A panel of financial experts has urged the Federal Reserve to consider setting up an emergency facility to manage the potential unwinding of highly leveraged hedge fund basis trades – a move aimed at safeguarding the $29tn US Treasuries market from systemic risk, according to a report by Bloomberg.
The basis trade – a strategy where hedge funds exploit small price gaps between Treasuries and futures – has grown to an estimated $1tn, with some experts warning that a disorderly unwind of these positions could disrupt not only the Treasuries market but also broader financial stability.
During the March 2020 Covid crisis, the Fed intervened by purchasing $1.6tn in Treasuries over several weeks. However, a Brookings Institution paper, co-authored by academics from Harvard, Columbia, and the University of Chicago, suggests that a hedged bond purchase facility would be a more efficient alternative to outright bond-buying.
Under this proposal, the Fed would step in only during crisis scenarios, purchasing Treasury securities while fully hedging the position by selling offsetting futures. This would alleviate pressure on bond dealers, who might otherwise struggle to absorb a sudden surge in unwinding trades.
During the 2020 intervention, basis trades totalled $500bn –half of today’s volume. The risk now, according to one of the paper’s co-authors, Anil Kashyap, is that the trade is highly concentrated among fewer than 10 hedge funds, making any rapid liquidation even more precarious.
The idea of a “basis purchase facility” raises concerns about moral hazard, with critics arguing that it could incentivise excessive risk-taking among hedge funds. However, the authors counter that a structured auction process, where hedge funds face penalty discounts when offloading trades, could mitigate this risk.
“A basis purchase facility wouldn’t be that far afield from current open market operations,” the paper argues, highlighting its similarities to repo transactions. The Fed’s existing repo facilities already involve transactions conceptually similar to basis trades, just with different counterparties.
While the legal framework for such a facility remains unclear, policymakers are actively exploring broader Treasury market reforms. Upcoming measures include:
Minimum margin requirements for leveraged Treasury purchases
Expansion of the Fed’s Standing Repo Facility
A mandate for central clearing in the Treasuries market, set to take effect by 31 December, 2026.
