By Davide Barbuscia and Gertrude Chavez-Dreyfuss

NEW YORK Hedge funds will likely become increasingly important buyers of U.S. Treasuries, providing liquidity in the world's biggest bond market at a time of rising investor concerns over supply-demand dynamics, several market participants said on Thursday.

Hedge funds' short positions in some Treasuries futures, contracts for the purchase and sale of bonds for future delivery, have recently hit record highs due to their involvement in so-called basis trades, which take advantage of the premium of futures contracts over the price of the underlying bonds.

The trade, which contributed to severe disruptions in the Treasuries market when it was unwound rapidly in March 2020, has recently drawn attention from economists at the Federal Reserve as well as from the Bank for International Settlements. The risk, they have warned, is that large basis positions could once again exacerbate vulnerabilities in the U.S. bond market, which is a linchpin of the world's financial system.

Some bond market participants, however, say hedge funds using the strategy provide crucial demand for Treasuries at a time when the government is issuing more debt while the Fed - which used to be a big buyer in the market - has been reducing its bond holdings since June last year.

"It's necessary for those participants to come in because of the funding demands of the issuers, the issuers here being (President) Joe Biden and (Treasury) Secretary (Janet) Yellen," said Jason Granet, chief investment officer at BNY Mellon, during a panel at the ISDA derivatives trading forum in New York on Thursday. "These basis positions with these transformations are going to be a part of the equation because it's a necessary evil to get the capital to meet the demand."

The Treasury announced this summer it intended to increase coupon auction sizes in the third quarter and that additional gradual increases will likely be necessary in coming quarters.

Higher supply comes as liquidity in Treasuries has been problematic for most of last year, partially due to rising volatility spurred by the Fed's aggressive rate hiking cycle.

The Fed is also progressing with "quantitative tightening" - a reversal of the massive central bank bond purchases undertaken to support markets as the coronavirus hit in 2020.

Mark Wendland, chief operating officer and partner at DRW Holdings, which is trading the cash-future basis in Treasuries, said the trade has an essential function as it supports liquidity in the market, despite some regulators’ concerns regarding leveraged players.

“The importance of the basis trade cannot be underestimated particularly given supply-demand imbalances in Treasuries,” he told Reuters on the sidelines of the forum, referring to factors such as higher government bond issuance and lower demand from the Federal Reserve as a buyer.

Cash-futures basis trades - typically the domain of macro hedge funds with relative value strategies - consist of selling a futures contract, buying Treasuries deliverable into that contract with repurchase agreement (repo) funding, and delivering them at contract expiry.

Leverage levels were very high in Treasuries during previous episodes of market stress such as March 2020 or September 2019, when dwindling bank reserves sent the cost of overnight loans as high as 10%, forcing the Fed to intervene.

But Richard Chambers, global head of repo trading and global co-head of short macro trading at Goldman Sachs, told the trading forum on Thursday that the repo market was now more efficient.

"We will have more levered investors buying Treasuries into 2024 and so demand for leverage in Treasuries will increase," he said.

(Reporting by Davide Barbuscia, Gertrude Chavez-Dreyfuss, Carolina Mandl and Laura Matthews in New York; Editing by Matthew Lewis)