MNI: Fed Should Create Backstop For Basis Trade Unwind - Paper

The Federal Reserve ought to consider creating a standing facility or conducting auctions that would cap the Treasury-futures basis in periods of extreme illiquidity in Treasury markets such as that of March 2020, according to a paper co-authored by former Fed Governor Jeremy Stein to be presented at the Brookings Institution on Friday. 

Enormous growth in the cash-futures basis trade, the vast majority of which is conducted by fewer than a dozen highly leveraged hedge funds, has created systemic risk in the USD28 trillion Treasury market, write Anil Kashyap of the University of Chicago, Stein, Jonathan Wallen of Harvard Business School and Joshua Younger of Columbia University. (Younger is also a senior policy advisor at the New York Fed.) 

As the Covid-19 panic thrashed markets in March 2020 and investors became desperate to raise cash, hedge funds rapidly unwound their positions, creating a negative feedback loop that exacerbated market strains. As yields soared, the Fed was forced to step in, purchasing USD1.5 trillion of Treasuries in a single week. 

A standing facility could set a cap on the price gaps between Treasury securities and futures so the Fed would buy the requisite amount of cash bonds through a conventional open market operation and short the equivalent amount of futures whenever the basis threatened to breach the cap, the authors propose. 

The structure would resemble that of the Fed's standing repo facility, which aims to cap spikes in repo spreads, they said. Conducting auctions of bundled basis packages would be another way to structure it, they added. 

HIERARCHY OF ESCALATION

"Think of their being a hierarchy of escalation," Stein told reporters on a call Tuesday. "Before, the hierarchy was you do repo, if that's not enough you do some other stuff, and if things get really bad, you just buy a ton of bonds. We're just proposing something in-between on the hierarchy." 

As the lender of last resort, the Fed could set the cap at a penalty rate that's better than the disruptive market conditions but not as good as normal times, he said.

"If we had a replay of March 2020, they could have done this, and I think they would have stopped doing this much sooner. I have no doubt about that," Kashyap told reporters.

Such a facility would also force the Fed's to clearly delineate its rationale for massive bond purchases and separate monetary policy objectives from financial stability, Kashyap said. The Fed's conflated the two motivations in 2020 as QE morphed seamlessly from easing market functioning to supporting the economy. 

Whether the Fed has the power to short futures will be a question for lawyers to figure out, Stein said. And there may be potential doubt over whether such a facility would be enough to restore market calm, after the Fed's whatever-it-takes pledge in 2020.  

"I don't think this is going to cure everything," Kashyap said. Nevertheless, "everything you can do to shore up the Treasury market and make sure it functions normally and isn't subject to these bouts of extreme volatility enhances financial stability."