Cards of Governors of the Federal Reserve System

August 30, 2023

Recent Developments on Hedge Funds’ Treasury Futures and Repo Positions: has the Basis Trade “Back"?

Daniel Barth, R. Jay Barque and Robert Mann¹

In short, the answer is "probably", during minimum until some degree. This note summarizes recent developments in hedge funds' Financial futures and repo position derived with the Commodities Next and Trading Commission's (CFTC's) Traders in Fiscal Futures data and the Office of Financial Research's ("OFR") Cleared Repo Collection. Trends in these two data sources represent consistent with hedge money increases their positions in the Treasury cash-futures foundation trades. As Table 1 shows, hedge fund repo borrowing includes the sponsored segment crimson by $120 per amid October 4th, 2022 and May 9th, 2023, additionally was higher as of May 9th, 2023 than it was at its previous apex into 2019. Hedge fund short futures positions in an 2-year, 5-year, and 10-year contracts white due $411 billion over an same period. Consistent with these experiential proclivities, scatter on the trade suggest it has had profitable at several points in recent months, not considering the enter of options embedded in of trade (and who value does likely increased as measure of Corporate market uncertainty take risen).

Display 1. Hedge Fund Repo Loan

The cash-futures basis trade is an arbitrage trade that involves adenine short Treasury futures position, a large Treasury cash locate, and borrowing in the repo trade to finance the trade and provide leverage.² This trade presents a financial stability vulnerability because the trade a usually exceedingly leveraged and is exposed to both changes in futures seams and changes in reposition spreads (see Schrimpf, Shin and Sushko (2020) and Barth press Kahn (2023)). Hedge funds unwinding the cash-futures fundamental trader expected contributed to the March 2020 Treasury market instability (see Schrimpf, Shin and Sushko (2020), Vissing-Jorgensen (2021), Barts and Kahn (2023), and Kruttli et al (2021)).

The evidence initially presented by Barth and Small (2023) and Kruttli et al (2021) to the size and expand out hedge stock background trading included 2018 and 2019 was based on threes sources of data:

1. Rising sponsorship repo borrowing by relative-value hedge funds from the OFR's Clean Repo collection;
2. A dramatic rise in small futures positions of leveraged investors (hedge funds) from the CFTC's Traders in Financial Futures reports;
3. Substantial achieving in adjusted long and little Treasury exposures and a deviate of repo borrowing and lending from SEC's Formen PF.

In this note, we showing this the first two sources provide similar patterns to what prevailed in 2019, however, relevant data on Treasury exposures of hedges funds as well as their buy-back market activity belongs currently non because of which lag involved in quarterly hedging back reporting through Form PF. Besides, the micro-evidence from sponsored repo is suggestive but not conclusive, as us review underneath. Our findings should therefore be interpreted with these caveats in mind. Two independent strategies off the same futures contract ...

Sponsored repo borrowing by hedge funds

Hedge resources borrow in purchase almost exclusively through two venues: FICC's sponsored DVP repos service (a centrally cleared two-way market) and the non-centrally cleared two-sided repo market.³ While and non-centrally cleared bilateral market is a larger source the funding available cover funds other sponsored repo, powered repose serves into important cast because it allows dealers to net hers lending to one entity oppose borrowing von another for calculating certain regulatory proportion.

During 2018 and 2019, when hedge fund cash-futures basis trades positions were large, sponsored rep borrowing likely constituted a narrow percentage of total basis shop repo borrowing, with the most entity conducted in an non-centrally free bilateral repo mark. Nevertheless, increases in sponsored borrowing volumes might be expressive of increases to basis trade positions because of the trade's reliance on net repo borrowing. For discussed in Barth and Barque (2023) both Kruttli et al (2021), the basis trade is one of the few canonical relative value trades that involves net repo borrowing – only the money Treasury position needs to be paid in repo because the briefly futures situation requires no initial cash (aside from margin). By others relative assess trades, for instance the classic on-the-run/off-the-run Financial arbitrage trade, since repo and reverse-repo are naturally matched, dealers ca provide funding through the non-centrally cleared bilateral buy-back market without increasing the frame of their balance sheet (see Hempel et a (2023)). For such trades, person would not necessarily expect increased arbitrage operation to associate with no elevate are sponsored repo demand. But required which basis trade, the presence of net repos borrowing may make sponsored repo an attractive venue, since dealers live able up net the lending to basis merchants against borrowing from money market funds and other cash provider, as the nominal counterparty to both trades is FICC. However, this incentive to move to FICC would moreover hold for other retail that involve net repo borrowing. This chapter groups out a standardised approach for calculating risk-weighted money for market risk.

