As per a US Office of Financial Research paper said, US hedge funds participation in a complex kind of shadow banking transaction involving Treasuries and repurchase agreements, still is risky after the Fed rescue in March.
Repurchase agreements is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also a common tool of a central bank open market operations. The US repo market provides more than $3 trillion in funding every day.
These basis trades tie Treasuries, futures, and repos in a three-legged transaction, leading to potential spillovers into the funding markets, as per the paper. Making it possible a future market instability on the Treasury market. Because of the high leverage of hedge funds involved in basis trades, which can have a potential systemic risk the larger hedge funds, who magnify it.
Therefore, the possibility of creating illiquidity on the Treasury Market sends signals to the broader universe of markets, because Treasuries are the highest credit quality among all debt, and their market is normally very liquid.
Shadow banking which is the group of financial intermediaries facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions. Examples of intermediaries not subject to regulation include hedge funds, money-market mutual funds, pensions, insures, private equity funds, unlisted derivatives, and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.
The Fed emergency intervention, in March, to unclog these markets in the wake of the pandemic eruption may have slowed the potential impact of basis trades on Treasury illiquidity as well as wider spillovers the paper said.
And the trades attractiveness among hedge funds has declined since March due to high losses at the time. Nonetheless, risks of basis trades persist.
Very high leveraged hedge funds are more sensitive to sell-offs because small price changes can trigger big losses. Which can magnify if dealer’s larger exposure to Treasuries hinder their market making ability.
The basis trade, as per the paper, can be defined as the relationship between cash Treasuries, where investors buy these securities immediately, Treasury futures, where investors agree on a fixed price to pay for securities to be received in the future; and repos, where investors borrow or lend Treasuries against cash today.
Taking in consideration that hedge funds, which are far less regulated than banks, are marketed via private placements to institutional, professional or sophisticated investors. They manage $4.8 trillion in assets worldwide (2018 – as per Financial Stability Board) and around 80% of their assets are on the Cayman Islands.
FSB chief Randal Quarles is trying to build an “holistic view of resilience” on this sector, after sounding the bell about hedge funds and other non-banks.
Is planned to review March market turmoil by the time of the G20 summit in November. At the same time the Switzerland based authority also begun to map “critical connections” between banks and non-banks internationally.
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