News Digest:

Financial experts are urging the Federal Reserve to establish an emergency facility to manage highly leveraged hedge fund trades in the $29 trillion US Treasuries market. A disorderly unwinding of approximately $1 trillion in hedge fund arbitrage bets could destabilize not just Treasuries but other financial markets, potentially requiring Fed intervention.

During the March 2020 Covid crisis, the Fed bought $1.6 trillion in Treasuries over several weeks to stabilize markets. However, a Brookings Institution paper authored by Anil Kashyap (University of Chicago), Jeremy Stein (Harvard, former Fed governor), Jonathan Wallen (Harvard Business School), and Joshua Younger (Columbia University) suggests a more efficient approach: hedged bond purchases.

Stein emphasized this strategy as a valuable addition to the Fed’s policy toolkit. The key risk is the “basis trade,” where hedge funds profit from tiny price gaps between Treasuries and futures. Kashyap noted this concentrated trade involves fewer than 10 hedge funds.

In a rapid market downturn, bond dealers might struggle to handle the high volume of liquidations. In 2020, the basis trade was worth $500 billion, half of today’s value. The proposed “basis purchase facility” would let the Fed buy Treasuries while simultaneously selling futures, relieving dealer stress and maintaining market liquidity.

However, concerns about moral hazard remain. A facility that effectively bails out hedge funds could incentivize risk-taking. Yet, Stein argued that the 2020 precedent of outright Treasury purchases already carries moral hazard. Simple Treasury purchases also blur the line between financial stability and monetary policy, influencing long-term yields.

To mitigate moral hazard, the authors proposed auctions where primary dealers bundle cash securities and futures contracts, with a minimum bid price to ensure hedge funds incur a penalty discount. This approach separates market support from quantitative easing (QE) and avoids long-term bond sale timing issues.

The authors noted the similarity between the proposed facility and the Fed’s existing repo operations. However, legal questions remain unresolved. Policymakers have also suggested regulatory adjustments, margin requirements, and central clearing mandates to improve Treasury market resilience.

“Hedge funds are in a very aggressive position,” Stein warned. “Even a small market move could push them out.”

End Notes

Source: https://finance.yahoo.com/news/fed-urged-mull-hedge-fund-010000060.html

Source: https://www.brookings.edu/articles/treasury-market-dysfunction-and-the-role-of-the-central-bank/