A Profound Statement In the Ongoing Saga of Shadow Money
AP Photo/Karel Navarro, File
A Profound Statement In the Ongoing Saga of Shadow Money
AP Photo/Karel Navarro, File
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Could low repo haircuts on US Treasury collateral actually be a source of potential danger? That it might be is itself a profound statement in the ongoing saga of shadow money and its key component of money dealer capacities. Bills and Treasury futures, hedge funds and money market funds, basis trades, repo, and, most of all, balance sheet constraints. A saga truly for the ongoing imperfections of a global money system never quite able to get over itself.

In the worst parts to the first global financial crisis, repo and haircuts found their way into the mainstream if only briefly. To briefly recap: toxic waste of subprime mortgage securities had been thought less risky than they really were and in the ensuing revaluation of those risks haircuts on them were raised (and not just for the toxic stuff) akin to a systemic collateral/margin call which could not be processed in anything resembling an orderly fashion.

A repo haircut is simply this: as the cash lender, I need to protect myself in the event of default from the borrower. This is the whole point of repo, a collateralized, short-term loan therefore intended to be of very little risk. Having lent the cash, I receive a financial instrument as security, the collateral.

What I care about is the liquidity of that instrument; if I have to sell the thing tomorrow morning upon notice of the borrower’s default, am I reasonably certain that I can get my money – all my money – back from the sale? Thus, I have to have some sense of assurance about market volatility and the liquidity characteristics of the collateral being offered.

For any offered of the “best” quality, what that really means is that I’m very, very certain I can liquidate the asset easily, dependably, and predictably factoring only small daily movements. The haircut wouldn’t need to be excessive.

For a borrower posting an on-the-run (OTR) US Treasury security, including T-bills which are all OTR, an appropriate haircut might be nothing more than 1% or 2%; which simply means that I’d lend $98 or $99 when given $100 of the best collateral. Because I don’t expect much movement in price, if default happens the next day, I need only exercise my right to seize and sell which I’d do highly assured I’m going to get every last penny of my $98 or $99 lent out (plus owed interest).

What that means on the other side, for the borrower, is tremendously powerful leverage. If you can get into this repo market stuff, then in this same situation you’d need only $1 or $2 of your own money in order to participate in the low-haircut repo trade I just outlined; 50 or 100-to-1 leverage.

Such leverage necessitates some serious care, such as within an arbitrage opportunity which, as the term pronounces, is by definition low risk (not zero, though). You take often directly opposing positions which offset each other and gain profit by realizing the very real imbalance between them; whether price or some other financial characteristic.

One of these happens to have become very popular around early 2018; though it has been evident and observable with less enthusiasm for decades. The central basis for this basis trade is the presence and persistence of a noticeable divergence between US Treasury futures and US Treasury cash prices. In a frictionless world that only exists in theory, such a thing never happens.

Since we don’t live in a DSGE model (thank you very much), let’s presume that real world financial investors increasingly desire exposure to the Treasury market via Treasury futures rather than outright purchases (cash market). There are any number of reasons for this, especially balance sheet constraints and poorly thought-out regulation, meaning that it might not take much for pension funds or insurance companies to prefer futures over cash Treasuries (treated differently by accounting).

This might then cause an imbalance in the futures market whereby futures prices elevate relative to cash prices. In this situation, the arbitrage being set in motion is a basis trade; short the Treasury future and go long the Treasury bill, bond, note, whatever. Because, over time, matching terms (duration) on both sides of it, those prices will eventually converge; they have to since the cash Treasury is delivered to the futures contract to settle it out.

Thus, for an overvalued futures price relative to cash, the futures price will stay the same or decline over time while the cash instrument’s price will stay the same or rise, each coming together near delivery. Done right, there’s no price risk – but there are complications.

