IMF says bond bets made some hedge funds too big to fail

“There has been a concentration of vulnerabilities, as a handful of highly leveraged funds account for the majority of short positions in Treasury futures,” the IMF said in its Global Financial Stability Report released this week. “Some of these funds may have been formed organically.” “Treasury and repo markets are critical, and the stress they face could impact the broader financial system.”

The IMF’s comments came in a section discussing so-called basis trading, which contributed to turmoil in the world’s largest bond market as the pandemic spread in 2020.

In this trading, hedge funds take advantage of small differences between cash Treasury and futures prices, using large sums borrowed from the repurchase-agreement market to enhance returns. Because of this leverage and reliance on short-term funding, these bets are coming under greater scrutiny from regulators. And now the IMF is highlighting another risk: concentrated positions.

Read more: The kings of giant bond trading who are scaring regulators

According to the IMF, as of December, nearly half of two-year Treasury short positions in the futures market were in the hands of eight traders or fewer. It was at the same level at the end of 2019, before rising funding costs in the early days of the pandemic prompted traders to reduce positions, helping to fuel volatility in bonds at a time of turmoil in financial markets. .

The IMF did not cite specific funds, but Bloomberg reported in December that companies including ExodusPoint Capital Management, Millennium Management and Citadel had used stakes.

The popularity of basis trades increased as the Federal Reserve increased interest rates, potentially making the strategy more profitable by widening the price differential between the cash and futures markets.

Read More: What is Aadhaar Trading? Why does this worry regulators?: QuickTake

A Fed study last month estimated that hedge funds have accumulated at least $317 billion in Treasury holdings related to basis trades since the first quarter of 2022, although the size is “significantly” less than previously estimated.

The Securities and Exchange Commission is working to rein in basis trading and increase transparency of hedge funds’ exposure to the strategy. In December, the SEC required funds and brokerages to centrally clear a far greater share of their U.S. Treasury transactions, a move to increase oversight of basis trades.

Since then, there are signs that use of trading may be declining: Commodity Futures Trading Commission data shows a decline in leveraged funds’ short positions in bond futures.

Concentration in these bets has also reduced. In two-year futures, net short positions controlled by eight traders or fewer have fallen to about 38% of total open interest, down from 50% in early January, according to CFTC data compiled by Bloomberg.

Despite that exemption, the IMF said short positions of leveraged funds remain large, meaning they could still be exposed as risks.

As the Fed reduces its holdings of Treasuries, a process known as quantitative tightening, it could also reduce liquidity in the financial system, potentially causing a jump in funding costs and in basis trading. A decline could come, the IMF said.

“Basis trading investors rely on lower repo haircuts and lower repo rates to leverage their positions and increase basis trading profitability,” the report said. For example, a surprise increase in quantitative tightening due to an increase in repo rates could impact trade. This is unprofitable and could lead to forced selling of Treasury securities and rapid shortfall of futures positions as funds seek to be delivered quickly.”

-With assistance from Liz Capo McCormick and Edward Bolingbroke.

(The sixth paragraph adds to previous reporting on firms using Basis Trade.)

More stories like this are available on Bloomberg.com

©2024 Bloomberg L.P.

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Published: April 19, 2024, 01:31 am IST