How Hedge Fund Leverage Became Vital to the Treasury Market

Key Takeaways

• Highly leveraged hedge fund strategies, like "basis trades," were a factor in recent US Treasury market turbulence, amplifying volatility.  
• These trades exploit small price differences between Treasuries and derivatives, using significant leverage to generate profits.
• The March 2020 market stress saw a major unwind of these positions, nearly causing a crisis, and similar dynamics reappeared recently.  
• Despite concerns, regulatory efforts to rein in leverage through rules like central clearing and dealer registration have faced significant pushback.  
• Hedge funds engaging in these strategies have become major holders of US debt, nearly matching Japan's central bank holdings.
• Their buying power is now seen as essential for absorbing massive US debt issuance, even though their trading adds fragility.
• Without these leveraged players, analysts believe US borrowing costs could rise significantly, impacting taxpayers.

The Genesis of Leveraged Treasury Trading

• The concept of exploiting price discrepancies between Treasury bonds and their derivatives isn't new, dating back to strategies observed in the late 1970s when financial futures were novel.
  • Initially, pioneers like John F Eckstein noticed Treasury futures were cheaper than the underlying bonds, allowing for a "basis trade" involving buying futures and shorting bonds.
  • This early form required borrowing heavily to magnify near risk-free returns but faced risks if prices temporarily diverged, demanding more collateral.
• Salomon Brothers, particularly trader John Meriwether, adopted and profited from this strategy after Eckstein faced collateral issues, highlighting the potential rewards and risks early on.
• Meriwether later industrialized the basis trade at his hedge fund, Long Term Capital Management (LTCM), although by then the market dynamics had shifted, leading to the modern version of the trade.

Understanding Modern Relative-Value Strategies

• Over time, investor comfort with derivatives grew, leading Treasury futures to often trade at a premium compared to the underlying bonds, reversing the original dynamic Eckstein exploited.
• The contemporary Treasury "basis trade" typically involves buying Treasury bonds and simultaneously selling Treasury futures contracts, aiming to profit as the price difference (the basis) converges at the contract's maturity.  
• The high quality of US government debt allows these bonds to be used as collateral in the short-term "repo" market, enabling hedge funds to achieve extreme leverage, sometimes up to 100 times their initial capital, turning small price differentials into substantial profits.
• Another significant relative-value strategy involves "swap spreads," betting on the relationship between Treasury yields and the fixed leg of interest rate swaps.
  • Post-2008 regulations constrained banks, often causing swap rates to yield less than comparable Treasuries (negative swap spreads).
  • Hedge funds have wagered on these spreads normalizing (becoming less negative or positive) by betting against swaps and buying Treasuries, again using leverage to enhance returns.  

Leverage, Volatility, and Recent Market Shocks

• The significant leverage employed in these trades makes them vulnerable during market turbulence, as counterparties demand more collateral (margin calls) when prices move unexpectedly. Failure to meet these calls can force funds to rapidly unwind positions, worsening volatility.  
• The "dash for cash" during the COVID-19 pandemic in March 2020 demonstrated this risk vividly. Basis trades unwound chaotically as volatility surged, requiring massive Federal Reserve intervention to stabilize the Treasury market.  
• While the exact contribution is debated, analysts suggest a similar dynamic occurred in April 2025. A rapid unwind of basis trades and swap spread bets followed a weak government debt auction and increased market turbulence, contributing to the sell-off.
  • Although some analyses suggest the basis trade unwind was more orderly this time compared to March 2020, the sheer size of these positions (estimated around $800bn for the basis trade alone) meant even a controlled reduction impacted the market significantly.
  • The unravelling of swap spread trades, where funds betting on normalization were caught out by widening negative spreads, is cited by many as a primary driver of the recent instability.
• Market liquidity, measured by the depth of buy and sell orders, dropped sharply in mid-April 2025, falling from around $200mn-$300mn to a low of $67mn, indicating significant stress, though not as severe as the $38mn nadir seen during the pandemic.

Regulatory Responses and Industry Pushback

• Recognizing the systemic risks posed by these leveraged strategies, regulators, particularly the SEC under former chair Gary Gensler, initiated reforms following the March 2020 turmoil.
• A key proposal was the "central clearing" rule (passed in 2023, implementation expected by 2026), designed to mandate more Treasury trades through a clearing house, which would effectively reduce leverage by increasing collateral requirements for hedge funds.
• Another measure was the "dealer rule" (passed in 2024), which aimed to force large trading firms, including hedge funds active in Treasuries, to register as broker-dealers, subjecting them to greater oversight.  
• However, the hedge fund industry has strongly resisted these changes.
  • The dealer rule was successfully challenged and struck down in a federal court in 2024, a decision the current SEC chose not to appeal.  
  • While the central clearing rule remains, Wall Street firms are actively lobbying the SEC to extend the implementation timeline beyond 2026.  

Hedge Funds: Destabilizers or Essential Buyers?

• Despite the risks they introduce, hedge funds employing relative-value strategies have become indispensable players in the US Treasury market, especially given the scale of government borrowing.
• According to the Office of Financial Research (OFR), hedge funds reporting to the SEC held nearly $3.4tn in gross US government bond positions at the end of 2024, a figure that roughly doubled since early 2023.
• Estimates suggest that relative-value funds alone likely hold around $1tn in Treasuries, making their collective holdings comparable to major foreign holders like Japan's central bank and exceeding China's official holdings.
• This growing presence creates a dilemma: the very entities whose leveraged trades can amplify market shocks are now crucial for absorbing the massive supply of US debt, particularly if foreign buyers become more hesitant.
• Market participants argue that removing the ability for these funds to execute leveraged trades efficiently would significantly increase US borrowing costs, ultimately impacting taxpayers. As one senior trading executive noted, without these trades, "Treasury yields would be much higher."

Hedge fund leverage in the Treasury market introduces fragility, amplifying shocks through strategies like basis and swap spread trades. However, these same funds have become vital buyers, essential for absorbing vast US debt issuance, creating a complex dependency that regulators struggle to manage without increasing government borrowing costs.