Ken Griffin, the founder and chief government of $62bn US hedge fund Citadel, has warned regulators that they need to focus their consideration on banks reasonably than his trade in the event that they wish to scale back dangers within the monetary system stemming from leveraged bets on US authorities debt.
World regulators have warned about rising dangers rising from the so-called Treasury basis trade — promoting Treasury futures whereas shopping for US authorities bonds and extracting positive aspects from the small hole between the 2 utilizing borrowed cash.
However Griffin stated they need to deal with the danger administration of banks that allow the commerce by lending to hedge funds, reasonably than attempt to enhance regulation of the hedge funds themselves.
The US Securities and Trade Fee, which regulates hedge funds, has proposed a brand new regime for the Treasury market that might deal with hedge funds just like the broker-dealer arms of banks.
“The SEC is trying to find an issue,” Griffin informed the Monetary Occasions. “If regulators are actually nervous in regards to the size of the basis trade, they’ll ask banks to conduct stress exams to see if they’ve sufficient collateral from their counterparties.”
Hedge fund bets in opposition to US Treasuries futures climbed to new highs within the seven days to October 24, with document internet shorts in opposition to each the two-year and five-year future. Most, however not all, of those bets are within the foundation commerce.
Citadel, alongside rival hedge funds Millennium Administration and Rokos Capital Administration, is amongst many which might be routinely utilizing the idea commerce.
The Financial institution for Worldwide Settlements and researchers on the US Federal Reserve are amongst these to have warned in regards to the dangers of a fast build-up of hedge fund bets within the Treasury market, which is magnified by leverage ranges that may exceed 100 instances.
If the commerce strikes in opposition to them and hedge funds are pressured to promote their Treasury bonds on the identical time, regulators fear it may result in a collapse of the world’s most essential bond market, with extreme implications for the broader monetary system.
The BIS blamed a “disorderly discount in margin leverage” as a contributor to the collapse of the US Treasury market in March 2020 on the onset of the pandemic. Nonetheless, within the Fed’s newest Financial Stability Report final month, the central financial institution stated dangers associated to the idea commerce “are seemingly mitigated by tighter financing phrases utilized to hedge funds by vendor counterparties over the previous a number of quarters”.
The prime brokerage divisions of banks play a key half within the foundation commerce as a result of they lend cash to hedge funds whereas utilizing their Treasury bonds as collateral. Banks are anticipated to judge how the portfolios of their hedge fund purchasers carry out underneath numerous market stresses to verify they’ve sufficient collateral to face up to a market shock.
Griffin stated he was not against laws capping the quantity of borrowing by hedge funds within the Treasury market, offered the proposals had been “topic to sound financial evaluation and proposed for public remark”.
He famous that the idea commerce introduced down the price of issuing authorities bonds, as hedge funds purchase massive portions of Treasuries to pair in opposition to their brief futures positions.
“The power for asset managers to effectively acquire publicity to Treasuries by way of futures permits them to liberate money to spend money on company bonds, residential mortgages and different property,” he stated.
It is because futures are leveraged merchandise requiring a fraction of the money posted as collateral to take care of the place, reasonably than paying full value for a Treasury bond now.
“If the SEC recklessly impairs the idea commerce, it could crowd out funding for company America, elevating the price of capital to construct a brand new manufacturing facility or rent extra workers,” Griffin stated. “It could additionally enhance the price of issuing new debt, which will probably be borne by US taxpayers to the tune of billions or tens of billions of {dollars} a yr.”
Addressing dangers elsewhere within the monetary system, the Citadel founder stated “the dangers lie the place there’s a vital mismatch between property and liabilities relative to the leverage employed”, pointing to the collapse this yr of Silicon Valley Financial institution.
The US lender’s $180bn in deposits offered low cost short-term funding and since mortgage demand was weak it purchased long-term bonds that had been unhedged, however rising rates of interest devalued the bonds, resulting in a liquidity disaster when prospects tried to withdraw their cash.
“Silicon Valley Financial institution utilizing buyer banking deposits to spend money on long-dated Treasuries is profoundly completely different from a hedge fund shopping for a Treasury bond and promoting a futures contract that may be closed out by delivering the bond,” Griffin stated.
The SEC underneath chair Gary Gensler has unleashed the most important regulatory blitz because the monetary disaster. A rule that might power bigger gamers to register as broker-dealers or authorities securities sellers is amongst proposed laws that might topic hedge funds to elevated oversight.
“Regulators ought to deal with the banks as a substitute of requiring each hedge fund that’s going to partake within the Treasury market at any cheap scale to be a registered broker-dealer,” Griffin stated. “It is a rather more cost-effective method to handle any considerations that the SEC or different regulators on this house may need.”
Extra reporting by Kate Duguid in New York.