FSB warns of risks in "basis trading": $3 trillion leverage financing could become the "trigger point" for a bond market crisis.

The world's top-level financial stability regulatory body urged policymakers in governments around the world to more deeply and accurately examine the leverage bets on government bonds that reach trillions of dollars, with repo agreements backed by government bonds as collateral, favored by hedge funds and other large institutional investors for a long time. According to reports, the Financial Stability Board (FSB) called for enhanced regulation of the risks specific market participants undertake in repo agreements secured by government bonds. In a research report released on Wednesday, the FSB identified and outlined several "vulnerability indicators" that regulatory authorities can track to "strengthen monitoring capabilities." In recent years, the borrowing size of hedge funds in the repo market has increased. The FSB estimates this size to be around $3 trillion, approximately 25% of their total assets. This trend occurred as leveraged hedge funds entered into high-profit strategies such as cash-futures basis trading; this strategy uses leverage to capture slight value differences between bonds and corresponding futures contracts. The latest FSB report stated, "Given the significance of the repo market in the global financial system, it is crucial to ensure its functioning is maintained, especially during periods of stress." The report also emphasized, "The overall accumulation of leverage by market participants remains a concern that merits further attention." This recommendation is the latest effort by regulatory bodies to proactively address potential market risks related to leveraged operations in the global bond market. The repo market is used by various asset management institutions and large commercial banks to exchange bonds for cash assets for lending, or vice versa. FSB research indicated that central banks and fiscal authorities need to closely examine the vulnerabilities and leverage risks in government bond-backed repo markets, with cash-futures basis trading in the U.S. bond market being one of the most typical, profitable, and closely-watched high-leverage strategies; hedge funds borrowing size/leverage financing in the repo market amounts to an estimated $3 trillion, about 25% of their assets. What exactly are leveraged bond trades as mentioned by the FSB? The report stated that in the U.S. financial markets, bond traders consider "on-the-run vs. off-the-run arbitrage, yield curve or duration trading, and cash-futures basis trading" as the most popular strategies among hedge fund clients. In the Eurozone, yield curve or duration trading dominates, and cash-futures basis trading is also "generally present." One of the core concerns of the world's highest-level financial stability regulatory body is that leveraged investors facing sharp liquidity demands in the short term may be forced to sell larger assets to raise funds. The report stated that if these asset sales occur when the market is already under liquidity pressure, it could "further exacerbate market volatility and lead to unfavorable feedback loops." The "leveraged bond trades" mentioned and highlighted by the FSB here do not simply refer to "buying bonds with leverage." It refers to a type of strategy that uses government bonds as collateral and amplifies positions through short-term financing such as repo, typically executed by hedge funds. The FSB is concerned about market participants accumulating leverage and depending on short-term financing in government bond-supported repo markets; once faced with margin calls, tightened financing, or market volatility, they may be forced to deleverage, sell assets, and amplify volatility; unexpected large-scale deleveraging can magnify volatility and even create feedback loops. These leveraged bond trades primarily include basis trading, and basis trading is one of the highlighted "representative strategies" by the FSB. The so-called "cash-futures basis trade" involves going long on cash bonds, short on corresponding government bond futures, and financing the cash position through repo to leverage it, capturing small price differences (basis) between cash and futures in a leveraged manner. The Federal Reserve's research directly defines U.S. government bond market basis trading as a high-leverage arbitrage of "short-term repo financing + cash long position + futures short position," and points out its vulnerabilities stemming from changes in futures margin requirements and repo financing spreads/availability changes. The FSB's research also mentions that the borrowing size of hedge funds in the repo market has significantly increased, and basis trading is listed as one of their popular, leverage-dependent strategies. Minimum discount proposal Both the FSB and the Bank of England have proposed the idea of minimum haircuts, which involve mandatory markdowns on the collateral exchanged in repo transactions. This would limit the leverage scale that the repo market can accumulate. Hedge funds and the traditional asset management industry strongly oppose such proposals, stating that they could harm liquidity. Jillien Flores, Chief Advocate of the Investment Management Association, stated on Wednesday, "By not implementing blunt and harmful restrictive measures, such as mandatory minimum haircut benchmarks, ensuring that these markets have deep, reliable liquidity support will help maintain low borrowing costs for taxpayers." "In my view, alternative asset management companies are important participants in the global sovereign debt market." The committee chaired by FSB Chairman Andrew Bailey, Governor of the Bank of England and responsible for steering reforms, recommends that global central bank officials closely monitor various indicators related to market activities, structure, trading resilience, and intermediation capabilities. The report encourages further work to overcome several data-related challenges, which make it difficult for some member parties (including major global central banks, financial regulatory bodies, and national finance ministries) to accurately monitor risks. The FSB research report stated that monetary policy authorities and fiscal authorities should also review the specific practices of information disclosure between leveraged non-banking institutions and leverage providers. In cases where such practices are inadequate and insufficient, "it is recommended to consider establishing public-private partnerships with the industry to develop standards and/or regulatory guidelines."