When economic fears take hold, investors seek safety in Treasuries—high demand raises Treasury prices and lowers their yields.
But that’s not what happened in early April, when plans for US tariffs roiled global markets and shook investors’ confidence in the American economy. Treasuries sold off as investors required higher yields amid an uncertain outlook for economic growth and policy.
Another force was also at work: leverage in the Treasury market. In particular, hedge funds had more than $1 trillion of leveraged relative value arbitrage—a strategy that relies on borrowing to boost returns—in the Treasury market as of March. These trades are like picking up pennies in front of a steamroller—they earn small spreads and have highly leveraged positions.
You have this derisking of leveraged players that causes a lot of fast selling, and that causes instability.
In the start of the COVID crisis of March 2020, spreads widened sharply, hedge funds made large losses and rapidly deleveraged, resulting in dysfunction in the Treasury market.
“You have this derisking of leveraged players that causes a lot of fast selling, and that causes instability,” says Jonathan L. Wallen, an assistant professor at Harvard Business School who studies the currency and debt markets. Unlike during COVID, this time “policymakers responded before we got to the point where we saw widespread deleveraging” that could destabilize the market.
While Treasuries have long been considered a safe haven, new research by Wallen and Lina Lu, a senior financial economist at the Federal Reserve Bank of Boston, reveals how regulatory shifts have created the conditions for risk. Their latest study looks at how dealer banks amplify leverage in the Treasury-secured lending and borrowing market.
In this market, Treasuries are pledged as collateral in exchange for cash. Dealer banks mediate this market by borrowing from money funds at positive haircuts and lending to hedge funds at negative haircuts.
At a positive haircut of 2 percent, dealers borrow from money funds at 50 times leverage. However, when hedge funds borrow at negative haircuts, they have more the infinite leverage– leveraged borrowing against Treasuries can fund other trading positions.
A negative haircut is a package of a safe secured loan and a risky unsecured loan. Dealer banks have a regulatory incentive to package these two loans together because it masks the riskiness of their loans. The risky unsecured loan is hidden in the negative haircut of the Treasury repo. Hiding this risk is a regulatory arbitrage, which enables banks to take more risk and hold less capital.
An industry response to these concerns is that borrowing with negative haircuts against Treasury collateral is safe because there are other assets in their portfolios that serve as collateral. This practice is referred to as cross-margining. Although this may help during normal times, Treasury haircuts rise sharply during crises. During the March 2020 COVID crisis, Treasury haircuts widened from about -50 bps to positive 150 bps. Cross-margining of non-Treasury collateral may help support negative Treasury haircuts in normal times, but not during crises. This suggests that the non-Treasury collateral is of worse quality and less pledgeable during crises.
“One message that emerges here is that even the Treasury market is susceptible to the adverse effects of leveraged intermediaries,” the authors write in the working paper, “Negative Treasury Haircuts.” Wallen and Lu used confidential regulatory data from the Federal Reserve to understand the cash, collateral positions, and resulting haircuts in the repo market.
HBS Working Knowledge talked to Wallen about his latest research and shifts in the Treasury repo market, which plays a key role in the financial system. The interview has been edited for clarity and length.
What does your research say about the current state of Treasuries?
Wallen: A challenge that the market is facing is that the supply of Treasuries has grown a lot. This is something that I talked about in my work with Jeremy Stein, Anil Kashyap, and Joshua Younger, in our Brookings paper, as well.
If you think about the financial system, where these primary dealers are important for the intermediation of Treasuries, the Treasury supply is getting bigger and bigger, and growing faster than the size of these primary dealers. It becomes harder for them to do this intermediation, and you start seeing other players in this market, in particular, very leveraged hedge funds.
The dealers are using the hedge funds to do some of this intermediation that they would previously have done themselves, were it not for regulations.
Some of that's good in the sense that we do want to move risk away from these large, systemically important banks. On the flip side, the bad part is when you move it away from the regulated sector to non-bank financial intermediaries. Because they're unregulated, they can take more risk and they don’t internalize some of the risk that they pose for the financial system.
It doesn't present a threat to the funding of the US government or to the safe asset supply of Treasuries. But the growth of these leveraged investors in the Treasury market right now does seem to be posing a threat to the stability and well-functioning of the Treasury market. And this paper points out that one incentive underlying this growth and leverage is the bundling of unsecured loans with secured repo.
