Vulnerabilities in the Treasuries market aren’t going away

Three years ago, investors learnt that the mighty US Treasuries market is not always as mighty as it seems. When the Covid-19 shock hit in March 2020, US interest rates gyrated in a way that created massive losses for hedge funds that had taken hidden, highly leveraged bets on Treasuries, via derivatives and repurchase agreements (“repos”) that swap bonds for cash.

The ensuing wave of forced sales caused the entire Treasuries market to seize up — until the Federal Reserve intervened on a record scale. Ouch.

Fast forward to 2023, and you might think that those hedgies had learnt their lesson. After all, since 2020 US rates have risen sharply, and they could fluctuate again in the coming year; particularly since a third of all US government debt — some $7.6tn — must be refinanced in 2024, as Torsten Sløk, analyst at Apollo, recently noted to clients.

Think again. Last week the US Fed issued a report that suggests this so-called hedge fund “basis trade” is reappearing. After parsing data from the Commodity Futures Trading Commission, its economists note that “hedge fund repo borrowing rose by $120bn between October 4 2022 and May 9 2023, and was higher as of May 9 2023 than it was at its previous peak in 2019”. 

Yes, you read that right: positioning is apparently more extreme today than before that pandemic debacle. And this, they note, “presents a financial stability vulnerability because the trade is generally highly leveraged and is exposed to both changes in futures margins and changes in repo spreads”. In plain English: if US rates swing sharply, prepare for jolts.

This week the doughty Financial Stability Board has also raised some red flags. In a new report issued before the G20 meeting, it warns that leverage among “non-bank financial intermediaries”, such as hedge funds and family offices, is surging in ways that are hard to track because it is “synthetic” (ie derivatives-based).

The FSB is concerned about more than Treasuries. But it is clearly on its mind. “The March 2020 turmoil underscored the need to strengthen the resilience of NBFI,” the report states — before explaining that excess leverage could leave the financial system vulnerable to “further liquidity strains” if a nasty shock hits.

Now I daresay that some ordinary mortals — and politicians — might roll their eyes. Hedge funds are infamously fond of high-rolling bets. And if these fail in a way that hurts their wealthy clients, few voters will shed a tear. People feel similarly about the fast-expanding family office sphere.

But the reason why the FSB is ringing alarm bells is that March 2020 demonstrated how shockwaves from NBFI trades could spread. And what is particularly unnerving right now is that the structural vulnerabilities in the Treasuries market that exacerbated that Treasuries basis trade shock not only remain in place — they could actually be getting worse.

Most notably, while banks used to operate as market makers, greasing the wheels of the Treasuries and repo sector in a crunch, they stepped back from doing so after financial regulation tightened following the 2008 crisis. New entrants, such as algorithmic trading houses, do not perform these roles.

Indeed Darrell Duffie, a Stanford professor, writes in a recent paper that “since 2007, the total size of primary dealer balance sheets per dollar of Treasuries outstanding has shrunk by a factor of nearly four”. He warns the ratio could deteriorate further, as debt issuance rises. This is one of the most startling statistics I have recently seen.

The Fed has made modest tweaks to the structure of the repo market since 2020. But this sphere lacks the type of centralised clearing system or official government backstop that could guarantee trading will always happen in a crunch.

So without “intermediaries that can augment the money supply” (ie market makers), there is a risk that the market gums up again, as the Columbia Law School academics Lev Menand and Joshua Younger note in another startling paper. They write that while investors have hitherto presumed that “Treasuries are nearly equivalent to cash” because they can sell them “quickly, cheaply, and at scale” — an assumption that “in many places [is] enshrined in law” — this increasingly seems fallacious.

Is there any solution? There are plenty of proposals flying around. The FSB wants more reporting of synthetic NBFI leverage, and more caution from the primary dealers who supply this credit. Gary Gensler, head of the Securities and Exchange Commission, is pushing for greater oversight of big market players and more central clearing for repos and Treasuries.

Meanwhile, Duffie goes even further. In addition to central clearing, he suggests tweaks to liquidity rules that would enable dealers to hold more Treasuries, moves to enable the Fed to act as a dealer of last resort and enhanced trade reporting.

This is all sensible stuff. However — sadly — there is little political appetite in Washington (or elsewhere) for implementing these changes now, and it is unlikely to emerge unless another shock hits. So if funds’ synthetic leverage keeps rising, regulators’ unease will mount too. Anyone feel a sense of déjà vu?

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