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Ken Griffin, the founder and chief executive of $62bn US hedge fund Citadel, has warned regulators that they should focus their attention on banks rather than his industry if they want to reduce risks in the financial system stemming from leveraged bets on US government debt.
Global regulators have warned about growing risks emerging from the so-called Treasury basis trade — selling Treasury futures while buying US government bonds and extracting gains from the small gap between the two using borrowed money.
But Griffin said they should focus on the risk management of banks that enable the trade by lending to hedge funds, rather than try to increase regulation of the hedge funds themselves.
The US Securities and Exchange Commission, which regulates hedge funds, has proposed a new regime for the Treasury market that would treat hedge funds like the broker-dealer arms of banks.
“The SEC is searching for a problem,” Griffin told the Financial Times. “If regulators are really worried about the size of the basis trade, they can ask banks to conduct stress tests to see if they have enough collateral from their counterparties.”
Hedge fund bets against US Treasuries futures climbed to new highs in the seven days to October 24, with record net shorts against both the two-year and five-year future. Most, but not all, of these bets are in the basis trade.
Citadel, alongside rival hedge funds Millennium Management and Rokos Capital Management, is among many that are routinely using the basis trade.
The Bank for International Settlements and researchers at the US Federal Reserve are among those to have warned about the risks of a rapid build-up of hedge fund bets in the Treasury market, which is magnified by leverage levels that can exceed 100 times.
If the trade moves against them and hedge funds are forced to sell their Treasury bonds at the same time, regulators worry it could lead to a collapse of the world’s most important bond market, with severe implications for the wider financial system.
The BIS blamed a “disorderly reduction in margin leverage” as a contributor to the collapse of the US Treasury market in March 2020 at the onset of the pandemic. However, in the Fed’s latest Financial Stability Report last month, the central bank said risks related to the basis trade “are likely mitigated by tighter financing terms applied to hedge funds by dealer counterparties over the past several quarters”.
The prime brokerage divisions of banks play a key part in the basis trade because they lend money to hedge funds while using their Treasury bonds as collateral. Banks are expected to evaluate how the portfolios of their hedge fund clients perform under various market stresses to make sure they have enough collateral to withstand a market shock.
Griffin said he was not opposed to regulations capping the amount of borrowing by hedge funds in the Treasury market, provided the proposals were “subject to sound economic analysis and proposed for public comment”.
He noted that the basis trade brought down the cost of issuing government bonds, as hedge funds buy large quantities of Treasuries to pair against their short futures positions.
“The ability for asset managers to efficiently gain exposure to Treasuries through futures allows them to free up cash to invest in corporate bonds, residential mortgages and other assets,” he said.
This is because futures are leveraged products requiring a fraction of the cash posted as collateral to maintain the position, rather than paying full price for a Treasury bond now.
“If the SEC recklessly impairs the basis trade, it would crowd out funding for corporate America, raising the cost of capital to build a new factory or hire more employees,” Griffin said. “It would also increase the cost of issuing new debt, which will be borne by US taxpayers to the tune of billions or tens of billions of dollars a year.”
Addressing risks elsewhere in the financial system, the Citadel founder said “the risks lie where there is a significant mismatch between assets and liabilities relative to the leverage employed”, pointing to the collapse this year of Silicon Valley Bank.
The US lender’s $180bn in deposits provided cheap short-term funding and because loan demand was weak it bought long-term bonds that were unhedged, but rising interest rates devalued the bonds, leading to a liquidity crisis when customers tried to withdraw their money.
“Silicon Valley Bank using customer banking deposits to invest in long-dated Treasuries is profoundly different from a hedge fund buying a Treasury bond and selling a futures contract that can be closed out by delivering the bond,” Griffin said.
The SEC under chair Gary Gensler has unleashed the largest regulatory blitz since the financial crisis. A rule that would force larger players to register as broker-dealers or government securities dealers is among proposed regulations that would subject hedge funds to increased oversight.
“Regulators should focus on the banks instead of requiring every hedge fund that’s going to partake in the Treasury market at any reasonable scale to be a registered broker-dealer,” Griffin said. “This is a much more cost-effective way to address any concerns that the SEC or other regulators in this space might have.”
Additional reporting by Kate Duguid in New York.
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