Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Look, sorry, Alphaville will never ever get tired of writing about Treasury market structure. If this isn’t your cup of tea then check out Trevor Milton’s 10/10 plea for leniency or the latest twist in the Amigo saga.
If you’re still here, the topic du jour is the Treasury basis trade, and whether it is the single most dangerous hedge fund strategy in history or a vital cog in ensuring the vibrancy of the global financial system.
Citadel’s Ken Griffin is obviously in the latter camp, earlier this month warning the SEC against “recklessly” impairing it. Now the Managed Fund Association — the US hedge fund industry’s lobbying body — has followed up with a “primer” on the role its members play in the Treasury market.
Its position can not unfairly be summed up thusly:
However, to give its defence some veneer and not appear to be purely industry bleating, Bryan Corbett, the MFA’s president and CEO, stressed that its members were open to “sensible enhancements”.
Alternative asset managers play an important role in the Treasury markets. Their participation in the markets increases liquidity, dampens volatility, and lowers the cost of government borrowing. The Treasury markets are not perfect. Sensible enhancement should be made to improve market function. However, policymakers should refrain from making ill-considered changes that decrease the number of market participants at a time when foreign central banks, the Fed, and banks are all reducing their exposure to Treasuries. The outcome could harm the health of the markets and increase the cost of borrowing for consumers, corporations, and the U.S. government.
To be fair to the MFA, its report is a decent if not-exactly-objective introduction to the subject.
While it obviously argues that the SEC’s plans to expand who is considered a Treasury market dealer is awful, terrible, cats and dogs living together etc, the “sensible enhancements” it proposes do look sensible, if very modest:
— Improving data collection by adding customer legal entity identifiers (LEIs) and a clearing arrangement indicator to TRACE for cash trades;
— Requiring reporting of repo and reverse repo transactions to a central depository (such as the OFR recently proposed);
— Expanding the use of voluntary central clearing in the dealer-to-customer segment of the Treasury market for both secondary cash market transactions and repos;
— Requiring clearing members of FICC (the only clearing agency for Treasury securities) to accept transactions executed by their customers with third-party executing firms (“done away” trades);
— Providing for segregation of customer margin at FICC; and Introducing cross-margining for end-users for Treasury futures and cash Treasury transactions
Moreover, the MFA’s list of benefits from the Treasury basis trade . . .
— Increasing liquidity;
— Dampening volatility;
— Reducing bid-ask spreads;
— Lowering the cost of government borrowing; and
— Helping pensions and other buyers of futures optimize their allocation of capital.
. . . isn’t actually wrong. These are all real things!
We know arbitrage and hedge fund provoke visceral reactions among some people, but these are actual benefits. For example, it’s entirely plausible that the recharged Treasury basis trade has helped reduce US government borrowing costs a little this year. The greater liquidity and tighter bid-ask spreads are one of the reasons why US Treasuries are the world’s dominant reserve asset.
It just leaves out the single biggest downside: it makes the world’s single most systemically important financial market more fragile at times of severe stress — exactly when you want it to function smoothly.
The MFA’s argument that zero haircut repo financing on the actual Treasury purchases is a “misnomer” because hedge funds have to post margin on the futures leg of the basis trades also seems wilfully obtuse.
Wall Street is figuratively littered with the corpses of financial institutions and individual careers of people who didn’t foresee how different legs of the same holistic trade can unravel horribly in the wrong circumstances. Eg LTCM.
