Mounting derivatives bets on growing government debt creates market time-bomb

(Originally published Dec. 3 in “What in the World“) Worries that the Fed might not cut rates next month are prompting a stampede of funds into hedges.

Investors are snapping up derivatives called swaptions, which are option contracts on interest-rate swaps, the derivative contracts that allow investors to trade fixed-rate interest payments for floating-rate payments, or vice versa. Investors use such swaps to hedge against interest-rate risk, especially that changes in interest rates will reduce the value of their bond holdings. Swaptions are a cheaper, and potentially riskier, way of doing the same thing.

What worries financial regulators is when the volume of cash into such hedges starts to exceed the value of the investments they’re meant to hedge. But that’s what’s happened: while the entire universe of bonds stands at an estimated $145.1 trillion, there are at least $600 trillion in derivatives contracts. Not all of those derivatives have bonds as their underlying security, of course. Some use currencies as their underlying security, commodities, equities, or even an index of bond, stock or commodity prices. But you get the idea: when the derivatives surpass the value of the thing they’re intended to hedge, the hedge can determine the value of that thing. The tail wags the dog.

What’s even more dangerous is that hedge funds are borrowing money to buy these swaps and swaptions. When the amount of borrowed funds in the derivatives market starts to rival the value of the things they’re meant to hedge, the tail not only wags the dog, it can get spooked and swing poor Fido into the path of an oncoming truck. This is what happens if the derivatives bets start going the wrong way: hedge funds may face margin calls from the banks and other investors who lent them the money to buy their hedges, forcing them into a fire sale that not only collapses the value of the derivatives, but the value of the thing they were meant to hedge against. The hedging then compounds risk, rather than offsetting it.

That’s why the new head of the Bank for International Settlements is warning about the level of hedge fund activity in derivatives for government bonds. BIS General Manager Pablo Hernández de Cos warned in a speech at the London School of Economics that authorities need to rein in the amount of leverage hedge funds are using in the market for government-bond derivatives.

De Cos—and now with him FT columnist Martin Wolf—is particularly worried about the market for a different kind of derivative: repurchase agreements that use government bonds as collateral. Regular readers will remember this concern from during the market sell-off back in April:

…the U.S. Treasury market has become incredibly leveraged in much the same way that the U.S. housing market became leveraged before the global financial crisis. Funds have been buying Treasury futures to bet on bond-market movements without having to pony up the cash for actual Treasuries. Typically, such positions are used to hedge cash positions, but with the cash required so low, many simply buy the futures without any corresponding position in actual bonds.

For funds to buy these futures, someone has to sell them. That’s where hedge funds come in. They write the futures contract and sell them. Why? Because, as FT Alphaville writes, ‘Treasury futures contracts typically trade at a premium to the government bond you can deliver to satisfy the derivatives contract.’ A premium in price for a bond translates into a discounted yield. So, by selling the derivative and buying the physical bond, a hedge fund can collect a profit from the slight difference between the yield they collect on the real Treasury and the lower yield they have to pay on the futures contract. This is called a basis trade.

So far, so good. The problem is that, to make these tiny basis trades worth their time, hedge funds leverage them by using the actual bonds they buy to cover their futures risk as collateral for repurchase agreements—they sell the bonds with a promise to buy them back later at a slightly higher price. This repo agreement is effectively a loan whose collateral is the underlying bond: if the bond’s seller doesn’t repay, the bond’s buyer gets to keep the bond. By leveraging their cash bonds to borrow money and buy more, the hedge funds can sell even more Treasury futures, and so on. How many times can they repeat this? FT Alphaville estimates up to 100: “just $10 million of capital can support as much as $1 billion of Treasury purchases.”

So how big is this? Hard to say. But FT Alphaville reckons a good proxy is the net short positions hedge funds hold in Treasury futures, which has roughly quadrupled in the past four years, to $800 billion.

De Cos warns that, with government’s ramping up their debt levels to buy more weapons to counter Russia and care for their ageing populations, they can’t afford to risk having the derivatives market crash the party. Reining in leverage among non-bank financial institutions, de Cos said, should be a “key policy priority.”

Wolf reminds us that these hedge funds and their fantastic government bond holdings are only part of the larger and dangerous rise in non-bank financial institutions that has taken place since the global financial crisis.

As explained back in March, 2023:

As early as 2016, the International Monetary Fund noted that post-crisis regulation of banks had prompted a shift in finance from banks to bonds, which in turn shifted the job of allocating capital around the world to non-bank players. Instead of banks, an armada of insurance companies, pension funds and asset managers like Blackrock and Citadel Securities—in other words, all our savings vehicles beyond ordinary bank deposits—filled the void and became big lenders and market makers in their own right.

This sector of largely unregulated credit is often referred to as “shadow banking,” and one country that has battled it for years is China, where banks and other finance companies have used nonbank financing to keep funds funneling into the nation’s property sector in defiance of official efforts to curtail it.

In theory, spreading these intermediary roles among more players reduced systemic risk, since if any single insurer, pension fund or asset manager made a bad bet and failed, they’d be smaller and have less impact on the overall system than if a huge bank failed. Sound familiar? It should: it’s more or less the same argument for how mortgage-backed securities were supposed to reduce the risk of a housing-market collapse.

But the smaller non-bank financial intermediaries, the IMF noticed, tend to behave as a herd, taking bigger risks on a less diversified range of investments. That means they’re all more likely to run towards the same exit in the event of a fire. And because regulations allow them to take bigger risks with less visibility of other investments, they’re more sensitive to changes in interest rates, not less. As a result, when interest rates rise, banks reel in credit and shrink their balance sheets, but “nonbank financial intermediaries contract them more than banks.” Worse, they reel in their credit much more quickly than banks, too.

The IMF has worried about the particular risk this poses to mutual funds. While an individual fund’s manager may not feel the need to panic in the event of an adverse event, the same cannot be said of the fund’s investors. If they, like SBV’s depositors, panic en masse and begin a wave of redemptions, the fund’s manager might have to start dumping the fund’s assets, thus triggering a wider tsunami of selling and a shortage of liquidity in smaller markets for stocks and bonds.

That makes markets more susceptible to, and thus more easily spooked by, any sign of a big move in cash into or out of markets. The latest worry: Rising Japanese interest rates may be torpedoing what’s known as the yen carry trade. That’s the once-reliable flow of savings out of aging Japan’s pension funds into global markets to beat perennially low interest rates they earn in Japan’s deflationary economy. Problem is, Japan has finally managed to revive inflation and the country’s central bank has been raising interest rates for the past year. That tempts Japanese investors to keep their money stashed at home rather than risk it overseas and have to also contend with the vagaries of currency exchange rates.

Japanese investors aren’t the only ones taking advantage of the yen carry trade, though. Global investors also borrow yen at Japan’s low rates and then invest it abroad. With Japanese borrowing costs on the rise, they too will need to re-evaluate whether it makes sense. Combined, higher Japanese rates could mean less easy money propping up asset prices all over the world.