U.S. regulators are considering measures to curb highly leveraged hedge fund trading due to concerns about risks to the financial system, according to a Bloomberg report, which cited people familiar with the matter.
Of particular worry is the basis trade, a strategy profiting from price gaps between Treasury futures and cash markets. The practice of using U.S. Treasuries as collateral in the repurchase market has seen significant growth in recent years, reaching nearly $3 trillion.
While hedge funds are subject to less direct regulatory oversight, they rely on large, highly regulated banks to finance their trades. This reliance gives regulatory agencies the ability to influence and limit these activities. In preliminary plans, regulators are considering various options, including encouraging banks to gather more data on exposures and increasing haircuts on some secured borrowing, according to the sources.
SEC Chair Gary Gensler highlights prime brokerages providing generous financing as the greatest risk to the financial system. The SEC is seeking rule changes, and the Financial Stability Oversight Council formed a working group to address hedge fund-related risks.
Officials have discussed a 2% haircut on Treasury repo borrowing to increase the cost of leveraged trading. Advocates for hedge funds argue that the basis trade serves an important market function, helping insurance companies and pension funds manage their interest-rate exposure. They caution that cracking down on it could have unintended consequences. But regulators are exploring options within their current powers over banks to address these risks promptly, without waiting for more extensive proposals that could face legal challenges and bureaucratic delays. The ultimate concern is a repeat of the 2020 scenario when the pandemic disrupted the Treasury market, catching hedge funds off guard and requiring intervention by the Federal Reserve to restore normalcy.
The hedge fund working group at FSOC, whose members include the Treasury, the Fed, the SEC, and the FDIC, identified the basis trade as a potential danger during stress. Data shows a surge in repurchase agreements secured by U.S. Treasuries in the past two years, indicating growing popularity in the basis trade.
The Biden administration is also working on a broader effort to designate firms other than banks as systemically important, potentially including hedge funds. However, this initiative faces significant legal challenges as industry leaders are prepared to resist such designations and increased oversight by the Federal Reserve.