Ken Griffin, the founder and chief executive of the $62 billion US hedge fund Citadel, has articulated concerns to regulators, suggesting that the focus should be directed towards banks rather than solely on his industry in efforts to mitigate risks in the financial system arising from leveraged bets on US government debt.
Recent alerts from global regulators have highlighted increasing risks related to the so-called Treasury basis trade, a practice involving the selling of Treasury futures while simultaneously purchasing US government bonds, profiting from the slight difference between the two using borrowed funds.
However, Griffin emphasized that the primary concern should be the risk management practices of banks facilitating these trades by lending to hedge funds, rather than intensifying regulations exclusively on the hedge funds themselves.
While the US Securities and Exchange Commission (SEC) proposed a new regulatory regime for the Treasury market to treat hedge funds akin to the broker-dealer arms of banks, Griffin expressed skepticism regarding the SEC’s approach. He suggested that regulators could address concerns about the size of the basis trade by urging banks to conduct stress tests to evaluate collateral adequacy from their counterparties.
Hedge fund bets against US Treasuries futures surged to new peaks in a recent seven-day period, with record net shorts against both the two-year and five-year futures. Notably, most, but not all, of these bets are part of the basis trade strategy.
Citadel, along with other hedge funds like Millennium Management and Rokos Capital Management, actively engage in the basis trade.
Concerns from entities like the Bank for International Settlements and the US Federal Reserve have centered on the risks associated with a considerable increase in hedge fund bets in the Treasury market. Leveraging up to over 100 times has magnified these risks, raising apprehensions of a potential market collapse, thereby affecting the broader financial system.
The involvement of prime brokerage divisions in banks is pivotal to the basis trade, as they provide funding to hedge funds while utilizing their Treasury bonds as collateral. To mitigate potential market shocks, banks are tasked with evaluating their hedge fund clients’ portfolios for sufficient collateral under various market stress scenarios.
Griffin expressed a willingness to consider regulations capping borrowing by hedge funds in the Treasury market, provided that these proposals undergo comprehensive economic analysis and public feedback.
Highlighting the benefits of the basis trade, Griffin emphasized how it contributes to reducing the cost of issuing government bonds. He explained that this trade facilitates asset managers in freeing up cash for investments in corporate bonds and other assets, leveraging futures’ ability to maintain positions with a fraction of the posted collateral, as opposed to an immediate cash purchase of a Treasury bond.
Griffin warned against the potentially adverse impact on corporate funding and the cost of issuing new debt if the SEC’s regulations disrupt the basis trade. He underscored the potential burden on taxpayers, estimating costs in the billions or tens of billions of dollars annually.
Discussing risks in the financial system, Griffin pointed to a significant mismatch between assets and liabilities relative to leverage, referencing the collapse of Silicon Valley Bank earlier this year. He delineated the differences between Silicon Valley Bank’s investment using customer deposits and a hedge fund’s approach involving Treasury bonds and futures contracts.
In response to the SEC’s regulatory push under chair Gary Gensler, Griffin advocated a focus on banks rather than requiring every hedge fund participating in the Treasury market to be a registered broker-dealer. He emphasized this as a more cost-effective means of addressing regulatory concerns.
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