A Harvard researcher has found that hedge funds were not responsible for the turmoil in the Treasury market in March. The FSB is watching closely.

The Financial Stability Board is examining the behavior of hedge funds and other non-bank investors during the market tumult caused by the coronavirus earlier this year.

“The market dysfunction has been exacerbated by substantial sales of U.S. Treasuries by some non-bank investors and foreign leveraged holders,” the FSB, a global group of finance officials, said on Tuesday when announcing its report on market turmoil in March. “Dealers have also struggled to absorb large asset sales, amplifying turbulence in short-term funding markets.”

Recent research by Marco Di Maggio, professor of finance at Harvard Business School and research fellow at the National Bureau of Economic Research, found that hedge funds do not disrupt the Treasury market because they represent a relatively small trading role. . Foreign sellers were “a bigger cause of illiquidity,” he suggested in an article about the uproar.

But the FSB said in its report that “some leveraged investors” made the market worse by unwinding nearly $90 billion in US Treasuries trades in March. That’s the volume of sales that would have been made by relative-value hedge funds that focus on fixed-income markets, according to Di Maggio – a figure he said was dwarfed by net outflows of 260.4 billion. dollars from the foreign sector in Treasury securities in March.

According to the FSB, foreign holders sold a record nearly $300 billion worth of Treasuries and Treasuries in March on a net basis. “Around a fifth of these sales were made by foreign official institutions, including central banks,” the policy group said in its report. “The accumulation of dollar credit abroad may have increased liquidity pressures in the US Treasury market.”

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Still, leveraged investors likely contributed to the “short period of extreme illiquidity” in government debt, the FSB said. “Since 2018, these investors had taken increasingly leveraged positions in certain government bond markets, seeking to arbitrate market price differences between the value of the derivatives and the cash instruments they reference. “

This “basic trade” became problematic when a spike in demand for the most liquid safe assets in mid-March led to a decoupling of prices of US Treasuries from futures, according to its report. . Positions turned loss-making and increased volatility led to margin calls for commodity trading investors, some of whom struggled to renew funding for their trades, the FSB said.

Hedge funds, even after including leverage, only contributed 4-9% of total Treasury trading volume in the spot market and 12-15% in the futures market , according to research by Di Maggio. His article showed that fixed income relative value hedge funds have an average leverage ratio of around 3, a level that Di Maggio says is not as high as many might think.

For him, this was further proof that hedge funds had neither the ability nor the resources to drive the sell-off in Treasuries in March.

Both Di Maggio and the FSB have seen dealerships overwhelmed by turmoil, unable or unwilling to absorb assets from their balance sheets. The Harvard professor cited balance sheet and capital ratio requirements put in place after the 2008 financial crisis as the reason for the constraint.

“Limited dealer intermediation” combined with large asset sales from leveraged investors and foreign accounts has increased volatility and illiquidity in the Treasury market, according to the FSB. The group said stress in the financial system would have escalated significantly had it not been for the swift and drastic action taken by the Federal Reserve during the unprecedented tumult.

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