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A top Federal Reserve official has warned that a growing debt-fuelled trade hedge funds are making in Treasury markets could magnify instability in the world’s most important financial market.
Fed board governor Lisa Cook said on Thursday that funds’ so-called basis trades, which take advantage of tiny price discrepancies in Treasuries, risked making the $30tn market “more vulnerable to stress”, and in extreme cases could impact market functioning.
“Outside of episodes of stress, relative value trades substantially improve the efficiency and liquidity of Treasury securities and related markets,” said Cook, who is the governor responsible for financial stability. “Yet, during episodes of stress, the unwinding of crowded positions in such trades could magnify instability in these markets.”
Regulators — including at the Fed — have long cautioned about the outsized role hedge funds have played in Treasury markets.
Funds’ bets on the trade have risen substantially in recent years. The Fed in October published research highlighting what economists described as a “massive increase” in Cayman Islands-based hedge funds’ exposure to US government debt.
It found that the funds had absorbed more US Treasury issuance between January 2022 and December 2024 than all other foreign private holders of US Treasury debt combined.
Cook noted that the proportion of the hedge funds’ holdings of Treasury cash securities had increased to 10.3 per cent in the first quarter of this year — above the pre-pandemic peak of 9.4 per cent.
While the differences in price between Treasuries in the cash market and their equivalents in the futures market are typically tiny, hedge funds borrow huge amounts of money to place these trades, allowing them to multiply their profits.
The trade has been at the centre of multiple financial crises.
The most notable example was in March 2020, when the onset of the Covid-19 pandemic hit markets and forced hedge funds to unwind their basis trades, leading to a rapid shift in Treasury prices that quickly spread panic to other markets and forced the Fed to intervene.
The trade was also at the centre of the 2019 repo crisis when basis traders were forced to rapidly unwind positions after the Fed’s quantitative tightening programme, which removes reserves from the system, created a dearth of liquidity.
The forced selling of both cash Treasuries and futures stressed the short-term funding, or repo market, causing a spike in corresponding interest rates. The Fed forced to step in during this episode too
In 2021, the New York Fed introduced a twice-daily Standing Repo Facility aimed at ensuring short-term borrowing costs remain within central bankers’ target range.
The central bank’s second major quantitative tightening programme, which has run over the past three years, contributed to a rise in repo market rates towards the end of October — on some days above the cost of borrowing from the SRF.
The Fed said last month it would halt the latest QT programme starting December 1, with several officials signalling the US central bank could expand its holdings of Treasuries beginning early next year.