Financial experts have advised the Federal Reserve to establish an emergency program aimed at managing highly leveraged hedge fund positions during potential crises in the $29 trillion US Treasury market. The recommendation comes amid growing concerns over
approximately $1 trillion in hedge fund arbitrage positions that could require federal intervention to maintain financial stability.
The proposed intervention would specifically target the basis trade, a strategy employed by fewer than ten major hedge funds that profit from minor price differences between Treasury securities and futures contracts. The current scale of these trades has reached unprecedented levels, with regulatory capital among the six largest multi-strategy hedge funds – including Millennium, Citadel, Balyasny, Point72, ExodusPoint, and Lighthouse – hitting a record $1.5 trillion, marking a $300 billion increase from the previous year.
More concerning is the rise in average regulatory leverage among these funds, which has climbed to 7.8 times from 6.3 times over the past year. The Federal Reserve estimates that the inherent leverage in basis trades can reach up to 56 times, while the Treasury Borrowing Advisory Committee suggests a more conservative but still significant 20 times leverage ratio.
This situation mirrors previous market stress events, notably the September 2019 “repocalypse” and March 2020 Covid crisis, when the Fed had to intervene to prevent market collapse. During those episodes, the basis trade volume was approximately $500 billion – less than half of today’s exposure.
A paper published by the Brookings Institution, authored by financial experts including former Fed governor Jeremy Stein, suggests implementing hedged bond purchases as an intervention strategy. This approach would involve the Fed counterbalancing Treasury security purchases with futures sales, effectively managing market stress without traditional quantitative easing measures.
The authors acknowledge the moral hazard implications of such interventions, where the existence of safety nets might encourage even riskier behavior from hedge funds. However, they argue that comparing this approach to the alternative of no intervention is unrealistic, given the Fed’s established precedent of market support through outright Treasury purchases.
The proposed facility would operate similarly to current open market operations, though specifically targeted at basis trade unwinding. This similarity to existing repo transactions provides some
institutional framework, despite primarily benefiting a concentrated group of hedge funds.
Implementation challenges remain, including legal considerations which the authors note are beyond their current analysis. The Treasury market is already undergoing structural changes, with upcoming mandates for central clearing of Treasuries and repo effective December 31, 2026.
Current market conditions suggest increasing vulnerability, with hedge funds maintaining aggressive positions that could face difficulties with relatively minor market movements. Traditional dealers appear inadequately positioned to handle potential large-scale unwinding of these trades, raising concerns about market stability.
This situation highlights a persistent challenge in financial markets: the concentration of risk in a small number of highly leveraged institutions whose potential failure could necessitate government intervention to prevent broader market disruption. The proposed framework attempts to balance the need for market stability with concerns about moral hazard and appropriate use of public resources in private market operations.