It is hard to underestimate the enduring resonance of the 1980s comedy Trading Places in the finance world. The story of the Duke brothers seeking to profit in orange juice futures from ill-gotten inside information was even referenced in a recent speech by Beth Hammack, president of the Cleveland Federal Reserve
She was warning about an issue that is increasingly worrying global policymakers — the amount being borrowed by hedge funds to inflate their trading positions relative to their assets, or leverage. In Trading Places, the Duke brothers came unstuck and went out of business, partly because they were too leveraged in what they thought was a riskless trade and could not meet calls to pay more margin, or collateral, when it turned sour.
In the Dukes’ case, there was not a lot of obvious systemic fallout. But the real world, of course, is messier. Policymakers around the world such as Hammack are increasingly worried about growth in an arcane corner of finance called the cash-futures basis trade.
This arises from a disconnect between prices for contracts to buy bonds in the future and the value of bonds eligible for their delivery. It is nearly free money that is available for those with the wherewithal to take it.
The basis trade makes money, but not very much per dollar deployed. To eke out decent returns you need leverage. Before the global financial crisis investment banks took this money. But following systemwide financial meltdown and subsequent bailout, post-crisis regulation was brought in to limit bank leverage, forcing banks to exit some activities. While this might be great for taxpayers, it has been less great for the hyper-efficiency of fixed income markets.
Hedge funds have since stepped into the void, and with gusto. Instead of making calls about the future of monetary policy or geopolitics, fast money has been buying Treasury bonds and selling futures — the Wall Street equivalent of hoovering up nickels on the sidewalk.
It’s hard to put a precise number on it, but the IMF estimates hedge funds now account for around 11 per cent of the US Treasury market, and that basis trades constitute around $1tn of this position. In Europe the footprint is much more modest, measured in the mere tens of billions, though ECB analysis suggests it has grown quickly. As central banks unwind their Covid-era bond purchases and governments continue to run substantial deficits, should we be thankful that hedge funds are there to absorb the supply? As always, there’s a catch.
The popularity of the basis trade has fuelled the growth in hedge fund leverage to new highs. According to the US Office of Financial Research, hedge fund borrowing in so-called repo markets has increased by $1.5tn since the end of 2022, almost a trillion of which is accounted for by solely the largest 10 funds.
And the risk is that leverage creates vulnerabilities in market-based finance which amplify shocks. This risk is not just theoretical. During the turmoil in US overnight money markets in September 2019 and the generalised mayhem of March 2020, the basis trade unwound, contributing to Treasury market problems that forced the Fed to step in.
Market-based finance is supposedly less prone to herding because risk is spread across a diffuse set of buyers. But as the UK pension fund crisis in 2022 demonstrated, if market participants operate with a common operating model and motivation, they can act as one and throw bond markets into chaos. With such a large basis trade, it’s easy to see how market tremors are increasingly putting officials on edge.
Paradoxically, obvious remedies — mandating greater collateral on overnight borrowings and futures contracts, and a shift to central clearing of trades — are the sort of thing that might trigger rather than defuse a market crisis. Leverage is dangerous at a system-level precisely because it introduces the risk of rapid synchronised deleveraging. As the saying goes, “it’s not the speed that kills, it’s the sudden stop”. Mandating higher margin requirements could catalyse this threat.
The Financial Services Board, a body set up by the G20 to co-ordinate national financial authorities, recommends central banks step up their monitoring, development of strategies to address vulnerabilities, as well as more information sharing across borders. In her speech, Hammack raised the prospect of relaxing a cap on the amount of leverage a bank can take relative to its capital, giving dealers room to help hedge funds unwind their trades in times of stress. The Bank of England meanwhile is working on a facility to allow non-bank markets participants to borrow cash against gilts in such periods Both look like good practical ideas.
It’s not hard to imagine the US Treasury market being tested with shocks over the next four years. While the cash-futures basis trade is, in theory, riskless, regulators are right to look to it as a potential catalyst for instability. And as the fictional Duke brothers will attest, financial calamities can most usually be traced to a seemingly safe trade being leveraged up.
