The US often runs politics under the “Pottery Barn Rule” – if you break it, buy it.
This usually just means that elected officials and their political parties are responsible for whatever they screw up. (It was probably supposed to be called the Pier 1 Rule, after the liquidated discount housewares retailer, but the current name is very impressive.)
The rule often also applies to market structure regulation. A good example is the regulatory focus on certain hedge funds after the Treasury market went haywire in March 2020.
As our colleagues Kate Duguid and Phil Stafford have reported, companies making more than $25 billion a month are having to
Our colleagues have also reported on the backlash the proposal has received from market makers, mutual funds and other firms – almost all but primary dealers, who are already heavily regulated, and some outside organizations such as Better Markets.
This brings us to the biggest challenge of the Pottery Barn rule – showing that a certain group broke something.
Enter the Treasury Department’s Office of Financial Research or OFR. This week she released new research that sure sounds like a case for hedge fund regulation, more than a year after she examined the impact of hedge fund cash/futures arbitrage on the March 2020 riots.
The OFR examined hedge fund data not available to the public: positioning reports filed privately (via Form PF) with the SEC. And it is argued that hedge fund movements have a significant impact on Treasury market movements.
The paper estimates that a monthly change (one standard deviation) of $41 billion in hedge fund positioning accounts for about a 6 basis point move in the 5-year yield. At least at the 5-year maturity, the paper estimates that the impact of changes in hedge fund positioning is comparable to changes in inflation:
Based on monthly analysis from 2013 through the fourth quarter of 2020, we find economically significant and supportive evidence that changes in hedge fund exposures are associated with changes in treasury returns. A one standard deviation increase in net Treasury exposure growth, equivalent to a $41 billion monthly increase in hedge fund net exposure, is associated with a 6.2 basis point decline in five-year bond yields. The size of this estimate is not sensitive to the control of known macroeconomic drivers of the yield curve, such as economic growth and inflation, and exists for different maturities. It is also robust to controlling the valuation effects of returns on exposures and changes in other financial institutions’ treasury exposures.
The authors of the study argue that the result holds even after accounting for changes in monetary policy and the activity of other investors. They also found that the effect is not due to hedge fund position values changing with market movements.
This is completely intuitive for us. Hedge funds make up a larger proportion of the market’s investor base than they used to, and it seems perfectly reasonable to think that changes in demand will affect the market price! Therefore, providing OFR resources for this argument makes the most sense from the perspective of the current regulatory debate.
Before delving into the paper’s other (rather more interesting) conclusions, let’s review the years-long saga of interest rate regulation:
Treasuries have been a topic of interest since the ‘flash crash’ in yields in October 2014, when dealers at banks’ primary dealers stopped answering the phone (and at least one admitted to having his computer off). Prop traders took some of the blame at the time, but industry executives noted that the moves lacked the classic meltdown signs of arbitrage strategies; Price relationships normally monitored by these fixed trades, particularly the relationship between futures and spot markets.
Then these highly arbitrated price relationships erupted in the early days of the Covid-19 pandemic. The odd movements and inefficient pricing prompted regulators – and our peers – to turn their attention to arbitrageurs, including relative value funds, whose strategies have come under pressure. Of course, that happened in large part because their bank financing became very expensive very quickly. (They are also said to have contributed to the September 2019 repo market chaos.)
In other words, one could argue that relative value strategies broke the market in March 2020, so regulators are making them pay.
One response is that the US regulators’ response — which is causing large numbers of traders to register as government securities dealers — is too broad, encompassing other types of funds that don’t use much leverage.
But the OFR notes that in March 2020 the stocks are excluded multi-strategy and managed futures Funds had the strongest relationships with price movements. They also include a chart that breaks down the different types of hedge funds in the market by size:
First, this raises some questions about how multi-strategy and relative value funds are classified. Is a pod shop with relative value strategies (à la Millennium) multi-strategy or relative value? The OFR says they use self-identification from Form PF filings and it would be interesting to see more insight into how these funds are classified.
Second, even assuming that all futures arbitrage strategies are included in the relative value category, the conclusion makes perfect sense. Leveraged Treasury market arbitrage trades were a problem in March 2020 because a surge in funding costs blew up their trades, not because their presence makes Treasury trading perpetually volatile.
The paper indirectly touches on a controversial issue that has reportedly gotten the OFR in hot water before – the sometimes blurred distinctions between systemic intermediaries and the impact of end investors on markets.
After the GFC, officials made compelling arguments that the central role of banks as intermediaries makes them particularly important systemically. Investors, according to this view, must bear the consequences of their own impact on the market so that they would not have to face the same level of regulation.
The problem is that in less regulated markets like Treasuries, the distinction can become blurred. We’ve heard from thoughtful people that making markets with a view can be an extremely lucrative investment strategy. And the OFR’s paper points out that having a large cohort of highly price-sensitive traders in a market can make it more volatile, especially during times of high emissions and economic uncertainty:
Taken together, these results suggest that hedge fund trading activities can be linked to market price movements. At the same time, it is important to recognize that these results do not show that hedge funds are the sole or primary drivers of price volatility in the Treasury market. Nor are they necessarily the source or originator of the fundamental shocks that sweep through the financial system. Of course, there are other forces driving price movements in these markets. Based on this last point, it might be difficult to prove that hedge fund trading was the primary cause of the wide swings in government bond yields and the drop in liquidity during the March 2020 episode. However, they may have served the role of a reinforcement mechanism.
There’s not much the SEC can do about the high Treasury issuance and economic uncertainty (that’s the job of the Treasury Department, Congress, and the Fed). But it can extend its surveillance to Treasury markets to get a better idea of who these price-sensitive traders are and effectively limit leverage.
If the goal were solely to create a resilient Treasury market structure independent of political pressures, which is certainly a fantasy in the US, regulators could focus on systemic solutions to manage funding costs in times of crisis. They could look for clearing solutions or set more guidelines on counter-cyclical changes in trader regulations.
But if regulators are using the Pottery Barn rule instead, the focus on hedge funds makes perfect sense.