For many fixed income traders, the defining market event of the Covid-19 crisis was the mass unwinding of bond/futures basis trades by levered hedge funds, which sent shockwaves through an already glutted US Treasury market in March.
The sudden surge in volatility upended the arbitrage between bonds and futures and triggered margin calls on a scale not seen in a decade. As hedge funds rushed for the exits, bid-ask spreads in off-the-run US Treasuries, which are typically a fraction of a basis point, shot up to as much as 3bp in the 30-year bond. On March 15, the US Federal Reserve announced it would purchase $500 billion of government bonds to restore market functioning.
The break down left some market veterans stunned.
“The Treasury market broke first – that has never happened before,” says Susan Estes, former global head of US Treasury trading at Morgan Stanley and member of the Treasury Borrowing Advisory Committee, and now chief executive at bond platform OpenDoor Securities.
Estes traded through Black Monday, the Asian financial crisis and the global financial crisis. “At no point, even when we had to use pencil and paper to manage positions, did we stop making markets in US Treasuries,” she says. “If we had, our knuckles would have been cracked by the Fed.”
Six months later, hedge funds seem to have avoided serious punishment.
At a congressional hearing on September 23, Federal Reserve chair Jerome Powell was asked whether they had earned a rap on the knuckles. He hedged his bets, saying that while hedge funds were “part” of the problem, they were “far from the whole story”.
A July report from the US Treasury’s Office of Financial Research also seemed to absolve hedge funds of major blame. “While funds appear to have partially exited these trades based on sales of the cheapest-to-deliver notes, it is not clear that these sales actually impaired Treasury market liquidity,” reads the report. “Instead, the basis trade appears to have continued to provide net liquidity to underlying Treasuries.”
Others are more explicit in blaming hedge funds for the market tumult. In a speech on June 9, Bank of England deputy governor Jon Cunliffe said “these highly leveraged funds appear to have become an amplifier of stress” during the Covid-19 crisis.
Former Fed chairs Janet Yellen and Ben Bernanke also pointed the finger at hedge funds in an article for the Brookings Institution, published in July.
The official line will be hashed out by the Financial Stability Board. The global regulatory group is examining the role non-banks – particularly money market and hedge funds – played in the crisis. A report is due in November.
By then, the US could be preparing for a new administration in Washington. A change in leadership at the Fed and Treasury may portend a renewed focus on hedge funds by the Financial Stability Oversight Council, the body tasked with neutralising threats to the US financial system.
“If there is a Biden administration, there will be an effort to start designating hedge fund entities as systemically important,” says a former member of the US National Economic Council, which advises the White House.
The FSOC seemed to be heading in this direction under the Obama administration. A 2016 report from the body’s hedge fund working group (HFWG) identified “data gaps and limitations” in the existing regulatory framework and recommended “continued monitoring of potential financial stability risks” in the sector.
The HFWG was sidelined after Donald Trump’s election victory in 2016 – along with the whole concept of non-banks as systemically important financial institutions (Sifi). FSOC rescinded the non-bank Sifi designations of AIG and Prudential in 2017 and 2018 respectively and declined to challenge a court ruling relieving Metlife of the label.
The shift away from non-bank Sifi designations culminated in a unanimous vote on December 4, 2019 in favour of adopting a so-called activities-based approach to dealing with non-bank systemic risk. While FSOC retains the power to designate non-banks as Sifis, it may only do so if the risk they pose cannot be tackled through existing regulatory channels.
The Treasury market broke first – that has never happened beforeSusan Estes, OpenDoor Securities
Now, some think the tide may be turning once again. “The Trump administration was not interested in doing anything that increases regulation and regulators weren’t really too concerned about hedge funds,” says Lee Reiners, executive director of the Global Financial Markets Center at Duke University School of Law, and a former New York Fed official. “Now that seems to have changed.”
Regulators are said to considering a range of responses to the market meltdown in March – including a possible clearing mandate for US Treasuries.
Any effort to tighten rules for hedge funds is likely to face resistance from the industry. “We support the effort of policy-makers at the Fed, FSB and other global regulators to get the diagnosis right as they assess the root causes of the March sell-off,” says Michael Pedroni, head of international affairs at the Managed Funds Association, a hedge fund lobby group, adding: “There are no indications in the data that any hedge fund posed a systemic risk.”
