One year ago, a pocket of borrowed money on the edge of UK bond markets imploded with enough force to topple a prime minister and draw the Bank of England into an emergency rescue.

Now the world’s most influential regulators are intensifying their scrutiny of a mounting potential risk to the gilt market’s much bigger cousin: the $25tn US government bond market.

Over the past month, the Bank for International Settlements, a convening body for the world’s central banks, and the US Federal Reserve have both pointed to a rapid build-up in hedge fund bets in the Treasury market.

The so-called basis trade involves playing two very similar debt prices against each other — selling futures and buying bonds — and extracting gains from the small gap between the two using borrowed money.

Both the protagonists and the strategy itself are different from those involved in the UK’s liability-driven investment meltdown last year. But they have one thing in common: the collision of heavy leverage with sudden and unexpected market movements, and the speed with which that can cause potentially serious problems.

The scale of the basis trade is hard to pin down. Even the Fed lacks precise data. But leveraged funds’ short positions in the most liquid futures contracts reached an all-time high of almost $900bn in late August, according to Commodity Futures Trading Commission data. Even if not all of that is used for the basis trade, the Fed has said the strategy poses a “financial stability vulnerability” while the BIS said it had the potential to “dislocate” trading. 



Such risks matter because the US Treasury market underpins the global financial system. The yield on federal government debt represents the so-called risk-free rate that is the benchmark for every asset class. And the short but destructive UK market crisis a year ago highlighted how quickly markets can become disorderly when leverage has been employed — an increasingly pressing concern for regulators focusing on potential problems that accumulated during more than a decade of super-low interest rates.

Analysts, experts and investors argue that the Fed’s interventions in the Treasury market in September 2019 and March 2020, among others, have led to a belief that the Fed will intervene in any instance of extreme market instability, implicitly backstopping speculative trading. 

“I do think moral hazard is very real here,” says Morgan Ricks, a professor at Vanderbilt Law School, where he specialises in financial regulation. “So I don’t think it’s unreasonable to think that the Fed’s implicit backstop of this trade is encouraging more of the trade to happen.”

But hedge funds retort that they are now vital providers of liquidity in this sector. “The market needs arbitrageurs,” says Philippe Jordan, president of Capital Fund Management, a hedge fund with $10bn in assets. “Without them it’s going to be more expensive for the government to issue paper, and more expensive for pension funds to trade. There is a reason this ecosystem exists.”

Back to basis

Hedge funds have been playing an increasingly important role in the functioning of the Treasury market in recent years.

Primary dealers, the 24 banks that transact directly with the Treasury department and facilitate trading for investors, have pulled back from their role since 2008, deterred by rules that have made it more expensive for them to hold bonds.



As the Treasury market has grown — from about $5tn at the start of 2008 to $25tn today — hedge funds and high-speed traders, which are less transparent and less tightly regulated than banks, have picked up the slack. They now play an essential role, buying bonds and making prices for other investors, partly through the basis trade.

Basis trades have proliferated this year as the Fed has raised interest rates and the size of the Treasury market has grown. Both factors have pushed yields higher, increasing demand in the futures market from asset managers looking to lock in returns; their long positions in some Treasury futures have reached record highs in recent weeks.

The basis trade works by exploiting the gap in prices between Treasury futures, which commit users to buying at a certain price on a future date, and on cash bonds. Hedge funds sell the futures and buy the cash bonds, which they can deliver to the counterparty when the futures contract comes due.

The difference between Treasury and futures prices is small, often just a few fractions of a percentage point, so the return is minuscule. But hedge funds can magnify their bets that the gap will close by using borrowed money to fund the trade.



Because Treasuries are considered the highest quality collateral, the prime brokerage divisions of major Wall Street banks are happy to lend against them, often at their full face value rather than a slight discount. In the repo market — short-term lending that facilitates a lot of Treasury trading — hedge funds need to post only small amounts of cash against their credit lines, sometimes levering up by more than 100 times. 

