In a stark warning that reverberates throughout the financial world, the Bank for International Settlements (BIS), the global umbrella group for central banks, has raised concerns about the accumulation of leveraged bets in the mammoth $25 trillion US Treasuries market. The BIS’s latest quarterly report, released on Monday, underscores the risks associated with the proliferation of basis trades, a strategy often employed by hedge funds to exploit minuscule price differentials between Treasury bonds and their futures counterparts.
The BIS report explicitly states, “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 focal point of this concern is the leverage utilized in the futures market for margin posting, a practice that has the potential to unleash chaos if deleveraging occurs disorderly. The report ominously warns that such a scenario “has the potential to dislocate core fixed-income markets.”
The US Treasury market holds a pivotal role globally as it determines borrowing costs for US government debt. A staggering $750 billion worth of transactions took place daily in August alone, according to data from the Securities Industry and Financial Markets Association (Sifma).
The historical evidence is compelling. The unwinding of leveraged Treasury positions in moments of crisis, notably in September 2019 and March 2020 during the onset of the coronavirus pandemic, led to tumultuous swings in both the Treasury and repo markets. These tumultuous events ultimately compelled the Federal Reserve to intervene to restore stability.
Supporting the BIS’s apprehensions, data from the US Commodity Futures Trading Commission reveals a surge in short positions in Treasury futures contracts, reaching record levels in some maturity periods in recent weeks. The BIS estimates the total value of short positions in Treasury futures to be approximately $600 billion.
The BIS’s cautionary note joins a chorus of regulatory bodies expressing concerns about the mounting hedge fund bets in the bond market. In August, the Federal Reserve highlighted the rising volume of basis trades and warned of the financial stability risks associated with their accumulation. Additionally, the Financial Stability Board, comprising top finance ministers, central bankers, and regulators worldwide, issued a recent warning about hedge funds with high levels of synthetic leverage, generated through derivatives, posing a potential threat to market stability.
The basis trade strategy predominantly finds favor among hedge funds employing relative value strategies. This approach involves establishing a long position in the cash market while simultaneously taking a short position in the futures market, often financed through repurchase agreements. While there is no precise data quantifying the extent of the basis trade, weekly CFTC figures tracking short positions in Treasury futures serve as a proxy indicator. Moreover, borrowing levels in the repo market remain under constant scrutiny.
What amplifies the risks associated with basis trades is the substantial leverage deployed by hedge funds, particularly in long cash market positions. However, the BIS’s report also shines a spotlight on elevated leverage in futures positions, with leverage ratios reaching as high as 70 times in five-year Treasuries and 50 times in ten-year notes, albeit below the levels witnessed just before the pandemic struck.
In futures trading, participants often use margin to magnify the value of their positions, contributing only a fraction of the total trade’s value upfront. The BIS underscores the precarious situation where highly leveraged futures investors could be compelled to liquidate their positions if the market moves against them, potentially triggering a cascade of market sell-offs.
As the financial world closely monitors these developments, the BIS’s warning serves as a stark reminder of the delicate balance between risk and stability in the intricate domain of global finance.
