Memories are short, particularly in Washington DC. Remember Too-Big-To-Fail (TBTF), the proposition that some banks are SOO big that they cannot be allowed to fail? The same applies to any, big powerful company who will lobby Congress and The Regime to be bailed out? But I never thought I would see the day when HEDGE FUNDS would be considered TBTF.

Bloomberg’s Ye Xie reports that a small group of funds has accumulated such large short wagers in the Treasury market that they could destabilize the broader financial system during times of stress, according to the International Monetary Fund.

“A concentration of vulnerability has built up, as a handful of highly leveraged funds account for most of the short positions in Treasury futures,” the IMF said in its Global Financial Stability Report released this week.

“Some of these funds may have become systemically important to the Treasury and repo markets, and stresses they face could affect the broader financial system.”

The IMF’s comments came in a section discussing the so-called basis trade, which contributed to turmoil in the world’s biggest bond market at the time of the pandemic outbreak in 2020.

In this trade, hedge funds exploit tiny differences between the prices of cash Treasuries and futures, using large sums of money borrowed from the repurchase-agreement market to amplify returns. Because of this leverage and reliance on short-term funding, the bet has drawn increasing scrutiny from regulators. And now the IMF is highlighting another risk: concentrated positions.

As of December, about half the two-year Treasury short positions in the futures market were in the hands of eight traders or less, according to the IMF. It was at a similar level at the end of 2019, just before a surge in funding costs in the early days of the pandemic spurred traders to unwind the positions, which helped boost volatility in bonds at a time of upheaval across financial markets.

Source: IMF’s Global Financial Stability Report

The use of basis trades swelled along with the Federal Reserve’s interest-rate hikes, which potentially make the strategy more profitable by widening the price gap between the cash and futures markets.

A Fed study last month estimated that hedge funds have amassed at least $317 billion in Treasury holdings related to basis trades since the first quarter of 2022, although the size is “significantly” less than it previously estimated.

The Securities and Exchange Commission has been working to rein in basis trades and increase the transparency of hedge funds’ exposure to the strategy.

In December, the SEC required the funds and brokerages to centrally clear far more of their US Treasuries transactions, a move to bolster oversight of basis trades.

Source: IMF’s Global Financial Stability Report

Since then, there are signs that use of the trade may be waning: Commodity Futures Trading Commission data shows a decline in leveraged funds’ short positions in bond futures.

The concentration in these bets has also diminished.

In two-year futures, net short positions controlled by eight traders or less have dropped to about 38% of total open interest, from 50% in early January, according to CFTC data compiled by Bloomberg.

Source: CFTC’s Commitments of Traders data

Note: Data show percentage of two-year Treasury short futures contracts held on a net basis

Despite that unwinding, the IMF noted the short positions of leveraged funds remain large, which means they may still loom as a risk.

As the Fed shrinks its holdings of Treasuries, a process known as quantitative tightening, it also may reduce the liquidity in the financial system, potentially triggering a jump in funding costs and leading the basis trade to unravel, the IMF said.

“Basis trade investors rely on low repo haircuts and low repo rates to leverage their positions and increase basis trade profitability,” the report said.

“A spike in repo rates — triggered, for example, by surprises in quantitative tightening — can render the trade unprofitable and could trigger the forced selling of Treasury securities and a brisk unwinding of futures positions as funds seek to quickly delever.”

Which explains, as we noted previously, why the SEC is now scrambling to figure out just how much capital is truly allocated to basis trades within multi-manager/multi-strat hedge funds, but based on our quick look at regulatory leverage, the actual amount allocated to basis is orders of magnitude greater than $550BN, more likely in the $2+ trillion ballpark across the entire global hedge fund industry.

And there you have it: all the basis trade is, is the latest manifestation of the “collecting pennies in front of a steamroller” trade, because when it works it generates 10% returns every year like clockwork, with the only gating factor being how much leverage a hedge fund has access to.

However, during a crisis, such as the Sept 2019 repo fiasco or the March 2020 crash, it all goes to hell… and the Fed rushes to bail out not just bank but hedge funds which are now so tightly interwoven in the financial fabric (via ultra loose and generous Prime Brokerage linkages) that central banks have no choice but to bail out everyone, including the billionaires who run the hedge funds that have put on trillions of basis trades on!

…and The IMF is worried.