Adam Brinley Codd, Daniel Krause, Pierre Ortlieb and Alex Briers
We each drive automobiles, however the US drives on the precise whereas the UK drives on the left. We each stroll, however we achieve this on sidewalks within the US and pavements within the UK. We each have asset managers, who need to take leveraged positions in rates of interest. US asset managers had round US$650 billion of lengthy treasury futures in June 2023. UK asset managers, in Autumn 2022, held round £200 billion in leveraged repo. Nevertheless, the methods by which the monetary system discovered keen lenders for these debtors, and intermediated the danger via the system of market-based finance, differ.
This publish explores the similarities and variations between the exercise of asset managers and hedge funds in US Treasury (UST) futures markets, and the connection between liability-driven funding (LDI) funds and lenders within the gilt repo market.
Why and the way do asset managers use leverage?
Utilizing leverage in an funding technique entails borrowing (monetary leverage) or derivatives (artificial leverage) to realize increased publicity to threat elements and improve returns. In an effort to supply increased returns to their buyers, asset managers have, in precept, an incentive to make use of leverage. In follow, asset managers within the US and UK use leverage in numerous methods.
Within the UK, many outlined profit pension schemes have long-term liabilities on account of the longer term funds they owe to their pensioners. Many pension schemes use LDI methods (typically offered by asset managers) to match the profile of their property to that of their liabilities and hedge their publicity to long-term rates of interest and inflation. The essential constructing block of LDI methods is long-term, index-linked authorities bonds. In leveraged LDI methods, these bonds are used as collateral to borrow money through repurchase agreements (repo) (see Determine 1, left panel). The money acquired from these transactions is then invested in additional long-term authorities bonds, growing schemes’ sensitivity to (long-term) rates of interest, and higher matching their liabilities. An alternate however much less widespread approach for LDI funds to use (artificial) leverage is to make use of long-term rate of interest swaps to obtain a hard and fast fee whereas paying a floating fee. These leveraged LDI methods permit pension schemes to extend their publicity to long-term gilts, whereas additionally holding riskier and higher-yielding property, reminiscent of equities, as a way to increase their returns and shut potential funding gaps.
Whereas US asset managers apply leverage for a number of causes, boosting returns to outperform their benchmarks is a central motive. Leverage permits them to handle their portfolio length and, on the identical time, retain funds to spend money on increased return property, reminiscent of increased yielding company bonds, with shorter length. A method asset managers obtain this within the US is by shopping for UST futures (see Determine 1, proper panel). These contracts give asset managers publicity to a US Treasury bond, however without having to pay for the entire thing up entrance.
How do markets discover a lender for each borrower?
Within the UK, LDI funds’ demand for leveraged gilt repo is intermediated by supplier banks. LDI funds borrow from supplier banks utilizing time period repo transactions with maturities of as much as a number of months (see Determine 1, left panel). In utilizing short-term repo funding to spend money on long-term property, LDI funds have interaction in maturity transformation. On the opposite aspect of the UK repo market, cash market funds (MMFs) are an necessary supplier of liquidity: they normally lend to sellers through in a single day (reverse) repo. That is in line with their mandates to spend money on short-term secure property which might simply be reworked into money and transferred again to buyers.
Within the US, then again, asset managers’ demand for leverage via US Treasury futures is mirrored by hedge funds’ internet brief positions (see proper panel of Determine 1). Nevertheless, for hedge funds, the brief positions in UST futures are just one leg of a buying and selling technique generally known as the UST foundation commerce, which exploits an arbitrage alternative from comparatively increased UST futures costs in comparison with the underlying UST bonds. Hedge funds full the UST foundation commerce by shopping for a money bond that’s eligible for supply into the UST future and offsets their brief place sooner or later. Because the margins of this buying and selling technique are small, hedge funds attempt to enhance their income through the use of leverage. Like LDI funds within the UK, they borrow from supplier banks and MMFs within the repo market, utilizing their UST bonds as collateral, to promote extra UST futures and purchase extra UST bonds to hedge them. By doing so, hedge funds set up a hyperlink between asset managers’ demand for artificial length on one aspect and the US Treasury’s provide of longer-term bonds, serving to to align costs in each markets. Their demand for repo funding additionally serves as a secure, short-term funding for MMFs and banks.