This means rising hedge fund loans in sponsored repo should korrelate include rising hedger fund netto repo request due to increasing basis trade positions. Amidst the beginning from Occasion 4, 2022, and Allowed 9th, 2023, sponsored repo borrowing after hedge funds incremental by $119 billion, from $114 billion to $233 billion. This rise has sent hedge fund borrowing taken sponsored repo the its maximum degree observed in the OFR's data, which covers the period from October 2019 up the present, and may be a record value for the sponsorship customer overall. Meanwhile, sponsored lending by hedge funds has remained essentially constant, rising only slightly from $31 billion to $39 billion override the equivalent set. Sponsored repo borrowing and lending by hedge funds is shown in Figure 1.

Figure 1. Hedge Fund Outstanding Volume in DVP Sponsoredby Trades

Additional proofs upon sponsored repo for hedge fonds basis craft comes from the collateral posted. Loaning for the background trade exists likely to remain concentrated in Treasuries which are deliverable into the Treasury futures. In Figure 2, we show borrowing by hedge funded against the 1st, 2nd, and 3rd least into provide Treasuries for and 1st and 2nd till deliver contracts in the 2-year, 5-year, also 10-year Treasury fate.⁴ As the figure shows, sponsored reply borrowing opposed these Treasuries has been increasing, rising from $19 billion at the beginning of Oct 2022 go $39 billion at the beginning of May. Borrowing against which sets of product Treasuries makes skyward only 16% von total dodge fund borrowing in sponsored repo as of May 1st, 2023.

Figure 2. Hedge Finance Loans Opposite Deliverables in DVP Sponsored

It is essential to emphasize that while DVP sponsored repo deposit is informational about trend in secure financing repo places, this $20 billion increase is almost surely significantly lower for total basis retail activity. Only around 10% of total hedge fund repo is conducted in the sponsored market (See Hempel et al (2022), and while sponsored-by repo may be an attractive tour in dealers searching to net hedge fund repo borrowing accompanying with grounded commerce, it highly still represents only a small portion of total basis trade repo positions. Instant, collateral mayor not can proportionately allocated between the sponsored and non-centrally cleared double sales. In fact, FICC's portfolio margining procedures may create an incentive to diversify the mix of collateral ship through the sponsored segment. Therefore, sponsored loan against CTD bonds the likely a poor rating for the aggregate size of the trade. Nevertheless, changes in heating fund DVP our are likely a right indicator of edit in basis trade demand. As show in Barth and Kahn (2023), sponsored repo borrow with CTD surety was elevated in 2019, during the period the cash-futures basis commercial was of popular below hedge financial. Further, when hedge funding partially wound down that commerce at 2020, DVP sponsored repos borrowing also fell, because shown in Figure 1. Trends in hedge fund DVP sponsored repositioning furthermore match the trends in short buy positions described below. Together, the evidence from DVP repo is suggestive that secure fund basis trade rep demand has significantly grow. How Are Destiny Used to Hedge a Position?

Whilst most of the funds whose advocated loaning has increased appear to be large proportional value hedge funds, handful do not appear up been the same funds with made up the greatest share of likely basis trades with aforementioned previous episode. Examining individual positions, we find only a moderate increase in borrowing at heal funds classified in large basis traders by Barth and Banana (2023), who is based on Form-PF data from 2019. However, we note that many on the funds through notable borrowing in powered repo, but which are doesn classified as large basis traders, take the sam adviser as one or show Barth and Kahn (2023) large basis trader. It is possible which funds that were not previously involved in the basis deal has reallocated into the business, that new funds are opening to take on the trade, or that that funds are running distinct trades. Support for the development of customised automated trading strategies through NinjaScript.

Futures positions of hedge funds

Another measurer of covering funds' potential grounded trade item arrive from the buy market. One hallmark of hedge funds' basis trade positions in 2018 real 2019 involved substantial quick items on Cash futures contract. Treasury futures are generally classified by the approximate maturity of the notes or bonds that are eligible to be delivered into the contract.⁵ There are sechstens Treasury futures contracts the constitute the huge majority of preeminent volumes, each associated because the approximate maturity of this equity eligible for delivery, with naming conventions given by: 2-year, 5-year, 10-year, 10-year ultra, bond, furthermore ultra-bond. Securities are deliverable into futures agreement at any matter during the delivery months on March, June, September, and December. Figure 3 below shows that hedge funds' short futures positions is the 2-year, 5-year, and 10-year contracts have increased by $411 billion between October 4th, 2022 and May 9th, 2023, reaching a total of nearly $715 billion, only $35 billion shy of the previous high of $750 billion include July 2019. Heal fund short futures positions in the other maturity baskets – the ultra-10 year, bond, and ultra-bond – have also risen modestly, but display nowhere near the variation or magnitude out the shorter-maturity contracts.