There is borrowing on the other side of the trade too; futures are inherently leveraged products and again, hedge funds need to put up only a small amount of collateral to satisfy the margin requirements of futures exchanges. Ten-year Treasury futures offered by US exchange group CME allow trades of up to 54 times the cash margin posted, for instance.

By taking advantage of the ability to borrow on both sides of the trade, hedge funds can deploy huge leverage. The head of one fund that has engaged in this trade says traders have in the past been able to lever up to 500 times.

The strategy has attracted different types of hedge funds. Traders say diversified groups such as Citadel, Millennium Management and Rokos Capital Management as well as specialists such as Symmetry Investments and Garda Capital Partners are among many that are routinely using the basis trade. The funds in question either declined to comment, or did not respond to requests for comment.

What about the risks?

But central banks and regulators are fearful that the effect of any sudden dislocation in the market could quickly escalate and form ugly feedback loops.

Already there have been several warning shots. The Fed has said it believes stress on this trade played a role in hammering Treasury prices when Covid-19 lockdowns began in the US in March 2020, and it was also considered a factor in a brief seize-up in the repo market in September 2019.

There are several ways the trade can unravel. One is that banks can recoil from risk in moments of market stress, and cut back on the leverage they allow funds to deploy, or ramp up the cost of that short-term lending.

Another is that the clearing houses that facilitate futures trades can increase the amount of collateral they require against a trading position. This occurred when Silicon Valley Bank collapsed in March, with fears of contagion sparking a rapid surge in demand for the safety of US government bonds. In response, CME Clearing increased margins for 10-year Treasury note futures by 15 per cent.

Both make the trade less profitable and leave the hedge fund with a choice: keep the trade on for a higher cost or unwind it, potentially affecting broader markets. The trade is similarly vulnerable to a move in repo rates, which could reduce the amounts banks are willing to lend against hedge fund trades.

“All these strategies are at significant risk if liquidity worsens,” says an executive in this space at a large US bank. “For instance, if they can’t roll their repo trades or the [costs of] those trades increase.” 

Regulators say this all adds up to a situation where just a few large firms getting out of their bets could potentially encourage or force others to do the same, quickly leading to a doom loop of distressed selling in the world’s most important asset market.

“My biggest concern is that if we get a big unwind in this leveraged trade, it could really cause liquidity to dry up in the Treasury market,” says Matthew Scott, head of rates trading at AllianceBernstein. 

In such a situation, it would be highly unlikely for the US central bank to simply stand back and watch. The executive at the large US bank says: “The assumption is that the Fed will step in to save the repo market, which they have in the past, so my view is that they will step in again if anything happens.”

Intervention could involve buying bonds, thus undermining the central bank’s mission to tighten policy until it defeats inflation, and resembles an official safety net for the trade.

Some firms say they have started pulling back from the trade. “This is pretty crowded right now and there’s a lot of weight in it, so the concerns out there are not necessarily overblown,” says one executive at a large hedge fund. 

But most hedge funds active in this space say fears are misdirected and that any clampdown could have grim knock-on effects.

A senior executive at one of the world’s largest hedge funds says well-run entities are not taking on undue risks. “It’s not like an episode of Billions. You’re talking tiny margins on big positions,” the executive says. “If hedge funds stopped buying Treasuries, I don’t know who would buy them.”

A fixed-income trader at another large hedge fund says the basis trade “has been around for half a century and is well collateralised by design”. Provided it is properly managed, “it plays an essential role in the healthy functioning of the US Treasury market ecosystem”.

Funds also argue that the market is better protected thanks to the Fed’s creation of the standing repo facility, which will buy Treasuries and agency mortgage-backed securities from banks in exchange for overnight cash loans. Even though hedge funds do not have access to the facility, it helps prevent sudden spikes in repo rates. 

‘Free insurance’

The prospect of intervention if market conditions become unruly is tantamount to “free insurance,” says Ricks, of Vanderbilt Law School. “I think we should be worried about rent extraction by the funds that are engaged in this trade, who are piggybacking on a Fed backstop.”  

The executive at the large bank says that while the basis trade is “overfished”, it could “go on for quite some time because of this moral hazard”.