Determine 1: LDI and UST foundation commerce stylised intermediation chains
Sources: SMMD, Crane, SEC Non-public Fund Statistic and CFTC knowledge, and Financial institution calculations.
How can leverage threaten monetary stability?
When it isn’t correctly managed, leverage can jeopardise monetary stability in various methods. A primary channel has to do with costs. Leverage not solely enhances returns but additionally amplifies losses when costs transfer within the mistaken route: in itself, this creates potential dangers to counterparties as leverage makes defaults extra possible. Moreover, leveraged trades would possibly grow to be unprofitable if the price of financing them will increase (in Desk A under, rows 1 and a couple of describe how this threat is related for the respective entities within the intermediation chains described above). To forestall additional losses, asset managers would possibly resolve to deleverage by closing their positions. Ought to they achieve this, all the intermediation chain unwinds.
A second channel for potential dangers from leverage has to do with collateralisation, which is a characteristic of each repo and derivatives markets. Counterparties to those transactions are required to publish extra collateral every time their derivatives positions, or the prevailing collateral posted in repo transactions, declines in worth (eg variation margin). The identical normally applies when volatility will increase (eg preliminary margin and haircuts). Not having sufficient collateral at hand to fulfill this requirement when it arises may end in deleveraging (see Desk A, rows 3 and 4).
An instance is the extreme and sudden repricing of the UK gilt market in Autumn 2022. Many LDI funds couldn’t present the extra collateral required on their repo and derivatives positions, and had been compelled to deleverage by promoting long-term gilts into already pressured markets. This began a vicious spiral of falling gilt costs, collateral calls, and compelled gilt gross sales which threatened monetary stability. The Financial institution of England intervened through a short lived and focused programme of purchases of long-dated gilts to revive market functioning. This gave LDI funds time to construct their resilience to future volatility within the gilt market.
In the course of the ‘sprint for money‘ episode in March 2020, many buyers bought authorities bonds to lift money, inflicting Treasury market illiquidity and placing extreme pressure on foundation buying and selling hedge funds. The spike in volatility brought on by the onset of the Covid-19 pandemic elevated the quantity of collateral hedge funds needed to publish for his or her futures positions. Going through increased collateral necessities, mark-to-market losses, and better refinancing prices within the repo market, hedge funds had been compelled to unwind elements of their foundation commerce positions. Due to this fact, hedge funds purchased UST futures and bought the underlying bonds, widening the unfold between futures and bond costs and exacerbating losses additional. An intervention by the Federal Reserve prevented additional spillovers to the US Treasury market that would have jeopardised monetary stability.
Desk A: Dangers confronted by the totally different entities within the intermediation chain
What does this comparability train us about monetary stability?
LDI methods and the UST foundation commerce each symbolize an intermediation chain that hyperlink asset managers’ demand for leveraged long-term rate of interest publicity on one aspect to a requirement for short-term secure property by buyers reminiscent of MMFs on the opposite aspect, with supplier banks sitting between them. In that sense, each trades carry out an necessary operate for the monetary system. However on each side of the Atlantic this intermediation entails the usage of leverage, which, if not correctly managed, can threaten monetary stability. Nevertheless, there are clear variations between the 2 methods; understanding and addressing dangers in market-based finance subsequently all the time requires a holistic and context-dependent method to related markets, contributors, and their interactions.
Adam Brinley Codd, Daniel Krause and Pierre Ortlieb work within the Financial institution’s Market-Based mostly Finance Division. This publish was written whereas Alex Briers was working within the Financial institution’s Market-Based mostly Finance Division.
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