Saturday, 10 June 2023

Business News

Hedge funds exploit debt crisis through basis trade: sources

Hedge funds exploit debt crisis through basis trade: sources

A highly leveraged bond trade that’s become popular with hedge funds is drawing fresh scrutiny three years after it blew up spectacularly.

Officials at the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about leveraged trading in government bonds by their fast-money clients, according to people familiar with the matter, who asked not to be named citing the confidential nature of discussions. The dangers have been heightened as political brinkmanship around the debt ceiling has threatened to sink the US into default and unleash chaos in financial markets.

Several of the hedge funds that have recently pursued the so-called basis trade were also active in 2020, when the outbreak of the pandemic upended the Treasury market and caught them wrong-footed until Fed officials intervened to restore normalcy. The list includes Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, according to people familiar with the matter.

Opaque and risky, the strategy has long spooked watchdogs. It involves borrowing heavily in the repurchase market and using that leverage to exploit the price gap between Treasury futures and the underlying cash market. The trades, in some cases, have been levered 50-to-1, according to two of the people. The strategy’s enduring popularity is particularly alarming to SEC Chair Gary Gensler, who is on a broader mission to subject large speculators to more onerous regulations.

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

The New York Fed said in a statement that it “regularly reaches out to a wide range of market participants to gather information on financial market developments, and this outreach is consistent with typical market intelligence gathering.” 

Officials have been asking about current margin requirements and how a default, or a downgrade to the US’s credit rating, would impact the market plumbing including the value of collateral, the people said. 

The regulatory interest in the issue isn’t entirely new — some officials have been monitoring it ever since the last blow-up — but the possibility of a US default has added a new, and troubling, element. Financial watchdogs are under pressure after having…

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