Traditionally, this is exactly where money dealers and their warehouse functions used to operate. These the very spreads and arbitrage opportunities when, once upon a time, they used to police with great and ruthless effectiveness. Except for times of stress (which we’ll get to in a moment), this sort of thing had been their bread and butter.

And we’d want them to do this for several reasons. First of all, in the absence of a real money buyer (the pension fund which wants futures exposure, thus won’t be taking delivery of a Treasury position until the contract expires if at all) the dealer will end up creating a warehouse position which gets paid for by the arb; a very real incentive for dealers to act in, basically, the system’s best interest.

Second, in terms of futures vs. cash, smooth functioning – resilience, as Janet Yellen famously said – is a requirement given that cash prices and futures prices really should not be subject to substantial inefficiencies lest they create frictions which impose their own costs and risks spread out widely.

But (and this is crucial) what if dealers in the presence of this basis trade arbitrage are unable or unwilling to take advantage of it? Put another way, what happens if or when dealers are constrained?

The short answer is how this leaves open an (enormous) opportunity for someone else, say, hedge funds, to take advantage, therefore get compensated for taking on what should be a dealer role(s), but then do so in less understood ways. More shadow for these shadows, in other words.

Hedge fund participation in this basis trade goes pretty much the same way as it would for dealers: short US Treasury futures (overvalued relative to cash), long cash notes or bonds with that cash bond position financed in repo. Since the basis trade itself doesn’t really offer all that much in profit, leverage (as described above) is absolutely crucial, particularly of the kind presented by low and stable haircuts.

The substance of this activity was described and detailed in a (mostly) well-done paper (given the understated and really unassuming title of Hedge Funds and the Treasury Cash-Futures Disconnect) written by Daniel Barth of the Board of Governors and R. Jay Kahn of Treasury’s Office of Financial Research. Published just three weeks ago, on April 1, this was no fool’s undertaking and contains a dizzying amount of data, description, and detail; a true and valuable deep dive into the basis trade mechanism.

According to their findings, as usual using data those of us on the outside could only dream of getting our hands on, this thing really, really took off right at the start of 2018 (sounds familiar, something about Euro$ #4?)

“In December 2014, total hedge fund Treasury exposure was $851 billion. By the end of 2017, this exposure was $1.06 trillion, and by September 2019 had grown to $2.02 trillion.”

An extra trillion in hedge fund rather than dealer warehousing.

As the paper also states, the other ends of those cash Treasury positions had to have been repo borrowing as well as short Treasury futures – which they document to sufficient degree and certainty.

The key element, again, is dealer constraint which forms the eventual basis for the basis trade imbalance.

“In fact, deviations from arbitrage are highly correlated with volatility in financial markets…That these deviations grow larger in times of stress and high volatility in financial markets further suggests the importance of arbitrage activity.”

Rather than money dealers acting like, you know, money dealers they’ve instead outsourced this crucial activity – at least in this trillion-dollar case – to hedge funds by default. Judging the costs of balance sheet capacity too high for the profit of undertaking this widespread arbitrage, the nimbler if less predictable and reliable hedge fund takes its place using haircut leverage on the safest assets as their big motivation.

The warehousing gets done if via very different means.

What might that mean?

“First, as a result of constraints on dealers and limits to arbitrage, an equilibrium basis can emerge in which the return on holding a Treasury note to delivery in the futures market is higher than the bill rate. Second, hedge fund participation in the basis trade is larger when Treasuries are more costly to hold, and as demand for futures contracts increases. Third, basis traders are exposed to margin constraints and repo market illiquidity, which in times of large Treasury sales can exacerbate pressure on dealers.”

As noted, these non-bank balance sheets have taken up not just the role of warehouse but to a oversized degree since early 2018 – because dealers have been constrained (the authors really don’t say enough about this, and we won’t get into the possible reasons for it here; sufficing for now, from my view, I’ll just reiterate: Euro$ #4). In short, the better the basis arb, the more hedge funds take it on, the more we know that dealers must not be able to!

