Fed Urged to Explore Hedge Fund Bailout Tool for Basis Trade
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Fed Urged to Explore Hedge Fund Bailout Tool for Basis Trade
Alexandra Harris
5 min read
(Bloomberg) -- The Federal Reserve should consider setting up an emergency program that would close out highly leveraged hedge-fund trades in the event of a crisis in the $29 trillion US Treasuries market, according to a panel of financial experts.
Any vicious unwinding of a swath of the estimated $1 trillion in hedge fund arbitrage bets would not only hamper the Treasuries market, but others as well — requiring Fed intervention to assure financial stability. When the US central bank did that in March 2020, during the initial Covid crisis, it engaged in massive outright purchases of Treasury securities, to the tune of about $1.6 trillion over several weeks.
A better way of stepping in would be via hedged bond purchases, according to a Brookings Institution paper by Anil Kashyap at the University of Chicago, Harvard University’s Jeremy Stein — a former Fed governor, Harvard Business School’s Jonathan Wallen and Columbia University’s Joshua Younger.
“If the Fed is tempted to buy again, we’d rather they do that on a hedged basis,” Stein told reporters in a briefing on the paper, which was released late Wednesday. This approach “can be a valuable addition to the policy toolkit” at the Fed, the authors wrote in the paper.
What’s the Basis Trade? Why Does It Worry Regulators?
The key source of risk to address is the so-called basis trade, where hedge funds seek to profit from tiny price gaps between Treasuries and derivatives known as futures. Kashyap told reporters that “it’s a pretty concentrated trade,” involving perhaps 10 hedge funds or fewer.
If hedge funds need to unwind their positions quickly, the danger is that bond dealers may not be able to handle the enormous sudden volume of transactions. When the Fed had to intervene in 2020, the basis trade was roughly $500 billion in total — just half today’s figure.
“To relieve the stress on dealers, it would be sufficient for the Fed to take the other side of this unwind – purchasing Treasury securities, and fully hedging this purchase with an offsetting sale of futures,” the authors wrote.
With such a “basis purchase facility” in place, that would avoid a squeeze on dealers that risked disruptions in other activities — such as providing secondary market liquidity for Treasuries and intermediating in the market for repurchase agreements.
The paper recognized that “bailing out hedge funds” would raise questions, including moral hazard, where the existence of the facility could potentially encourage hedge funds to take on even more risk.
“The basis of comparison shouldn’t be ‘no moral hazard,’” Stein said.
That’s because the 2020 example of outright purchases is already part of the Fed’s record. Simple purchases of Treasuries involve their own costs. They remove “duration” from the Treasuries market, because the Fed is buying securities maturing over time and creating bank reserves, which carry an overnight interest rate. That can blur the line between financial-stability operations and monetary policy, the authors highlighted.
The cost of massive Fed Treasuries purchases is also seen in the diminished remittances from the US central bank to the Treasury, they noted. The US central bank is still unwinding its bond purchases, known as quantitative easing, from the 2020-2022 period.
“Purchases are an inelegant way to proceed,” Kashyap said on the reporter call Tuesday. “Buying looks a lot like QE and probably influences term premia,” he said, referring to the extra yield investors demand for longer-term securities versus just rolling over short-term ones.
The authors proposed auctions of bundled basis packages in which primary dealers submit both the cash security they intend to sell and the futures contract they intend to buy. The central bank could then set a minimum bid price on the bundles — limiting moral hazard by forcing the hedge funds to take a penalty discount.
Policy Distinction
This makes a clear distinction between market support and monetary-policy-motivated QE, the four experts said. Another advantage is that it’s basically self-liquidating — removing questions about the timing of future bond sales or a new quantitative tightening regimen.
It also protects the Fed from taking on “undue interest-rate risk,” such as the central bank has faces now — with the Treasuries it bought in 2020 paying coupon rates that are well below what the Fed is shelling out on the reserves it created to buy them.
The authors argued that a basis-purchase facility wouldn’t be “that far afield from current open market operations.” The Fed already engages in repo transactions, either through standing facilities or open market operations. Because basis trades involve a spot purchase and future sale, they are “conceptually very similar” to repo transactions — the only difference being different counterparties for the purchase and sale, according to the paper.
The legality of such a new facility “is an important question but beyond the scope of this discussion,” the authors wrote.
Policymakers in recent years have put forward suggestions to improve Treasury market functioning, ranging from adjusting bank regulations that impair dealer capacity, the creation of a Standing Repo Facility where the Fed could lend directly to hedge funds and imposing minimum margin requirements for repo-financed Treasury purchases. A mandate for central clearing for Treasuries and repo is set to take effect Dec. 31, 2026.
“Hedge funds are in a very aggressive position, where a relatively small move in the basis could push them out,” Stein said. “It doesn’t look like the dealers are super well positioned to handle this.”
(Updates with quote on interest-rate risk in second paragraph after ‘Policy Distinction’ subheadline.)