How does repo lending differ from other forms of commercial banking?
Wallen: These dealer banks are in the business of taking on credit risk and making these types of loans. Here, you see them lending to a financial intermediary, a super-leveraged hedge fund.
This is different from how they do other commercial loans. When a bank is lending to a real firm, the firm takes the loan and usually also gets a credit line, which ensures the liquidity of the firm.
Here, the repo loans are short term. During periods of financial stress, dealer banks switch from providing unsecured funding through negative haircuts to demanding safety just like the money funds themselves. And it's that switch that happens rapidly over the course of a few weeks that makes this particularly fragile.
What does the state of the Treasury repo market say about the role of hedge funds?
Wallen: This is a classic example of disintermediation of dealer banks. Prior to the global financial crisis, the hedge funds would be less involved in this trade, especially the relative value arbitrage trades. The dealer banks did these trades.
These trades are now more costly for dealers to do on their balance sheet. The spreads that we measure for these trades, as in the return per unit of balance sheet space, they're very low, much lower than other spreads that we see in the market.
The spreads would need to be much larger to compensate [dealer banks] for using their scarce balance sheet space. The hedge funds are a much more efficient intermediary in this market, but they are also more fragile.
Is that because hedge funds are more opaque than other asset classes?
Wallen: There is actually a fair amount of hedge fund disclosure. One challenge is that there's not much transparency in the Treasury market. There have been improvements with Treasury TRACE (Finra’s Trade Reporting and Compliance Engine), where they report trades, but that is not shared publicly, and the data is only held by the regulators.
For our paper, my coauthor Lina Lu at the Fed and I found a creative way to measure haircuts in these trades.
What’s the solution to maintain equilibrium in the Treasury repo market?
Wallen: The easiest solution to this is to require sufficiently large positive haircuts ( the value of the collateral promised exceeds the amount of cash borrowed).
If we were to, say, try to regulate hedge funds like we have dealer banks, then you may start to find asset managers doing this trade, or someone else. It’s sort of like a game of Whack-a-Mole. But with the way the repo market is structured, if the dealer banks are currently the important intermediary that borrows money from money funds and other real cash investors, and then lends to their clients, just requiring a sufficiently large haircut would help.
How did you become interested in studying Treasuries?
Wallen: First, I think it’s relevant. Second, I think it’s important. But also third, I feel that you can show more affirmative evidence of facts.
Suppose that we’re talking about pricing of risk in equity markets or for other risky securities. There, it's much harder, because such risk is complex, hard to understand and rapidly changing. Treasuries in some ways are much simpler.
Do the Treasury markets respond to shifts in economic conditions fairly predictably?
Wallen: Yes, prior to the last two crises. One thing that we're grappling with is that we have this sense that these are safe haven assets, but they haven't behaved that way during COVID, and they didn't behave that way in April of this year.
From your vantage point, what happened in April?
Wallen: So the short answer is, we're not a 100 percent sure yet. We academics tend to figure things out slowly, but I can tell you some things that stood out.
As a funding shock, the economic effects of COVID were much more clear. People were massively borrowing against their Treasury collateral. That went up by 20 percent—I show that in the paper. They were also just selling a bunch of Treasuries and not just Treasuries, but corporate bonds and the like.
In April, the amount of leverage in Treasuries held by hedge funds had doubled. Pre-COVID, that trade was about $500 billion. Now, it's about a trillion.
So you have this concern that if these hedge funds delever and unwind this trade, that's going to be a large supply of Treasuries that the market needs to absorb.
One particularly concerning thing that I talked about in the conclusion of the paper is that unlike in March 2020, when the Fed was happy to do quantitative easing to support the economy in response to COVID, we're currently in a cycle of quantitative tightening.
The Fed has been raising rates and shrinking its portfolio. When you have this type of Treasury market dysfunction, it’s particularly tough for the Fed to intervene with quantitative easing in the middle of a quantitative tightening cycle. In my work with Jeremy Stein, Anil Kashyap, and Joshua Younger, we discuss a novel policy tool that can help resolve this tension between market function interventions and monetary policy.
Image by HBSWK with asset from AdobeStock.
