Fed Urged to Explore Hedge Fund Bailout Tool for Basic Trades

A panel of financial experts has suggested that the Federal Reserve establish an emergency program to manage highly leveraged hedge fund trades in case of a crisis in the $29 trillion U.S. Treasuries market. The potential for a rapid unwinding of roughly $1 trillion in hedge fund arbitrage positions could not only disrupt the Treasuries market but also spill over into other areas, making Federal Reserve intervention necessary to maintain financial stability.

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During the early days of the COVID-19 pandemic in March 2020, the Fed responded to market turmoil by purchasing approximately $1.6 trillion in Treasury securities over several weeks. However, a more effective approach would be for the Fed to intervene through hedged bond purchases, according to a Brookings Institution paper authored by Anil Kashyap of the University of Chicago, former Fed governor Jeremy Stein of Harvard University, Jonathan Wallen of Harvard Business School, and Joshua Younger of Columbia University.

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“If the Fed is considering buying Treasuries again, we would prefer it to be on a hedged basis,” Stein stated during a briefing on the paper. The proposed strategy, the authors argue, could be a valuable tool for the Fed in ensuring market stability.

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The primary concern is the "basis trade," where hedge funds exploit small price differences between Treasuries and their corresponding futures contracts. Kashyap noted that this type of trade is highly concentrated, involving perhaps fewer than 10 hedge funds.

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If these funds need to quickly exit their positions, the risk is that bond dealers may not be equipped to handle the sudden flood of transactions. When the Fed intervened in 2020, the total value of basis trades was around $500 billion—just half of what it is today.

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“To alleviate the strain on bond dealers, the Fed could step in by purchasing Treasury securities while simultaneously hedging those purchases through an offsetting sale of futures,” the paper suggested. Establishing a “basis purchase facility” would prevent a liquidity squeeze on dealers, who play a critical role in providing secondary market liquidity and facilitating repurchase agreement (repo) transactions.

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The paper acknowledged that such a program could raise concerns about moral hazard, as it could encourage hedge funds to take on even more risk, knowing the Fed might step in if their trades start to unravel. However, Stein argued that the alternative—outright Treasury purchases, as seen in 2020—also carries risks. “The comparison shouldn’t be against ‘no moral hazard’ at all,” he explained.

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A key drawback of direct Treasury purchases is that they remove “duration” from the market, meaning the Fed acquires securities that mature over time while simultaneously creating bank reserves that accrue overnight interest. This could blur the distinction between financial stability operations and monetary policy, the authors noted.

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Additionally, the cost of large-scale Treasury purchases is evident in the reduced remittances from the Fed to the U.S. Treasury. The central bank is still in the process of unwinding its previous bond purchases—part of the quantitative easing (QE) measures implemented between 2020 and 2022.

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Kashyap pointed out that outright purchases are “an inelegant way” to manage market stress. “Buying Treasuries outright resembles QE and likely influences term premia,” he said, referring to the additional yield investors demand for holding long-term securities instead of rolling over short-term ones.

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To mitigate moral hazard, the authors proposed an auction mechanism where primary dealers submit bundled “basis packages” containing both the cash security they want to sell and the corresponding futures contract they intend to buy. The Fed could then set a minimum bid price, ensuring that hedge funds face a penalty discount rather than benefiting unconditionally from the facility.

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This method would create a clear separation between market-support operations and monetary policy-driven QE. Additionally, it would be largely self-liquidating, removing uncertainties about future bond sales or the need for further quantitative tightening. Another advantage is that it would shield the Fed from taking on interest-rate risk.

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The paper also highlighted that a basis purchase facility would not be entirely different from existing Fed operations. The central bank already engages in repo transactions, either through standing facilities or regular open market operations. Since basis trades involve a spot purchase and a future sale, they are conceptually similar to repos, with the primary difference being the counterparties involved.

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Although the legal framework for such a facility remains an open question, the authors noted that it was beyond the scope of their paper. In recent years, policymakers have discussed various reforms to improve the functioning of the Treasury market. These include adjusting bank regulations to enhance dealer capacity, establishing a standing repo facility to lend directly to hedge funds, and imposing minimum margin requirements for repo-financed Treasury purchases.

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A mandate for central clearing of Treasuries and repo transactions is already set to take effect by December 31, 2026. However, given the scale of hedge fund involvement in basis trades, the market remains vulnerable to volatility.

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“Hedge funds are in a highly leveraged position, where even a minor shift in the basis trade could force them out of their positions,” Stein explained. “Meanwhile, bond dealers do not appear to be well-positioned to absorb such a shock.”

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As concerns about financial stability continue to grow, the proposed basis purchase facility could provide the Fed with an alternative tool to manage crises in the Treasury market without resorting to broad-based quantitative easing.

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