The International Monetary Fund has raised concerns over a small cluster of funds holding substantial short positions in the Treasury market, potentially posing a risk to financial stability during periods of market distress.
These funds, leveraging significant amounts of capital, have concentrated their bets against Treasury futures, a situation that could impact the broader financial system adversely in times of turmoil, as per the IMF's Global Financial Stability Report.
The report specifically addresses the "basis trade," a strategy where hedge funds capitalize on minor price discrepancies between cash Treasuries and futures. This approach, which involves borrowing heavily from the repo market to enhance returns, has come under regulatory scrutiny due to its potential to amplify systemic leverage and risk.
As of the end of last year, the IMF noted that a handful of traders controlled about half of all short positions in two-year Treasury futures, a concentration level similar to that just before the pandemic-induced financial upheaval in early 2020. This concentration has led to heightened volatility in the bond market during critical times.
Notably, firms like ExodusPoint Capital Management, Millennium Management, and Citadel have engaged in these basis trades, although the IMF did not name specific entities. The Federal Reserve's rate hikes have only made these trades more attractive by increasing the price gap between cash and futures markets, further boosting their popularity.
However, a recent study by the Fed suggests that hedge funds' Treasury holdings related to basis trades have reached at least $317 billion since early 2022, albeit lower than previous estimates. The Securities and Exchange Commission has since mandated more extensive clearing of US Treasuries transactions to better oversee these trades.
Recent data from the Commodity Futures Trading Commission indicates a decline in leveraged funds' short positions in bond futures, suggesting a potential decrease in the prevalence of basis trades. Nonetheless, the IMF warns that the significant short positions maintained by leveraged funds continue to pose a risk, especially as the Fed reduces its Treasury holdings, potentially impacting liquidity and funding costs.
The IMF cautions that an increase in repo rates, possibly triggered by unexpected quantitative tightening, could make the basis trade unprofitable, leading to rapid unwinding of positions and increased market volatility.