The trade that landed hedge funds in the cross-hairs of regulators has long been a staple of fixed income hedge funds. As futures are widely used to hedge interest rate risk, they tend to be structurally richer than the equivalent bonds. Arbitrageurs capture this spread by selling the futures and buying US Treasuries with repo funding. As the futures contract nears maturity, the prices converge. Hedge funds cash out of the position by selling the bonds and buying the futures. CME nets out the residual long and short positions, delivering the spread to traders.
But this seemingly simple trade can be surprisingly complex to manage. CME’s US Treasury futures contracts deliver into a varied basket of bonds. For example, the five-year contract can be satisfied with any fixed coupon US Treasury with an original maturity of no more than five years and three months, and a remaining maturity of at least four years and two months. A conversion factor is used to make the bonds that are eligible for delivery economically equivalent.
To maximise profits, basis traders will typically purchase what is known as the cheapest-to-deliver (CTD) bond – typically an off-the-run – to hedge their short futures exposure. This creates a liquidity mismatch, where the offsetting bond position is less liquid than the future. To further reduce costs, the cash leg is often levered with overnight repos, which creates a maturity mismatch.
The spread between the bonds and futures is measured in ‘ticks’, which are equivalent to 1/32 of a percent. A hedge fund that takes a $1 billion position and captures three ticks would make around $1 million over the three-month life of the trade – an annualised return of just 0.4%.
To turn that into a respectable return, hedge funds apply large amounts of leverage. EG Fisher, head of liquid market strategies at hedge fund Mariner Investment Group, says leverage of 20 to 1 is fairly typical.
That means a hedge fund with $1 billion of capital to the trade would have $20 billion of gross notional exposure. The potential quarterly return on the position could be in the region of $20 million. That translates to annual returns of around 8%, before fees, which is consistent with the performance of the average relative value fixed income strategy.
Regulatory data backs that up. The SEC’s private fund statistics for the fourth quarter of 2019, drawn from Form PF filings, suggests the average relative value hedge fund has a gross notional exposure of 23.1 times its net asset value. But some funds run with far higher leverage.
We support the effort of policy-makers at the Fed, FSB and other global regulators to get the diagnosis right as they assess the root causes of the March sell-offMichael Pedroni, Managed Funds Association
In a June 4 speech, Andrew Hauser, executive director for markets at the Bank of England, noted that “leverage rates of 40-60 times were common” among fixed income relative value hedge funds, and that “anecdotal reports suggest some ran much higher”.
One industry source says they have seen the trade levered as high as 100 to 1.
Despite the liquidity and leverage risks, the trade has only become more popular since 2018. The SEC’s fourth-quarter report, published on October 2, shows the gross sovereign debt exposures of relative value fixed income hedge funds climbing to $717 billion from $496 billion in the first quarter of 2018. The SEC’s data only covers US hedge funds and is published with a six-month delay.
Other public data sources paint a similar picture. Short positions in US Treasury futures tripled between the start of 2018 and March 2020, according to data from the US Commodity Futures Trading Commission (CFTC), with open interest in two-year maturities shooting up from $300 billion at the start of 2018 to a peak of around $900 billion late last year.
Meanwhile, primary dealer data gathered by the New York Fed shows the net US Treasury positions of banks – a good proxy for client activity – grew 238% over the same period, from $65.7 billion to $222.2 billion. The two-year maturity accounted for 43% of primary dealer holdings in March.
Industry sources estimate that hedge funds globally had at least $500 billion of exposure to the US Treasury basis trade going into March. To maintain those positions, they needed a number of factors – including futures margin requirements and repo costs – to remain stable. The Covid-19 crisis threw everything into flux.
Cracking the champagne open
As the week of March 9 kicked off, a wave of investor redemptions forced asset managers to dump US Treasuries for cash. That in turn caused the cash/futures basis to widen, causing losses for hedge funds.
The jolt in volatility prompted CME to hike margin requirements. Maintenance margin for two-year Treasury futures contracts expiring within one month rose nearly 20% between March 9 and March 12 – and over 30% from the level on March 3. Over the same period, maintenance margin for 10-year futures contracts jumped over 50%.
