NEW YORK — The Federal Reserve's top regulator is keeping an eye on hedge fund engagement with U.S. Treasuries markets and wants more data about this activity.
Fed Vice Chair for Supervision Michael Barr delivered a speech Thursday morning flagging several areas of concern related to hedge funds and their so-called basis trading activities — in which groups buy and sell securities to take advantage of disparities between spot prices and futures contract values.
"Their highly leveraged positions in Treasury markets are facilitated by very low — or even zero — haircuts on their repo financing," Barr said, adding that demand for this leverage is highly concentrated among a handful of large hedge funds."
Recent months have seen an uptick in hedge funds using repurchase agreements, or repos, to sell cash futures in exchange for short positions on cash. Fed researchers have issued two notes since this summer warning that such activities create vulnerabilities in the financial system.
Barr, who delivered his remarks during the Federal Reserve Bank of New York's ninth annual Treasury Market Conference, said basis trades play an important role in improving market efficiency and the connection between cash and futures prices. He noted that leverage can "arbitrage away" pricing discrepancies and help Treasuries values be better reflected in related instruments and markets.
Still, he said, leverage brings risk, many of which came to a head in March 2020 during the so-called "
The Fed has windows into Treasuries trading activities through its oversight of Bank of New York Mellon — a leading provider of clearing services — and through data collected by the other entities, including the Treasury Department's Office of Financial Research. Also, 22 depositories that are supervised by the Fed submit data daily on Treasuries and mortgage-backed securities trades to the Financial Industry Regulatory Authority's Trade Reporting and Compliance Engine, or TRACE.
But Barr said even regulators are inhibited by significant blind spots, including activity in the non-centrally cleared bilateral repo market, in which traders transact directly with one another rather than through a central counterparty or tri-party custodian.
"All of us need to better understand this activity," Barr said.
A need for better and more transparent information was a theme throughout the conference's morning speeches and presentations. New York Fed President John Williams said despite the deluge of analysis available on data terminals, discerning the credibility of financial figures remains a challenge for researchers, regulators and reporters alike.
"While we assume that most data are 'good,' there are, unfortunately, 'bad' data, too," Williams said. "The very same terminal that gives you access to numbers that are supported by millions of transactions could also give you access to numbers that have not seen a transaction in quite some time, if ever. And it can be very hard — too hard, in fact — to spot the difference."
In January, the OFR proposed a rule that would mandate more reporting for non-centrally cleared bilateral repo transactions. The Securities and Exchange Commission is also considering a change that would require more Treasuries securities transactions to be centrally cleared — a development that proponents say will bring more stability and transparency to the market.
Barr said the Financial Stability Oversight Council's interagency working group on hedge funds has done "excellent work" identifying risks in leveraged basis trading. He added that recently risk capital requirements proposed by the Fed and other regulators over the summer would help insulate banks from volatility in Treasuries markets.
During his speech, Barr said Fed supervisors are working with banks to ensure they are managing interest rate risks on their Treasuries securities portfolios appropriately. He noted the role of declining securities values on Silicon Valley Bank's balance sheet played into the bank's failure and the ensuing bank crisis this past spring.
Barr said banks are taking steps to ensure they have ample emergency funding options should they need them. He noted that 10 banks have signed up for the central bank's Standing Repo Facility this year, meaning the lending facility is now available to banks that collectively hold more than half the assets in the banking system.
Many banks are reliant on private liquidity sources, such as the Federal Home Loan banks, but Barr cautioned that such entities could struggle to meet the needs of banks in the case of a systemic crisis, noting that they are reliant on the private sector to generate liquidity.
"When the market is not working, such sources of funding and liquidity come under strain," he said.
Barr
"The discount window, however, can play these important roles only if eligible institutions are both willing and ready to use it," he said. "This means that it is important that banks establish borrowing arrangements, pre-pledge collateral and engage in test transactions at regular intervals."
