A highly leveraged bond trade that’s become popular with hedge funds is drawing fresh scrutiny three years after it blew up spectacularly.

Officials at the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about leveraged trading in government bonds by their fast-money clients, according to people familiar with the matter, who asked not to be named citing the confidential nature of discussions. The dangers have been heightened as political brinkmanship around the debt ceiling has threatened to sink the US into default and unleash chaos in financial markets.

Several of the hedge funds that have recently pursued the so-called basis trade were also active in 2020, when the outbreak of the pandemic upended the Treasury market and caught them wrong-footed until Fed officials intervened to restore normalcy. The list includes Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, according to people familiar with the matter.

Opaque and risky, the strategy has long spooked watchdogs. It involves borrowing heavily in the repurchase market and using that leverage to exploit the price gap between Treasury futures and the underlying cash market. The trades, in some cases, have been levered 50-to-1, according to two of the people. The strategy’s enduring popularity is particularly alarming to SEC Chair Gary Gensler, who is on a broader mission to subject large speculators to more onerous regulations.

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

The New York Fed said in a statement that it “regularly reaches out to a wide range of market participants to gather information on financial market developments, and this outreach is consistent with typical market intelligence gathering.”

Officials have been asking about current margin requirements and how a default, or a downgrade to the US’s credit rating, would impact the market plumbing including the value of collateral, the people said.

The regulatory interest in the issue isn’t entirely new — some officials have been monitoring it ever since the last blow-up — but the possibility of a US default has added a new, and troubling, element. Financial watchdogs are under pressure after having been blindsided repeatedly by instability in the bond market since the pandemic erupted.

Fed officials at the policy meeting earlier this month expressed concerns about the risks lurking outside the banking system in light of recent financial stresses. Minutes released Wednesday singled out “hedge funds, which tend to use substantial leverage and may hold concentrated positions in some assets with low or zero margin.”

Read more: Before Fed Acted, Leverage Burned Hedge Funds in Treasury Market

Memories of the 2020 rout are fresh. Back then, massive volatility in Treasury futures sparked margin calls and contributed to the Fed’s decision to pledge trillions in stimulus. ExodusPoint and Capula were caught out while Millennium closed several so-called trading pods in the crisis. For Citadel, the impact was smaller. The firm’s current positioning in the trade isn’t the largest it’s been historically, one of the people said.

Representatives for Citadel, Millennium, ExodusPoint and Capula declined to comment on their current exposures.

This time round, the build-up in short-futures positions by funds that use leverage has been hitting records. That’s a sign speculators are seeking to profit from a mismatch in pricing between Treasury futures and the cash market. Since the strategy typically yields minuscule returns, hedge funds borrow in the repo market to amplify gains.

A big bulk of such trades are conducted on a bilateral basis — meaning transactions take place between two firms without a central clearinghouse serving as a backstop. The Treasury’s Office of Financial Research has said it considers bilateral repo, the most common of all repurchase activities, as a regulatory blindspot. Post-2008 bank rules have also made repo activity more costly and less attractive to dealers — giving life to new market players who largely operate outside the reach of financial supervisors.

The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses. The agency also finalized a rule that would require private funds to report major losses, sudden margin increases, or other significant events within no more than 72 hours — or potentially sooner. But that regulation won’t go into effect for six months.

Meanwhile, the clock is ticking for debt negotiators in Washington. Traders assume that if push comes to shove, the Treasury would prioritize interest and principal payments on publicly held obligations. Yet even if there’s an 11th-hour agreement, prolonged fiscal brinkmanship could cause a surge in repo rates — and undermine one-way trades across a bond market that’s delivered blows to a host of money managers over the past year, while fueling the regional banking crisis.

To be clear, not everyone finds positioning in the bond market alarming. To Meghan Swiber, a US rates strategist at Bank of America Corp., hedge funds typically take the other side of the trade when asset managers amass massive long positions in futures. And to hedge themselves, the fast money goes on to buy obligations in the cash market, which helps at a time when the Fed is shrinking its bond portfolio, per Swiber.

“The asset manager community has seen such large demand for Treasuries that someone’s got to supply those asset managers liquidity,” she said.

With time growing short to avert a default, Republican and White House negotiators are moving closer to an agreement to raise the debt limit and cap federal spending for two years. However, details are tentative and no final deal had been reached as of Friday morning in Washington.

In the event the US actually defaults on some obligations next month, Gensler has warned that, among the many concerns, market funding and liquidity would be particularly problematic.

“It would be one heck of a mess,” he said at a recent press briefing.

--With assistance from Ye Xie, Edward Bolingbroke, Jenny Surane, Hannah Levitt, Christopher Condon, Katanga Johnson and Kate Davidson.

Author: Sonali Basak, Liz Capo McCormick, Lydia Beyoud and Hema Parmar