On March 11, the basis widened as much as six ticks for some tenors – an unprecedented move that would have translated to a $200 million intraday mark-to-market loss on a $1 billion notional position.
Scores of hedge funds hit their loss limits, setting off a mass unwind of basis trades. “Did we have certain situations where we limited specific clients in the middle of the day from conducting new risk-taking transactions? Absolutely, we did,” says Jason Radzik, head of derivatives execution and clearing at BNP Paribas. “With these relative value strategies, especially when bet the wrong way, you can see massive intraday changes to margin requirements. Then your risk system kicks in to say alert you’ve reached a certain threshold, and trading is halted other than de-risking transactions.”
The scale of the selling – hedge funds running basis trades are estimated to have offloaded at least $90 billion of US Treasuries that week – quickly overwhelmed dealer capacity. Some simply stopped answering the phones. By March 13, the world’s safest financial market was on the verge of breaking down.
Officials at the Fed had seen enough. On March 15, the central bank stepped in, announcing that it would purchase at least $500 billion of US Treasuries to stabilise the market.
Few in the market were as relieved as hedge funds. “If the Fed hadn’t come in when they did, at some point, in theory, every hedge fund could have had to stop themselves out. That’s the nature of leverage. And who would have taken the other side of that trade? That was the problem,” says Mariner’s Fisher.
If the Fed hadn’t come in when they did, at some point, in theory, every hedge fund could have had to stop themselves outEG Fisher, Mariner
Some hedge fund managers that were facing steep losses “started cracking the champagne open” when they heard the news, says a risk manager at one large bank.
A few firms had even anticipated the Fed’s response and positioned themselves to benefit. “We arrived at the conclusion that liquidity was so bad, the Fed was going to have its hand forced and would come into the market and provide liquidity, meaning the position was going to work out spectacularly,” says a rates trader at a New York-based proprietary trading firm. “And we were right.”
Others were just a mite late to the party. Citadel set up a new fund on March 13 to capitalise on the gaping basis and raised $2 billion for it over the weekend. The cash was returned to investors shortly after the Fed stepped into the market.
It could have been even worse. A year ago, a sudden evaporation of liquidity in the US Treasury repo market pushed the cost of overnight funding to 10% from normally low single digits. “If you’re borrowing overnight, and all of a sudden your borrowing cost escalates, that’s one reason why you need to exit a trade,” says Garth Friesen, chief executive at hedge fund III Capital Management. This time, funding costs were mostly stable – in large part because the Fed had already established a $100 billion per day repo facility after the events of last September.
None of this should have come as a surprise to regulators. Back in 2016, the FSOC’s hedge fund working group (HFWG) produced a report on how the industry’s use of leverage could pose risks to financial stability.
At a meeting of the FSOC on November 16, Jonah Crane, then deputy assistant secretary for the FSOC and chair of the HFWG, issued a prescient warning about market disruption from forced asset sales.
“The use of significant leverage means that even small changes in asset prices could lead to margin calls or funding pressures, particularly for funds relying on short-term funding, which could transmit risk by requiring rapid liquidation of positions,” Crane said, according to the minutes of the meeting.
He added that “while hedge funds may act as liquidity providers during times of low volatility, if they were to cease these activities during periods of stress, the resulting loss of liquidity could magnify the forced sale dynamics”.
Mary-Jo White, then chair of the SEC, issued a statement the same day commending the HFWG’s report. But White, along with many of the other regulators that were at the meeting, already had one foot out of the door following Trump’s victory in the 2016 presidential election 10 days earlier. The HFWG’s report was brushed aside by the Trump appointees that replaced them.
The HFWG’s recommendations may receive renewed attention following the events of March. These were focused on filling data gaps, particularly around funding terms, bilateral repo usage, posted margin and unencumbered cash at hedge funds.
“Data from advisers to hedge funds, collected by the Securities and Exchange Commission on Form PF and provided to the Office of Financial Research, is very useful in many respects,” Crane told the FSOC in 2016. “However, it does not provide complete information on the risk exposures arising from hedge fund leverage or potential practices that may reduce the risk associated with reported leverage levels.”