It’s not like an episode of ‘Billions’. You’re talking tiny margins on big positions

A senior executive at one of the world’s largest hedge funds
The Securities and Exchange Commission, led by chair Gary Gensler, has proposed several new regulations that would constrain hedge funds and high-speed dealers in the Treasury market.

Under one rule, these types of market participants would be required to register as dealers, which would increase oversight of and transparency in their trading activity. But the final version of that rule has not yet been published or implemented and one Washington insider believes hedge funds will resist any highly restrictive dealer rule through litigation. 

The clearest argument made by hedge funds, however, is not that the trade is risk-free, but that in the current market environment it has become essential to the functioning of the system. 

“The total amount of US Treasury debt is growing and deficits are here to stay, just as the Fed is reducing the size of its balance sheet,” says Don Wilson, chief executive of DRW, one of the world’s largest proprietary trading firms.

“The need for leveraged market participants to facilitate that cash-to-derivative transformation will keep growing, and discouraging it will bring significant adverse consequences.”

Additional reporting by Katie Martin and Laura Noonan in London

Data visualisation by Ian Bott and Chris Campbell

The UK’s top financial regulator is preparing to launch a sweeping review of valuations in private markets, according to people familiar with its plans, amid growing fears over the impact of higher borrowing costs on the sector.

The Financial Conduct Authority’s exercise, which follows a major review of asset managers’ liquidity in the aftermath of last year’s UK bond market turmoil, will look at the “disciplines and governance” over valuations, one of the people said.

That includes looking at who within a firm is accountable for valuations, how information about those valuations is passed upwards to the relevant management committee and board, and what other governance procedures are in place, the person said.

The exercise, to be kicked off by the FCA by the end of the year, comes as global regulators grow increasingly uneasy about the potential for blow-ups in private assets and other markets following the abrupt reversal of more than a decade of low interest rates.

Global securities watchdog Iosco recently warned that the $13tn global private capital sector was too complacent about the possible risks, highlighting valuations as one of a number of areas where vulnerabilities could emerge.

Private assets such as real estate and unlisted shares and bonds are often valued using models that are typically slower to respond to deteriorating market conditions than listed assets.

Assets are usually valued on a quarterly basis, meaning a sharp market correction may not feed through to the valuations for weeks, if not months.

Fund managers who invest in private markets typically have greater discretion over the valuation of their own assets because their holdings are not subject to the daily swings of public market sentiment.

If the FCA does not feel that the governance processes are robust, it can call out failures. If a firm does not respond to that then it can be ordered to make improvements, since valuations are “part of the risk environment” for regulated firms, the person added.

The second person said the review had not yet been fully scoped out and would not begin until later this year. The number and type of asset management firms involved has not yet been finalised, the person said.

The FCA declined to comment.

There are about 2,600 firms in the UK’s £11tn asset management industry, with the FCA acting as their primary regulator. They include hedge funds, venture capital and private equity, as well as large institutional asset managers.

In July, the FCA sharply criticised asset managers’ liquidity management, warning that some firms’ plans to deal with large-scale redemptions “lacked coherence”, and ordered them to make improvements.

US regulators have responded to fears about private markets by ordering private funds to make more extensive disclosures about their performance and expenses, an initiative that has prompted a lawsuit from a coalition of private equity, venture capital and hedge funds.

Additional reporting by Will Louch

There is no problem that private equity will not attempt to solve, including the problem of private equity itself. Interest rates have jumped and buyout exits have slowed amid a drought in M&A and new stock listings. The cash-churning machine is slowing. But here comes a new market.

This week, Goldman Sachs announced that it had raised $15bn for a private equity fund. The fund will not be used to buy companies. Rather, it will buy limited partner interests in other funds, a transaction known as a “secondary”.

In such deals, pensions and other institutional investors can get cashed out, often at a discount to net asset value, near the end of a particular fund’s life. The fund sponsor is not then forced to sell an underlying portfolio of companies before it believes it can get full value.

Private equity secondaries have grown from a niche strategy with $100bn of assets to one approaching $500bn. This coincides with the rise of other forms of financial engineering, including “net asset value” lending, using an underlying fund holding a series of companies. Recently, Vista Equity relied on a NAV loan to stump up the $1bn of equity it needed for a challenged software investment.

