Fed Urged to Mull a Hedge Fund Bailout Facility for Basis Trades

In the high-stakes world of finance, where fortunes are made and lost in the blink of an eye, the Federal Reserve is being urged to consider a radical new approach to managing the risks posed by highly leveraged hedge fund trades in the US Treasuries market. The proposal, outlined in a Brookings Institution paper, suggests the creation of a "basis purchase facility" that would allow the Fed to step in and purchase Treasury securities while fully hedging these purchases with offsetting sales of futures. This move, while potentially stabilizing the market, raises serious questions about moral hazard and the long-term health of the financial system.

The basis trade, a popular strategy among hedge funds, involves exploiting tiny price gaps between Treasuries and derivatives known as futures. This trade, while profitable in normal times, can become a ticking time bomb during market crises. In March 2020, during the initial Covid crisis, the Fed had to intervene with massive outright purchases of Treasury securities to the tune of about $1.6 trillion over several weeks. The authors of the Brookings paper, including former Fed governor Jeremy Stein, argue that a more targeted approach is needed to avoid the pitfalls of outright purchases.

The proposed basis purchase facility would work by relieving the stress on bond dealers, who might otherwise be overwhelmed by the sudden volume of transactions if hedge funds need to unwind their positions quickly. By taking the other side of these unwinds, the Fed could prevent a squeeze on dealers that could disrupt other market activities, such as providing secondary market liquidity for Treasuries and intermediating in the market for repurchase agreements.

However, the idea of the Fed bailing out hedge funds is fraught with moral hazard concerns. The existence of such a facility could potentially encourage hedge funds to take on even more risk, knowing that the Fed might intervene in a crisis. As Stein acknowledged, "The basis of comparison shouldn’t be ‘no moral hazard.’" The authors of the paper propose auctions of bundled basis packages where primary dealers submit both the cash security they intend to sell and the futures contract they intend to buy. The central bank could then set a minimum bid price on the bundles, limiting moral hazard by forcing the hedge funds to take a penalty discount. This approach makes a clear distinction between market support and monetary-policy-motivated quantitative easing (QE).

The facility would also be self-liquidating, removing questions about the timing of future bond sales or a new quantitative tightening regimen. This would protect the Fed from taking on interest-rate risk and ensure that the facility is conceptually similar to current open market operations, such as repo transactions. As the paper noted, "Because basis trades involve a spot purchase and future sale, they are ‘conceptually very similar’ to repo transactions – the only difference being different counterparties for the purchase and sale."



The implementation of a basis purchase facility could have significant implications for broader financial stability and market liquidity, particularly in times of crisis. By relieving stress on bond dealers and avoiding moral hazard concerns, the facility could help mitigate the risks associated with the basis trade and ensure that the financial system remains resilient. However, the legality of such a new facility is an important question that remains unanswered. Additionally, implementing such a facility would require significant operational changes and coordination among various market participants.

In conclusion, while a basis purchase facility could help manage highly leveraged hedge fund trades and mitigate market disruptions, it also raises concerns about moral hazard, legal challenges, and potential market distortions. The Fed must carefully consider these trade-offs as it navigates the complex landscape of financial stability and market liquidity. The stakes are high, and the decisions made today will shape the future of the financial system for years to come.