the money market, and borrow financial assets from brokers to extend their leverage in specific trades.
Before the pandemic, the initial margin requirement (similar to a security deposit needed for a loan) to borrow Treasurys was quite low. This allowed traders in the Treasury market to operate with leverage as high as 175 and 120 times the value of their initial deposits for five-year and ten-year Treasuries, respectively. However, with increased volatility in the Treasury market in 2021, the margin requirements tightened. Despite this, trading leverage remains elevated: 70 times the initial deposit for five-year Treasuries and 50 times for ten-year Treasuries.
In both September 2019 and March 2020, traders reduced their holdings of Treasury and corresponding futures contracts aggressively in response to sudden changes in margin requirements from brokers who fretted about economic conditions. This led to Treasury prices dropping very quickly in 2020, and the Federal Reserve bought $500 billion in Treasurys to smooth out the dysfunction.
If margin requirements tighten quickly again with the amount of leverage that’s being applied to the Treasury markets, the BIS warns, this very safe asset class could be in for another time of volatility.