What role did hedge funds play in the March market mayhem?
Regulators remain uneasy over the turmoil caused by bets on Treasuries
Regulators turn activists on hedge funds
Let’s cast our minds back to March when one of the “simplest” hedge fund bets blew up.
The so-called basis trade is a popular bet among hedge funds. Managers seek to eke out a profit from slight differences between the almost-identical US Treasuries and Treasury futures.
Because the returns are small, hedge funds juice them up by adding leverage. What could go wrong, right?
In all fairness, things move along pretty smoothly under normal circumstances. But, when coronavirus struck the US in early March, there was a dash for cash that led to a Treasury selling spree and caused all sorts of weird dislocations. One of them was widening the spread to Treasury futures — the precise opposite of what the basis trade bets on.
The move caught out many large hedge funds that operate relative value strategies. As they tried to exit the trade, the spreads between Treasury bonds and futures widened even more dramatically. The move sent the US Treasury market into a tailspin.
If the seriousness of this isn’t clear, some analysts say it could’ve put the US government’s ability to fund itself in danger at a pivotal time.
But the Federal Reserve stepped in, which prompted outcries from critics that the US central bank was bailing out hedge funds. Mark Yusko, the chief executive of Morgan Creek Capital, which allocates to hedge funds, said “too big to fail” is back. He took to Twitter to show his frustration:
Now, global policymakers are looking at the role hedge funds played in the March mayhem.
A report from the Financial Stability Board said the market “dysfunction”, which could’ve spiralled into a full on financial crisis without intervention from the Fed, was “exacerbated” by hedge funds unwinding the popular basis trade.
“Large-scale unwinding of these trades . . . was likely one of the contributors to a short period of extreme illiquidity in government bond markets,” the FSB said in the report.
What the FSB is really concerned about is something the finance world likes to call “moral hazard.”
If the Fed is willing to step in when the alternative is to allow a financial collapse, what is the risk for hedge funds to leverage up and put on even more aggressive basis trades in the future?