As risky trading activity turns the Treasury market into a steadily bigger financial stability threat, researchers say the Federal Reserve needs a new emergency response playbook.
In March 2020, the sudden unwind of the so-called
Since then, hedge fund activity in that trade has more than doubled — from $500 million to more than $1 billion — and appears poised for further growth.
In a new paper, researchers argue that the Fed’s response should not be to simply put a floor under the market by purchasing Treasuries, but rather to pairing those asset purchases with sales of Treasury futures — that is, taking a short position in, or shorting, the market.
“We think that what they ought to consider doing is actually buying the whole thing that the hedge funds would be selling, which is not just to buy the Treasury, but buy the Treasury, along with the derivatives that they’d be unloading,” said Anil Kashyap, economics and finance professor at the University of Chicago’s Booth School of Business and one of the authors of the study. “[The Fed would] just step in and take their place.”
Kashyap, a former Fed researcher, collaborated on the paper with former Fed Gov. Jeremy Stein, now a professor at Harvard University; former Federal Reserve Bank of New York researcher Joshua Younger, now with Columbia University; and Jonathan Wallen, an assistant professor at Harvard.
Kashyap and Stein discussed their findings with members of the media this week ahead of the Brookings Institution’s Papers on Economic Activity conference on Thursday and Friday in Washington, D.C.
The study comes at a time of growing concern about the stability of the Treasury market and a push for regulatory reforms to bolster it. Earlier this year, Fed Chair Jerome Powell
“I have, for a long time, like others, been somewhat concerned about the levels of liquidity in the Treasury market. The amount of Treasuries is growing much faster than the intermediation capacity has grown, and one obvious thing to do is to reduce the effective supplemental leverage ratio,” Powell told Congress in February. “So, that’s something I do expect we will return to and work on with our new colleagues at the other [bank regulatory] agencies, and get done.”
During the stress of March 2020, the Fed temporarily exempted Treasuries from the calculation of banks’ leverage ratios. Industry groups argued for the change to be made permanent to prevent the SLR from being a binding constraint on lending activity, but the relief lapsed in 2021. Comments from Powell and others suggest at least a partial exemption is in the offing.
Also, a new mandatory central clearing regime for Treasury securities was adopted in 2023 and is in the process of being phased in. The construct involves market trades being conducted through a central counterparty that would reduce default risk by sharing loss across member groups.
But Stein said these measures alone likely would not be enough to stem the sudden unwind of the cash-futures basis trade.
“A bunch of these things are helpful, but our view is that … if it’s a big shock, they’re not going to be enough, the existing regulatory tools are not going to be enough,” Stein said. “We’re surely not excited about the prospect of the Fed having to step in and buy bonds as sort of a last resort, we’re just saying if they get to that kind of uncomfortable place, better that they hedge those purchases than not. This doesn’t want to be a first line of defense by any means.”
The cash-futures trade involves hedge funds taking short positions on the Treasury futures market via swap contracts with counterparties looking to hedge long-dated exposures. Typically, those counterparties are pension funds, insurance companies, exchange-traded funds or other asset managers. Along with these short positions, hedge funds also buy physical Treasuries and profit off the spread between their short contracts and their Treasuries.
Because these spreads are quite narrow — typically less than 25 basis points — the profit margin is slim. To maximize their returns, hedge funds heavily leverage their investments, sometimes as much as 98 cents on the dollar.
In the paper, the researchers maintain that this style of investment is not an inherent point of financial fragility, noting that the hedged nature of strategy and the relative stability of the Treasury market during normal times make it fairly safe.
But the highly leveraged approach means that any type of shock to the market could lead to rapid sell-offs if the funds take losses, need to liquidate their equity positions to meet margin calls or simply want to de-risk their portfolios, Kashyap said. He added that the highly concentrated nature of the trade exacerbates this dynamic.
“It’s not like there’s 100 hedge funds in this — there’s six or eight or 10 of them. So, a lightning bolt that gets one of those guys into trouble, if they had to step out, could be a pretty big shock,” Kashyap said. “And the shock could just be them getting nervous and their own internal risk model, saying we’ve got to step back, may not be that they actually take losses. If they just decide that they don’t want to have that much risk exposure, then it’s off to the races.”
In the paper, the researchers argue that purchasing hedges alongside hard Treasury assets comes with several advantages, including separating the Fed’s financial stability activities from its monetary policy. The authors note that what began as a stabilization effort by the Fed in March 2020 eventually gave way to quantitative easing later in the year, without a clear distinction between the two types of purchases.
“This draws a key distinction between market-functioning purchases, which are designed to stabilize market conditions by providing a buyer of last resort over the short term, and quantitative easing, which is intended to supplement traditional forms of monetary policy,” the paper states, adding that the hedges have the added benefit of helping the Fed avoid taking on interest rate risk. Notably, its efforts to tighten monetary policy in recent years have caused it to generate losses on its own balance sheet assets. The authors say this more “surgical” approach would avoid that outcome.
The researchers note that there could be an inherent moral hazard to this type of all encompassing intervention, but they note that this could be mitigated by the Fed applying a discount, or haircut, to the assets and derivatives it purchases.
“If you did it through an auction, you can agree to only purchase at something other than the normal price, and you impose a little pain through this penalty discount,” Kashyap said. “Which would mean that the hedge funds wouldn’t be getting a free lunch.”