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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a professor of finance at Harvard Business School
The turmoil in the $28tn US Treasury market following the early April announcement of tariff rises by the Trump administration revived unsettling memories of the Covid-induced meltdown in March 2020. Once again concerns were raised about how such a large market could be shaken.
This in turn triggered questions about the diminished role of traditional broker-dealers in facilitating trades, and the growing presence of hedge funds as marginal buyers and intermediaries.
One policy proposal now under active discussion is to ease some of the capital rules on US banks imposed after the financial crisis — in particular, the supplementary leverage ratio. This stipulates how much capital banks must maintain as a percentage of their assets. Apart from a straight cut in the ratio, one idea being mooted is to exempt Treasuries from the calculation of the SLR. In effect, that would mean banks need to maintain lower capital buffers. It is argued that might spur them to buy more Treasuries.
Would such moves fix the Treasury market? The SLR is a blunt instrument, requiring banks to maintain capital against all assets, regardless of their riskiness. This has three separate implications across the banking sector’s activities in the Treasury market.
First, consider commercial banks, which directly hold about $1.7tn in Treasury securities, accounting for roughly 6 per cent of the Treasury market and 7 per cent of their own balance sheets. The idea that lower total leverage requirements would encourage considerably more Treasury holdings from these commercial banks is questionable. The collapse of Silicon Valley Bank in 2023 after suffering losses on big holdings of Treasuries when interest rates rose highlighted the risks here. Prudent management would discourage banks from increasing long-term bond holdings funded by flighty deposits.
Second, broker-dealers, many of which are part of banking groups, play an important role in Treasury auctions and in secondary market trading. But because Treasury purchases and sales can often be netted under current regulatory treatment, the SLR’s effect on broker-dealers’ outright Treasury holdings is limited. Currently broker-dealers’ net long Treasury holdings stand at a record high at $400bn but that is a mere 1.5 per cent of the market.
Third, and most crucially, broker-dealers also provide financing to non-bank buyers, particularly hedge funds, through collateralised lending such as so-called repos, where assets are sold and bought back.
Primary dealers’ total lending against Treasury collateral now stands at $3.2tn, roughly eight times larger than their net Treasury holdings. While dealers also borrow against Treasury collateral in similar volumes, most of these borrowing and lending positions cannot be netted for regulatory purposes under the current rule, making them especially costly under the SLR framework.
Therefore, an easing of the SLR rule, particularly by exempting Treasury repos from the ratio calculation, will have the most direct impact on the balance sheet constraint of dealers’ Treasury financing activities, and likely amplify the already elevated size of hedge fund bets on what is called the Treasury cash-futures basis trade.
Under such a strategy, hedge funds finance Treasury bonds purchases through borrowing from dealers and simultaneously sell futures contracts to hedge the interest rate risk of the bonds, pocketing the pricing differential. By doing so, basis traders have emerged as major intermediaries of interest rate risk in the Treasury market. But they remain highly dependent on broker-dealers, as the availability of balance sheet and the terms of financing ultimately determine both the scale and profitability of the trade.
As of May, hedge funds’ net short position in Treasury futures reached $1.1tn, up from $990bn on April 1 and $434bn before the onset of the Covid crisis. At the same time, dealer financing against Treasury collateral rose by more than $100bn in April following the tariff announcement, with no indication of a pull back. A further expansion of the hedge fund basis trade is hardly a desirable outcome. Given the high leverage embedded in these trades, a rapid unwinding of them could trigger fire sales of Treasuries.
Taken together, easing the bank leverage rule alone may have a paradoxical effect: while intended to strengthen the role of banks and dealers in the Treasury market, it could also bolster leveraged hedge funds, potentially reinforcing some of the very fragilities policymakers hope to mitigate.