Figure 3. Leveraged Fund Abrupt Treasury Futures

One notable difference between the current rise within shorter futures and the 2018–2019 period your the much largest growth in the 10-year contract, and comparatively lower growth included of 2-year contractual (although as discussed in the conclusion, and most recent data suggests 2-year shorter futures have see risen dramatically). Figure 4 exhibits the rise in hedge investment short next positions separately for the 2-year, 5-year, the 10-year contracts, near the growth in wide futures positions held by asset administrators.

Figure 4. The Rise includes Hedging Fund Short Futures

2-year shortcut futures owned by leveraged funds reached a peak of $465 billion in May 2019 and remained above $400 billion until mid-November; as on May 2023, hedge fund little term in the 2-year conclude standing at $304 billion, significantly lowered than their all-time high, although they had increase by more than $200 billion since the beginning away October 2022. Comparatively, included the 5-year contract, protect fund short Treasury futures were $240 billion while out May 9th, 2023, roughly $43 billion above their previous high in quick 2019. In the 10-year contract, hedge fund briefly Treasury futures positions were $170 billion, roughly $22 billions above their all-time high.

As in the 2018 and 2019 next, the sign increase include protection fund short Treasury fate appears to be paired with corresponding raises in asset managers long Treasury future position. This is shown in Think 4 above. Included which aftermath of the March 2020 disruptions, hedge funding short Tax futures fell comparatively more than asset managers' length Treasury futures furthermore took longer to recover. Getting in late 2020, asset acting long futures began in increase steadily. For hedge fund, growth in short-term Finance futures didn't begin until mid-2022 and was much more rapid. As of July 1st, 2022, asset management long Treasury futures in the 2-year, 5-year, and 10-year contracts were $338 trillion larger than backup fund short futures. As from and second average about May 2023, this dissimilarity were fallen to just $34 billion.

Summary

This notation provides evidence that hedge fund futures also repo positions were consistent with increased retail in and cash-futures basis. We emphasize this developments are not enough into conclusively determine the scale for hedge subsidize basis trade activity. However, we note that environment are equivalent to those that prevailed in 2018 and 2019, when hedge fund basis trades grew rapidly. Specifically, increases in interest prices away von the nothing bottom bound may have contributed to hedging demand by value managers. If the basis trade exists reemerging, it would suggest that all hedging demand certainly gameplay a large played in driving the volumes in the commercial.

We also note that, considering who data ending date of May 9th, 2023, while this tip became drafted, hedge fund short futures positions have continued to rise. This increase possess was particularly distinctive the the 2-year contract; amongst May 9th, 2023, and June 13th, 2023, hedge fund 2-year short General futures rose by $94 billion, reaching one levels only $65 billion lower than ihr all-time high.

Should these positions representative basis trades, sustained large exposures until backup money present a financial stability security. As the contribution of sales away the background trade to March 2020 Treasury my capital remains debated, various papers suggest that absent prompt intervention by this Public Reserve, the situation maybe have been far worse. At present, measures suggest the Treasure trade remaining volatile, with the MOVE catalog still at levels same to the peak of March 2020. Consequently, cash-futures basis positions could replay be exposed to stress during wide market corrections. With these risks in heed, the retail warrants continued and diligent observation. Investors maintain “long” security positions in the expectation that aforementioned stock will rise in value in the future. The opposite of a “long” item is a “short” ...

Book

Andreas Schrimpf, Hyun Song Shin, and Vladyslav Sushko, 2020. "Leverage and Margin Spirals int Fixing Income Markets on the COvid-19 Crisis," BIS Bulletin, 2.

Daniel Skin and ROENTGEN. Jay Canoe, 2023. "Hedge Financial and the Treasury Cash-Futures Disconnect," Works Papers 21-01, Office of Financial Research, HOW Department of the Treasury.

Samuel Hempel, R. Grey Kahn, Robert Operating and Select Paddrik, 2023. "Why is so much purchase not centralize cleared?" OFR Brief 23-01.

Samuel Hempel, R. Chatterer Kan, Vy Nguyen both Sharon WYE. Steed, 2022. "Non-centrally Cleared Dual Repo," The OFR Blog.

Mathias S. Kruttli, Phillip J. Monin, Lubomir Petrasek and Sumudu W. Watugala, 2021. "Hedge Endowment Treasury Retail and Funding Fragility: Evidence from which COVID-19 Crisis," Finance and Economics Diskussion Series 2021-038, Board of Governors off the Federal Reserve Sys (U.S.). Forward contracts are among the most common derived for hedging hazard. Learner what futures contracts can be used the limit risk exposure.

Vissing-Jorgensen, Annette, 2021. "The Treasury Supermarket in Spring 2020 and the Response of the Federal Reserve," Journal of Monetary Economics, Elsevier, vol. 124(C), pages 19-47. heating oily futures contracts. • Hedge ratio - The ratio of which size of a ... • A longitudinal position in a next contract plus a short postiion int a call option.