Could $1 Trillion Treasury Carry Trades Cause Clearinghouses to Collapse?
Understanding the Clearinghouse System
Russell Clark of Capital Flows and Asset Markets has expressed concerns about the clearinghouse system in global finance. This comes after reading an article by Brian Meehan of Bloomberg Intelligence, which highlighted a $1.1 trillion notional short position in US treasury futures. However, this should not be seen as a bearish stance on treasuries but rather as a leveraged trade to profit from the price difference between off-the-run treasuries and treasury future positions. For every short position in the treasury futures, there should be a long position in the physical market.
Size of the Trade and the Federal Reserve's Stance
The size of this trade has been significant for some time. The Federal Reserve has examined it and does not see it as a problem. Much of this trade has shifted from proprietary trading desks at banks to hedge funds in the post-GFC world. The Bank for International Settlements noted in 2019 that the Repo market has become bifurcated between banks and hedge funds.
Clearinghouses and Repo Trading
Clearinghouses, specifically LCH and CME, which are central to repo trading, are primarily concerned with the speed at which trades can be liquidated. They usually settle on a daily basis, and with hedge funds and other asset managers needing to settle constantly, they allow trades to grow in size considerably more than when investment banks were at the heart of the repo market.
Clearinghouses and the Pursuit of Volume
Clearinghouses cannot go bankrupt, and as such, they implement policies to increase volumes as much as possible. One such policy is compression trades, where very similar interest rate products can be combined into a single product to enable more leverage to be used. However, when a shock occurs in interest rate markets, liquidity vanishes, and the clearinghouse begins demanding more margin from all players, leading to a spiraling weaker market.
Clearinghouses and Risk Mispricing
Large investment banks are aware that clearinghouses misprice risk. They have suggested that clearinghouses should take on more financial risk in pricing to encourage them to do a better job. However, regulators have so far disregarded this advice.
Clearinghouses and LTCM
The case of Long-Term Capital Management (LTCM) is relevant here. LTCM focused on risk-free arbitrage trades, which required substantial leverage. The downfall of LTCM came when it was discovered that the firm had far more leverage than it had disclosed, leading to a market sell-off and eventually bankruptcy. Under the new clearinghouse system, such secrecy is not required. The clearinghouse actively encourages borrowing as much as possible, provided the liquidity and volatility seen over the look-back period - typically 10 years - are met.
Potential Risks
So, what could go wrong? In the US, after the presidential election, inflationary policies could be announced, leading to rising inflation expectations. Physical treasuries held in ETFs like TLT could see redemptions. This could result in a fall in treasuries, widening of the basis trade, issuance of margin calls, more selling of treasuries, and more basis widening until the Fed steps in to buy treasuries.
Clearinghouse Reform
Clearinghouse reform is seen as a failed reform, but it may take a crisis to bring about change.
Bottom Line
The situation described above paints a concerning picture of the potential risks inherent in the current clearinghouse system and the massive treasury carry trades. If these issues are not addressed, we could see significant disruptions in the global financial markets. What are your thoughts on this matter? Feel free to share this article with your friends and discuss. Remember, you can sign up for the Daily Briefing, which is available every day at 6 pm.
