Adam Brinley Codd, Daniel Krause, Pierre Ortlieb and Alex Briers
We each drive vehicles, however the US drives on the correct whereas the UK drives on the left. We each stroll, however we accomplish that on sidewalks within the US and pavements within the UK. We each have asset managers, who wish 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 through which the monetary system discovered keen lenders for these debtors, and intermediated the chance by means of the system of market-based finance, differ.
This put up 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 achieve larger publicity to threat components and improve returns. With a view to supply larger returns to their traders, asset managers have, in precept, an incentive to make use of leverage. In apply, asset managers within the US and UK use leverage in several methods.
Within the UK, many outlined profit pension schemes have long-term liabilities on account of the long run funds they owe to their pensioners. Many pension schemes use LDI methods (typically supplied by asset managers) to match the profile of their belongings to that of their liabilities and hedge their publicity to long-term rates of interest and inflation. The fundamental 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 frequent 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 charge whereas paying a floating charge. These leveraged LDI methods enable pension schemes to extend their publicity to long-term gilts, whereas additionally holding riskier and higher-yielding belongings, akin to 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 larger return belongings, akin to larger yielding company bonds, with shorter length. A technique 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 seller banks. LDI funds borrow from seller 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 belongings, LDI funds interact in maturity transformation. On the opposite facet of the UK repo market, cash market funds (MMFs) are an essential supplier of liquidity: they often lend to sellers through in a single day (reverse) repo. That is according to their mandates to spend money on short-term protected belongings which may simply be remodeled into money and transferred again to traders.
Within the US, alternatively, asset managers’ demand for leverage by means of US Treasury futures is mirrored by hedge funds’ internet quick positions (see proper panel of Determine 1). Nevertheless, for hedge funds, the quick positions in UST futures are just one leg of a buying and selling technique referred to as the UST foundation commerce, which exploits an arbitrage alternative from comparatively larger 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 quick place sooner or later. Because the margins of this buying and selling technique are small, hedge funds attempt to enhance their earnings by utilizing leverage. Like LDI funds within the UK, they borrow from seller 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 facet 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 protected, short-term funding for MMFs and banks.
Determine 1: LDI and UST foundation commerce stylised intermediation chains
Sources: SMMD, Crane, SEC Personal Fund Statistic and CFTC information, 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 in addition amplifies losses when costs transfer within the unsuitable route: in itself, this creates potential dangers to counterparties as leverage makes defaults extra possible. Moreover, leveraged trades may turn into unprofitable if the price of financing them will increase (in Desk A beneath, rows 1 and a pair of describe how this threat is related for the respective entities within the intermediation chains described above). To stop additional losses, asset managers may determine to deleverage by closing their positions. Ought to they accomplish that, all the intermediation chain unwinds.
A second channel for potential dangers from leverage has to do with collateralisation, which is a function of each repo and derivatives markets. Counterparties to those transactions are required to put up further collateral every time their derivatives positions, or the prevailing collateral posted in repo transactions, declines in worth (eg variation margin). The identical often applies when volatility will increase (eg preliminary margin and haircuts). Not having sufficient collateral at hand to fulfill this requirement when it arises may lead to 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 pressured to deleverage by promoting long-term gilts into already burdened 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 brief 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 traders bought authorities bonds to boost money, inflicting Treasury market illiquidity and placing extreme pressure on foundation buying and selling hedge funds. The spike in volatility attributable to the onset of the Covid-19 pandemic elevated the quantity of collateral hedge funds needed to put up for his or her futures positions. Going through larger collateral necessities, mark-to-market losses, and better refinancing prices within the repo market, hedge funds had been pressured to unwind components of their foundation commerce positions. Subsequently, 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 might have jeopardised monetary stability.
Desk A: Dangers confronted by the completely different entities within the intermediation chain
What does this comparability educate 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 facet to a requirement for short-term protected belongings by traders akin to MMFs on the opposite facet, with seller banks sitting between them. In that sense, each trades carry out an essential operate for the monetary system. However on either 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 strategy to related markets, individuals, and their interactions.
Adam Brinley Codd, Daniel Krause and Pierre Ortlieb work within the Financial institution’s Market-Based mostly Finance Division. This put up was written whereas Alex Briers was working within the Financial institution’s Market-Based mostly Finance Division.
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