The Bank for International Settlements (BIS) has issued a warning about the potential risks posed by leveraged bets in the $25tn US Treasuries market. According to the BIS, the growth of the so-called basis trade, which involves exploiting tiny differences between the prices of Treasury bonds and their equivalents in the futures market, could lead to market dislocation. The BIS highlighted the use of leverage in the futures market to post margin as a financial vulnerability worth monitoring. In moments of stress, such as in September 2019 and March 2020 during the coronavirus pandemic, the unwinding of leveraged Treasury positions caused wild swings in the Treasury and repo markets, prompting intervention from the Federal Reserve.
Data from the US Commodity Futures Trading Commission showed a rise in short positions in Treasury futures contracts to record levels in recent weeks, with the BIS valuing these short positions at about $600bn. The BIS is not the only regulatory body to express concerns about the risks posed by leveraged bets in the bond market. In August, the Fed warned about the financial stability risks associated with the build-up of basis trades, while the Financial Stability Board cautioned that hedge funds with high levels of synthetic leverage were a potential source of market instability. The basis trade is commonly used by hedge funds employing relative value strategies, involving a long position in the cash market and a short position in the futures market funded by repurchase agreements.
The difference between cash and futures bonds is typically small, allowing hedge funds to make significant profits by leveraging their trades heavily with minimal upfront cash. While much of the leverage is seen in long positions in the cash market, the BIS paper also highlighted leverage in futures positions. Leverage in futures is currently elevated, with traders using margin to magnify their positions, potentially leading to liquidity issues if the market moves against highly leveraged investors. In the event of market sell-offs triggered by forced liquidation of positions, there is a risk of further instability in core fixed-income markets.
The Treasury market is closely monitored as it sets borrowing costs for US government debt, with significant daily trading volumes. The unwinding of leveraged Treasury positions in moments of stress has led to market volatility in the past, prompting intervention from central banks. As such, the BIS and other regulatory bodies are urging vigilance in monitoring leveraged bets in the bond market to mitigate the potential risks of market dislocation. While there is no definitive data on the size of the basis trade, monitoring of short positions in Treasury futures contracts and borrowing levels in the repo market can provide insights into the extent of leverage in the market. Moving forward, continued oversight and risk management efforts will be essential to safeguard the stability of the US Treasuries market and prevent potential disruptions caused by leveraged bets.
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