Private equity firms are also increasingly selling equity stakes in fund managers to other specialised PE firms in order to give cash to partners.

Some industry veterans claim the golden era of private equity has passed now that low interest rates are unavailable and corporate valuations are more volatile. But the dollars keep flowing into these alternative assets. McKinsey estimates that there is now $12tn of private capital AUM. The total has grown at a 20 per cent compound rate over the past five years.

This complicates true price discovery. Public markets, while not flawless, tend to be a stricter test of fair valuations. The private equity industry deserves credit for finding continuous ways to bypass the issue and keep their fee stream running.

It was in December 1913, when Louis Brandeis, an American lawyer who was later appointed to the Supreme Court, stated in a now-famous essay that “sunlight is said to be the best of disinfectants”.

Focused on excessive fees charged to investors on financial markets at the time, he called for more transparency: “To be effective, knowledge of the facts must be actually brought home to the investor, and this can be best done by requiring the facts to be stated in good, large type write in every notice, circular, letter and advertisement inviting the investor to purchase.”

Fast forward 110 years and Kanye West has provided an illustration of why “sunlight” is still important for investors.

German sportswear maker Adidas set up a partnership in 2015 with the rapper and fashion designer to produce Yeezy sneakers. While Adidas did not make a secret of the fact that the shoes, with their futuristic design and price tag of more than €230, were highly successful, it never disclosed the brand’s revenue and profits.

But investors belatedly learnt just how important Yeezy was when shares in Adidas tanked after the sportswear group pulled the plug on the partnership after a series of antisemitic remarks by West, also known as Ye. It was later disclosed that the shoes accounted for more than 5 per cent of the group’s overall revenue and about a quarter of its overall operating profit.

The episode has been painful for Adidas and its shareholders, but it also raises questions more broadly on just how much companies should disclose on the profitability of specific products, regions and brands.

Under global accounting standards, the relevant rule gives companies a lot of leeway. IAS 8, which defines the guidelines for segment disclosure, follows the so-called “management approach”. It stipulates that a company’s external disclosure needs to follow its internal reporting lines.

As a result, “disclosures will not be consistent between entities, even those operating in similar industries”, warns Grant Thornton, an audit firm, in a note on the topic. And most listed companies keep their cards close to the chest. By doing this, they can at least partly hide highly profitable parts of the business from envious rivals while obscuring underperforming operations. “There is a common habit of combining strongly performing parts of the business with less successful ones,” a partner of a Big Four audit firm said.

There are several reasons why Adidas investors and analysts might have wanted to know about the scale and scope of Yeezy’s extraordinary performance well in advance. First, they might have asked inconvenient questions over the group’s growing dependency on the controversial, and unstable, Ye. Such questions were vented internally but brushed aside by the group’s management, as the Financial Times previously reported.

Second, and more important, shareholders would have wanted to know why the rest of the sportswear group’s empire was more lacklustre than the combined numbers suggested.

However, Adidas was far from alone in its approach. For example, German carmakers, which rely heavily on combustion engine vehicles and China for their profits, are reluctant to break out their profitability by region or drivetrain technology.

While tighter rules on better segment disclosure may be desirable, they seem difficult to implement as different industries are shaped by unique characteristics that change over time. Finding a better definition that works for fashion companies, global investment banks and carmakers all at the same time could be a stretch. And working out profitability within a division can be tricky given issues such as allocation of group costs.

A better, and more realistic lesson from Adidas’s Yeezy debacle is that investors should push individual companies much harder for meaningful disclosure of all aspects needed to fully comprehend the operations and risks a company is facing — be it the reliance on an erratic rapper or exposure to the Chinese car market. And companies need to ensure the narrative of their performance presented to the world is accurate, warts and all. Over the long term, this will be in the interest of executives, as more accountability is likely to lead to better decisions and superior performance. Companies that consistently shy away from sunlight deserve to trade on a shadow discount.

olaf.storbeck@ft.com