The full article, which title is “Margin leverage and vulnerabilities in US Treasury futures” and is a chapter of the BIS Quarterly Review is available here.
We prepared a summary with key factors mentioned in the article. The Bank of International Settlements, is the central bank of central banks. While its existence and functions are often ignored by retail investors, for institutional investors and policy makers its reports are very useful resources in research, education and decision making.
The authors of the article investigated the leverage and trading strategies on US Treasury Futures trading in recent years and potential implications for fixed income markets:
- Leveraged investors have recently accumulated net short positions in US Treasury futures valued at about $600 billion and over 40% of these short positions are focused on two-year contracts.
- This trend was similarly observed before the repo market disruption in September 2019 and US Treasury market disturbances in March 2020. The article investigates the often-ignored aspect of leverage in futures trading and how abrupt changes in this “margin leverage” can lead to unstable margin spirals.
- Price differences between futures and underlying cash bonds in 2019 and 2020 spurred highly leveraged funds to pursue relative value trades. Present evidence indicates a similar pattern now. A prevalent relative value trading tactic involves selling futures forward and acquiring bonds. This strategy relies on the convergence of futures and cash prices by the futures contract’s expiration.
- Investors often use high leverage to amplify returns, leveraging long positions by borrowing cash in the repo market and offering US Treasury holdings as security. Another overlooked aspect of leverage originates from futures markets, wherein traders post an initial margin (IM) when starting a futures contract. The leverage level is determined by the ratio of the futures contract’s value to the IM.
- Before the pandemic, leverage in US Treasury futures was notably high. However, since 2021, due to increased volatility in the US Treasury market, there has been a decrease in leverage, although it remains relatively high. Sudden hikes in IM requirements can compel traders to post additional cash or shut their positions. An abrupt decline in margin leverage intensified market turmoil in both September 2019 and March 2020. Current extensive leveraged short positions in US Treasury futures pose a potential financial risk due to the possible onset of margin spirals.
- Unregulated margin deleveraging can significantly disrupt central fixed income markets