Following through on the HFWG’s recommendations may provide tricky, however – especially under the FSOC’s activities-based approach to non-bank systemic risk. As Crane noted in his remarks to the FSOC in 2016, “hedge funds themselves are not directly regulated and their major counterparties, and the markets they operate in, are regulated by various agencies with different jurisdictions”.
Form PF could be improved to actually give regulators better information. There’s been a lot of work to try and streamline that – not from the perspective of reporting less, but actually reporting data that’s relevantLegal expert at a hedge fund
Short of designating large hedge funds as systemically important, and subjecting them to enhanced prudential requirements, the FSOC is fairly toothless. “All they can do is just make recommendations to the various agencies to do something,” says Reiners at Duke.
As a first step, the FSOC could ask the SEC to collect more data from hedge funds. “Form PF could be improved to actually give regulators better information,” says a legal expert at a hedge fund. “There’s been a lot of work to try and streamline that – not from the perspective of reporting less, but actually reporting data that’s relevant.” That may include disclosing not only leverage and exposure metrics but also funding and margin terms.
But hedge funds are only part of the puzzle. The FSOC will also have to consider the role of futures exchanges and clearing houses, which are regulated by the CFTC, and the prime brokers that ultimately determine the amount of leverage available to hedge funds through cross-margining agreements.
Even if the FSOC is able to put all the pieces together and determine that cash/futures basis trading posed a threat to financial stability, it is unclear what it should do about it. Designating larger hedge funds involved in that trade as Sifis may only serve to push the activity to smaller players with less robust risk management frameworks.
“FSOC has decided to focus on an activities approach, but hasn’t offered a plan for implementation. They should specify how to identify and address activities that will affect financial stability. Market participants want to understand the governance and rules of the game for any regulation,” says Richard Berner, clinical professor of finance at New York University’s Stern School of Business and former director of the OFR.
For that reason, the Fed may prefer to act alone. Officials at the New York branch have been reviewing the US Treasury market’s underpinnings since the so-called ‘flash rally’ in 2014. Back then central clearing of customer trades was floated as a way to standardise risk management practices.
Calls for a clearing mandate are being aired again after the meltdown in March. Darrel Duffie, professor of finance at Stanford University’s Graduate Business School, says a clearing mandate is necessary because the “size of the Treasury market will outstrip the capacity of dealers to safely intermediate the market on their own balance sheets”.
Clearing may also curb leverage. Currently, most hedge funds get their leverage from prime brokers. The cross-margining models of some prime brokers can allow hedge funds to take more leverage than would be permitted by clearing houses. This is because the offsetting nature of the long bond and short futures positions make the trade look largely risk-free.
“I am aware that people will offer those cross-margin packages and potentially go below the futures margin requirement, which would allow you to get leverage beyond what it says on the tin,” says the global head of prime brokerage at a European bank. “So offering cross-margining on highly correlated assets that have never shown a decoupling quite like they saw in March is where problems arise.”
The amount of leverage afforded to clients, and the way that risk managed, varies from bank to bank. “Not every prime broker moves their margining up and down at the same time, which creates a little bit of havoc,” says a senior hedge fund executive. “Central clearing, as you see in bond futures, is really relatively seamless and very transparent when margins have to go up.”
Others say CME’s margin hikes contributed to the stress in March and mandating more clearing could increase systemic risk. “You don’t necessarily want to compound the stress by margin levels going up significantly [during a crisis],” says the global head of prime brokerage at a European bank. “That’s what we saw right in the height of the [Covid-19] crisis, with demands for more margin than we’d previously collected. That puts a greater amount of stress on the system and might mean that more people have to liquidate positions, which can have a circular impact.”
Finding the correct model for dealing with non-bank systemic risks will not be easy. The cash/futures basis trade – which spans the cash and derivatives markets and connects hedge funds with banks, exchanges and clearing houses – exemplifies the challenges facing regulators. But among market participants, there is a growing sense that something must be done.
“There’s going to be some regulation that comes out of all of this,” says the head of rates at a large US asset management firm. “After the 2008 financial crisis, there were limits placed on the amount of leverage that banks can take. Now we have relative value hedge funds and risk parity funds running 30 to 50 times levered. That’s what caused the liquidity problems in March. The regulators need to look at that and decide whether holders of US Treasuries should be allowed to lever themselves that many times.”
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