A new research paper to be presented at the Brookings Papers on Economic Activity (BPEA) conference on March 28 proposes that central banks, particularly the Federal Reserve, should provide targeted support to hedge funds engaging in the basis trade during extreme market stress. The study highlights the increasing fragility of the U.S. Treasury market caused by highly leveraged hedge fund strategies and suggests a novel policy mechanism to address systemic risks while minimizing moral hazard.
Understanding the Basis Trade and Hedge Fund Leverage Risks
The basis trade is a common hedge fund strategy that seeks to exploit price discrepancies between cash Treasury securities and corresponding derivatives, such as Treasury futures. Hedge funds typically borrow heavily through repurchase agreements (repos) to finance large long positions in cash Treasuries, while simultaneously short-selling Treasury futures.
By February 2020, hedge funds had expanded their exposure significantly:
- Net short Treasury futures positions: ~$900 billion
- Cash Treasury long positions: Funded by ~$1.4 trillion in repo borrowing
- Leverage ratios: As high as 50-to-1, making funds vulnerable to small market shifts
This extreme leverage meant that even minor disruptions in market conditions could force funds into margin calls and rapid unwinding, leading to broader market instability.
COVID-19 Market Dislocation: Evidence of Treasury Market Fragility
The paper presents empirical evidence from the March 2020 market turmoil, when initial margin requirements on Treasury futures more than doubled for certain maturities. As a result:
- Hedge funds were forced to unwind ~$62 billion in short futures positions.
- Their corresponding repo-funded cash Treasury positions were liquidated.
- Dealers initially absorbed ~$57 billion in these positions but quickly hit their capacity limits.
- The cash-futures basis spread (normally ~5 basis points) spiked above 70 basis points, reflecting severe market dysfunction.
- Treasury bid-ask spreads quadrupled, and repo spreads surged.
These disruptions illustrated the systemic risk posed by leveraged hedge funds, particularly when market shocks force them to liquidate en masse.
Modeling Treasury Market Fragility
The study develops a quantitative model featuring three key market participants:
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Broker-dealers – Hedge interest rate exposure.
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Hedge funds – Engage in basis trade, taking leveraged Treasury positions.
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Asset managers (e.g., pension funds, insurers) – Need Treasuries to meet long-duration liability needs.
A key insight from the model is that as Treasury supply increases, hedge funds proportionally increase their short positions in futures, exacerbating fragility. Specifically, the study finds that:
A $100 billion increase in Treasury issuance raises hedge fund short positions in futures by $5 billion.
With the Congressional Budget Office (CBO) forecasting significant increases in Treasury issuance over the next decade, market fragility is likely to worsen.
Policy Recommendation: Hedged Purchases to Prevent Market Dysfunction
The paper argues that the Federal Reserve’s past interventions, such as $1.6 trillion in unhedged Treasury purchases during March–May 2020, were necessary but imperfect. These large-scale purchases blended monetary policy actions with financial stability measures, leading to potential distortions in market expectations.
To address this issue, the authors propose a new intervention tool:
“Hedged Purchases” – A More Targeted Federal Reserve Intervention Strategy
The Fed would buy Treasuries while simultaneously selling Treasury futures.
This would directly counteract forced unwinding by hedge funds, stabilizing markets without affecting monetary policy stance.
To prevent moral hazard, the Fed would conduct these purchases at penalty discounts, ensuring hedge funds do not assume full protection from losses.
Unlike Quantitative Easing (QE), which reduces interest rates and increases duration risk, hedged purchases would be neutral on term premia, focusing solely on preventing short-term dislocations.
Conclusion
The Brookings research suggests that central banks should play a more proactive role in stabilizing the Treasury market by backstopping hedge funds engaged in the basis trade—but in a targeted and disciplined manner. Hedged purchases offer a market-stabilizing tool that can reduce systemic risk without introducing significant distortions or encouraging excessive risk-taking.
With Treasury issuance projected to rise and leveraged hedge fund strategies continuing to expand, the proposed policy could become increasingly relevant in future periods of market stress.
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