Again? This scene in the US bond market once forced the Federal Reserve to open the floodgates!

According to a study published by the Federal Reserve,Hedge funds "may" have increased their positions in highly leveraged US Treasury basis trades, posing risks to financial stability。

Even the Federal Reserve can only guess at the size of the basis trade, which uses the spread between the price of Treasury futures contracts and deliverable notes and bonds. However, researchers Daniel Barth, R. Jay Kahn and Robert Mann wrote in a paper published on Wednesday that data on futures positions in deliverable securities and repo borrowing "are consistent with hedge funds increasing their positions in spot-futures basis trading in Treasuries".

Constrained by a lag in quarterly hedge fund reports, they measured the growth of secured repo borrowing and short positions in Treasury futures between October 2022 and May this year. Basis trading pairs short positions in futures with long positions in spot securities, financed by borrowing in the repo market.

While "insufficient to conclusively determine the scale of hedge fund basis trading activity", they wrote, the picture appeared to be similar to that of 2018 and 2019, when hedge fund basis trading grew rapidly as interest rate hikes by the Federal Reserve boosted hedge demand from asset managers.

Regulators concluded that the need for positioning squaring was exacerbating instability in the Treasury market as global investors sought safety during the 2020 epidemic outbreak. At the time, large swings in bond futures triggered margin calls and prompted the Federal Reserve's decision to commit trillions of dollars of stimulus money to intervene.Industrial foreign exchangeThe researchers wrote:

"If these positions represent basis trading, the continued large risk exposure of hedge funds creates vulnerabilities to financial stability. The Treasury market remains volatile and the spot-futures basis position could come under pressure again during a broader market correction."

Market watchers have long suspected an increase in basis trading as hedge fund short positions in Treasury futures continue to rise. Ben Emons, senior portfolio manager at NewEdge Wealth, said,The Federal Reserve's public admission highlights the significant risks it poses。

"Treasury basis trading is large enough for the Fed to realise that if it does tighten monetary policy too much by draining too much liquidity, it could cause surprises in the financial system.", he said.

Regulators have stepped up scrutiny of such deals in recent months, which in some cases have been leveraged 50-to-1. SEC and Federal Reserve officials have told agencies about leveraged trading of government bonds by their hedge fund clientsbrokerAsk questions.

Hyun Song Shin, head of research at the Bank for International Settlements, also recently noted that basis trading appears to have made a comeback, albeit on a "much smaller scale than the period before the March 2020 crash", urging regulators to closely monitor the trading strategy as it involves high leverage.