The other key takeaway and result is a much greater sensitivity to repo. Hedge funds performing this dealer activity are not dealers; this is not a trivial distinction, which forms a central point for Barth and Kahn’s paper. As many people have pointed out, since the first GFC the dealer banks, ironically, have fortified their own balance sheets (but having done so by becoming risk averse and balance sheet constrained for reasons beyond regulations).

Dealers not hedge funds would be the ideal stand-in during times of stress offering their hardened capacities to warehouse securities whose markets may be under substantial strain; taking those assets off the hands of those being forced into liquidations at reasonable prices maintaining orderly markets. This wouldn’t be the case with hedge funds particularly given their more tenuous reliance on overnight repo (and not just in this basis trade).

Thus, a significant proportion of systemic money dealing capacity has been taken under by a significantly weaker balance sheet dynamic.

And that brings us to last year’s judgement day (or month) – and here is where the paper, I think, really goes astray. After having set things up very well, explaining much about the intricacies behind the scenes for us in Euro$ #4, the authors then lose sight of what the hedge funds’ oversized presence really had told us about the situation leading up to this second global dollar crisis.

“During March 2020, as we will show, all three of these risks materialized: real money investors sold Treasuries, margins on futures contracts increased, and repo market illiquidity drove repo rates up. The model therefore illustrates how the imperfect nature of hedge fund warehousing can create or amplify stress in Treasury markets.”

Not just Treasury markets; that’s really the point which always, always goes overlooked by conventional thinkers. Why was there so much selling in Treasuries in the first place?

“Large sales from foreign central banks and asset managers put pressure on dealer balance sheets, raising Treasury price volatility, margins on Treasury futures, and increasing uncertainty on repo rates with Treasury collateral. In response, hedge funds appear to have reduced their basis positions, selling cash Treasuries and purchasing offsetting long futures contracts.”

The entire system de-stabilized, but their focus is only upon the hedge funds who came in with selling after all those things had happened and added much to the distress already in motion. Following which, they credit (of course) the Fed with its purported “rescue” of a Treasury market only in peril because of all these other things which came before and had created that very peril – dealer constraints.

Such and growing limitations, it needs to be pointed out yet again, despite either direction in the level of bank reserves; declining under QT from late 2017 until September 2019, and then rising again being substantially elevated by March 2020.

There’s so much here to really unpack, and even more to which there’s no space to fit it in (such as what happens to collateral flow and redistribution when in the case where huge chunks get repositioned to hedge fund warehousing instead of dealer warehousing?)

Recent scholarship focused on only last March appears unwilling – or unable – to recognize the deeper significance especially given what’s outlined right here. The hedge-funds-as-temporary-off-system-warehousing was already itself a warning as to the situation with the money dealers, and that’s where modern shadow money comes from. Dealer capacities make the world go ‘round; even in the case where hedge funds borrow in repo from largely money market funds.

Without dealer confidence, MMF’s, too, grow shy and amplify these shocks as they did in March 2020 (not unlike 2008). Fragility in every case, not resilience.

The very presence of this basis trade already demonstrates as much, the skittishness and constrictions on central money dealers (who aren’t, as popularly imagined, central banks). The more passed off to hedge funds (not just 2018-20, also, ahem, 2015-16, as well as 2008; Euro$ numbers 3 and 1) the more that says the monetary system must be trying its best to work around less than ideal conditions.

And, to make matters worse, it all depends upon the haircut leverage opportunity provided by the safest instrument. I simply cannot adequately describe just how profound, and profoundly unsettling, this is.

It doesn’t matter how many bank reserves are offered up, either. Ironically, it might have only been the more unique properties of US Treasuries as safe and liquid instruments and the overall continued demand for them which both created the opportunity as well as the desire for the emergence and proliferation of the basis trade laid out very well in this recent paper.

A truly unique, shadow spin on the interest rate fallacy. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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