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SEC tussles with shadow trades in the US Treasury market

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Wheeling and dealing in the $26tn US Treasuries market seems dull. But it is crucial to the pipework of the financial system. Increasingly, the plumbers who engage with it are sophisticated hedge funds and high-frequency traders.

Big banks, the traditional market makers, have curtailed their presence since the financial crisis, thanks to heightened capital requirements.

That opened a space for hedge fund Masters of the Universe, who had a freer hand. Until now. Last week, a divided Securities and Exchange Commission voted to bring these non-banks under their regulatory regime. The move will force these firms to hold more capital and be more transparent about their activities.

No good deed goes unpunished. The funds industry maintains that, in the face of retreating banks and trillions of dollars of incremental Treasury issuance, it is the market intermediary ready to step in. Exceptions include moments of stress, as in March 2020 when the Federal Reserve had to intervene to stabilise the Treasury market.

Among the reasons for regulatory concern about Treasury market structure is the “basis trade”, where hedge funds make multi-faceted and leveraged bets on the government debt to capture tiny pricing differentials for arbitrage profits. Because Treasuries are considered risk-free securities, the leverage embedded in these trades could reach stratospheric levels.

The new rule adopted, after a heavy lobbying effort by the fund industry, is softer than the SEC initially preferred. US authorities are grappling with difficult questions about how to respond to the huge growth in private capital assets. These have increasingly inserted themselves into traditional regulated banking activities. 

The funds industry maintains that it is not taking customer deposits, so its activities remain safer than traditional banks. However, the largest asset managers manage tens if not hundreds of billions of dollars that flow through to economies around the world. At the same time, their fund leverage levels often remain opaque and run through banks themselves. As such, any stress at an investment fund can then trigger problems at counterparty banks.

SEC chair Gary Gensler, in his comments on the new rule, recalled as a young investment banker in the 1980s a small investment fund managing a few million dollars that happened to collapse over a leveraged Treasuries trade. US authorities feel fortunate that a Treasury market blow-up has not yet metastasised. The current regime has broadly preferred to bet on more oversight than less in financial markets. The hedge fund industry will have no choice but to adapt.

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