Hedge Fund Treasury Trading and Funding Fragility: Evidence from the COVID-19 Crisis
67 Pages Posted: 5 Apr 2021 Last revised: 12 Jul 2021
Date Written: June 2021
Hedge fund gross U.S. Treasury (UST) exposures doubled from 2018 to February 2020 to $2.4 trillion, primarily driven by relative value arbitrage trading and supported by corresponding increases in repo borrowing. In March 2020, amid unprecedented UST market turmoil, the average UST trading hedge fund had a return of -7% and reduced its UST exposure by close to 20%, despite relatively unchanged bilateral repo volumes and haircuts. Analyzing hedge fund-creditor borrowing data, we find the large, more regulated dealers provided disproportionately more funding during the crisis than other creditors. Hedge funds exited the turmoil with 20% higher cash holdings and smaller, more liquid portfolios, despite low contemporaneous outflows. This precautionary flight to cash was more pronounced among funds exposed to greater redemption risk through shorter share restrictions. Hedge funds predominantly trading the cash-futures basis faced greater margin pressure and reduced UST exposures and repo borrowing the most. After the market turmoil subsided following Fed intervention, hedge fund returns recovered quickly, but UST exposures did not revert to pre-shock levels over the subsequent months. Overall, the step back in hedge fund UST activity was primarily driven by fund-specific liquidity management constrained by margin pressure and expected redemptions, rather than creditor regulatory constraints.
Keywords: Hedge funds, Treasury markets, relative value, arbitrage, liquidity, redemption risk, creditor constraints
JEL Classification: G11, G23, G24, G01
Suggested Citation: Suggested Citation