NEW YORK (Reuters) - An expansion of central clearing in the U.S. Treasuries market would reduce liquidity risks associated with a popular hedge fund arbitrage trading strategy that could strain the broader financial markets if it unravels abruptly, said Moody's (NYSE:MCO).
So-called basis trades in U.S. Treasuries take advantage of the premium of futures contracts over the price of the underlying bonds. The trades - typically the domain of macro hedge funds with relative value strategies - consist of selling a futures contract, buying Treasuries deliverable into that contract with repurchase agreement (repo) funding, and delivering them at contract expiry.
Most hedge fund activity in repo markets - where banks and other players such as hedge funds borrow short-term loans backed by Treasuries and other securities - is done bilaterally between brokers and customers.
But more centrally cleared trades could reduce the risk of disruption to counterparties caused by a rapid unwinding of hedge funds' leverage, the rating agency said in a note.
"The Treasury basis trade plays a crucial role in minimizing the price gap between Treasury futures and their underlying cash securities, but it also amplifies the exposure of highly leveraged hedge funds conducting such trades to market shocks, increasing counterparty risk for dealers and central counterparty clearing houses (CCPs)," said Moody's.
"Participation in centrally cleared transactions can significantly reduce this counterparty risk," it said.
Central counterparty clearing houses such as those operated by CME Group (NASDAQ:CME), the world's largest derivatives exchange operator, and the Fixed Income Clearing Corporation, currently the chief clearer of Treasuries, can "dynamically and prudently increase collateral requirements when markets dislocate," said Moody's.
The unwinding of basis trades likely exacerbated a crash in the world's biggest bond market in 2020, and the trading strategy has been under close scrutiny from regulators worried about a recent buildup of leveraged positions in Treasuries.
Treasury market participants are awaiting updates from the U.S. Securities and Exchange Commission about a key reform the regulator proposed in September last year, which would force more trades to central clearing.
"We view the proposal as credit positive because it would enhance the oversight, transparency and risk management of transactions involving US Treasury securities as well as reduce systemic risk," Moody's said.