Using the “Pottery Barn Rule” in the Treasury Market
The United States often sets its policy on the “Pottery Barn Rule” – if you break it, you buy it.
It usually just means that elected officials and their political parties are responsible for what they mess up. (It should probably be called the Pier 1 Rule, after the liquidated discount housewares retailer, but the actual name is very telling.)
The rule also often applies to market structure regulation. A good example is the regulatory focus on some hedge funds after the Treasury market went haywire in March 2020.
As our colleagues Kate Duguid and Phil Stafford have reported, companies that trade more than $25 billion in Treasuries per month may in future be required to register as brokers with the Securities and Exchange Commission in under the proposed rules.
Our colleagues also reported on the backlash the proposal received from market makers, investment funds and other firms – almost everyone except primary traders, who are already heavily regulated, and some outside organizations like Better Markets.
This brings us to the main challenge of the Pottery Barn rule – showing that a certain group broke something.
Enter the Office of Treasury Financial Research, or OFR. This week, he published new research that certainly rings a bell in favor of hedge fund regulation, more than a year after investigating the impact of hedge fund cash/futures arbitrage on turbulence of March 2020.
OFR reviewed data from hedge funds that cannot be obtained by the public: positioning reports filed privately (via Form PF) with the SEC. And he argues that hedge fund movements have a significant impact on Treasury market movements.
The paper estimates that a monthly change of $41 billion (one standard deviation) in hedge fund positioning is responsible for about a 6 basis point change in 5-year yield. At the 5-year horizon, at least, the paper estimates that the effects of changes in hedge fund positioning are comparable to changes in inflation:
Based on monthly analysis dating from 2013 to the fourth quarter of 2020, we find economically meaningful and robust evidence that changes in hedge fund exposures are linked to changes in Treasury bond yields. A one standard deviation increase in the net growth of Treasury exposures, which translates to a $41 billion monthly increase in net hedge fund exposures, is associated with a 6.2 basis point decline in bond yields at five years old. The size of this estimate is not sensitive to the control of well-known macroeconomic factors in the yield curve, such as economic growth and inflation, and exists at various maturities. It is also robust in controlling for valuation effects of returns on exposures and changes in cash exposures of other financial entities.
The authors of the study claim that this result holds even after adjusting for changes in monetary policy and the activity of other investors. They also found that the effect cannot be attributed to the changing values of hedge fund positions with market movements.
This is completely intuitive for us. Hedge funds make up a larger share of the market’s investor base than ever before, and it seems entirely reasonable to expect that changes in demand will alter the price of a market! Thus, the dedication of OFR resources to this argument makes the most sense through the prism of the current regulatory debate.
Before delving into the other (rather more interesting) conclusions of the article, we should review the years-long saga of rate market regulation:
Treasuries have been a hot topic since the October 2014 “flash crash” in yields, when primary bank traders stopped answering the phone (and at least one admitted to turning off their computer). Prop traders were blamed at the time, but industry executives noted that the moves lacked the classic signs of a collapse in arbitrage strategies; price relationships that are normally controlled by quickly held transactions, including the relationship between futures markets and spot markets.
Then, these heavily arbitraged price relationships exploded at the onset of the Covid-19 pandemic. The odd moves and inefficient pricing have led regulators – and our colleagues – to direct their attention to arbitrageurs, including relative value funds, whose strategies have come under pressure. Of course, that happened largely because their bank financing got very expensive, very quickly. (They also reportedly contributed to the September 2019 repo market mess.)
In other words: one could argue that relative value strategies broke the market in March 2020, so regulators are making them pay.
One answer to this is that the US regulatory backlash – requiring a wide range of traders to register as state stockbrokers – is too broad and encompasses other types of funds that don’t use a lot of technology. ‘leverage.
But the OFR finds that when March 2020 is excluded, the holdings of multi-strategy and managed futures contracts funds had the strongest relationship with price movements. They also include a table breaking down the different types of hedge funds in the market by size:
First, it raises questions about how multi-strategy and relative value funds are ranked. 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 nice to have more information on how these funds rank.
Second, even if you assume that all futures arbitrage strategies are included in the relative value category, the conclusion makes a lot of sense. Leveraged Treasury market arbitrage trades were a problem in March 2020 because a spike in funding costs sent their business skyrocketing, not because their presence makes Treasury trades perpetually volatile.
The document indirectly addresses a controversial topic that would have already got the OFR in hot water – the sometimes blurred distinctions between systemically important intermediaries and the impact end investors have on the markets.
After the GFC, officials made compelling arguments that the central role of banks as intermediaries makes them particularly systemically important. Investors have to bear the consequences of their own impact on the market, according to this view, so they have not had to deal with the same level of regulation.
The problem is that the distinction can blur in less regulated markets like treasury bills. We’ve heard thoughtful people say that “creating markets with a view” can be a very lucrative investment strategy. And the OFR paper suggests that having a large cohort of highly price-sensitive traders in a market can make it more volatile, especially in times of high emissions and economic uncertainty:
Taken together, these results indicate that the trading activities of hedge funds 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 decisive driver of price movements in the Treasury market. Nor are they necessarily the source or initiator of fundamental shocks that ripple through the financial system. Obviously, there are other forces that determine price movements in these markets. Extrapolating from this last point, it might be difficult to demonstrate that hedge fund trading during the March 2020 episode was the main driver of the large swings in Treasury yields and the decrease in liquidity. However, they could have acted as an amplification mechanism.
The SEC can’t do much about high levels of Treasury issuance and economic uncertainty (that’s the job of the Treasury, Congress, and the Fed). But it can extend its oversight to Treasury markets to get a better idea of who these price-sensitive traders are and impose de facto limits on leverage.
If the goal were only to create a robust Treasury market structure independent of political pressures, which is surely a fantasy in the United States, regulators could focus on systemic solutions to meet funding costs in time. of crisis. They could consider compensation solutions or develop more policies regarding counter-cyclical changes in dealer regulation.
But if regulators are using the Pottery Barn rule instead, the focus on hedge funds makes perfect sense.