Meanwhile, regulatory changes related to Treasuries transactions may alleviate the risks of the basis trade. At the end of this year the SEC will require much trading in Treasuries to be conducted through a clearing house, a step designed to make such transactions more reliable, by standardising collateral requirements, for instance. By mid-2027 a further slice of Treasury-related trading will be forced into clearing houses. All this will also give regulators a much clearer picture of what is happening in the Treasury market. Research published recently by Barclays, a big British bank, argues that a change in bank regulations, too, may reduce the risk of the basis trade. Since new rules on leverage for banks were confirmed last year, giving them more leeway to grow their balance-sheets, banks have been hedging against shifts in interest rates by taking short positions in Treasury futures markets. That makes them natural counterparties to the asset managers who buy trillions of dollars of Treasury futures, and so, in turn, should lessen the opportunity for debt-bingeing hedge funds. Some analysts have more novel proposals. Mr Kashyap, Mr Wallen, Jeremy C. Stein of Harvard University and Josh Younger of Tudor Investment Corporation, a hedge fund, suggested in research published in 2025 that the Fed itself could enter the basis trade to settle things down during moments of market turmoil. If hedge funds were dumping Treasury bonds in a panic, the Fed could buy Treasury bonds and short Treasury futures (essentially replicating what hedge funds do during normal times), which would lower the risk of market blow-ups without affecting monetary policy. Anyway, whatever the remaining risks, as the Treasury market expands and the ranks of reliable buyers thin, regulators cannot be too choosy. Direct bidders (a category that includes all manner of investment funds) and indirect bidders (buyers acting through an intermediary) now account for a combined 75% of demand at auctions of Treasuries maturing in a year or longer, up from 45% in 2009. The precise share of Treasuries sold to hedge funds is not known, but in private, financial officials say that the firms ensure that all the bonds on offer actually get sold, which is no small matter. Research published by the Federal Reserve last year shows that funds based in the financial haven of
the Cayman Islands have become enormous players in the Treasury market, partly because of their role in the basis trade. The paper suggested that the Treasury’s data on foreign holdings of American government debt undercounted the stockpile of hedge funds in the Cayman Islands by $1.4trn in 2024. Its new creditors may have troubling flaws, but America cannot afford to turn them away.■ This article was downloaded by zlibrary from https://www.economist.com//special-report/2026/06/01/like-it-or-not-hedge-funds- are-a-permanent-part-of-the-treasury-market
Partners in prime: The Fed and Treasury’s new relationship Scott Bessent and the new Fed chair have talked about co-ordinating their work June 4th 2026 NO FINANCIAL institution or government agency matters more to the Treasury market than does the Federal Reserve. The central bank’s responsibility for financial stability and monetary policy has made it a mammoth buyer of Treasuries in this century, snapping up trillions of dollars’ worth after the global financial crisis in 2007-09 and again during the covid-19 pandemic. As a result, the Fed’s balance-sheet is far larger than it once was: it held less than $1trn in assets two decades ago, but now wallows in around $6.7trn.
Kevin Warsh, who became chairman of the Fed in May, considers this an unhealthy aberration. He argues that the expansion of the Fed’s balance- sheet has mostly enriched people who were already wealthy (because when the Fed splashes money around in financial markets, the prices of the assets held by individuals go up). Perhaps more worrying, he says, the Fed’s repeated interventions muddy important market signals, and make it more difficult for investors to discern creditworthy borrowers from risky ones. He dreams of a Fed with a far smaller role in financial markets. In Scott Bessent, the treasury secretary, Mr Warsh finds a partner with similar views. Mr Bessent argued last year that the Fed’s balance-sheet expansion had strayed into territory usually reserved for elected policymakers—showering favour on, say, the biggest firms that borrow in bond markets, while potentially making it harder for small firms to find credit to expand. Mr Bessent could pursue a strategy that would both limit the Fed’s role in markets and reduce America’s burgeoning interest bill. Mr Bessent currently hopes for the Treasury to issue more short-term debt (known as bills), since the interest the Treasury has to pay on such bonds is typically lower. That might help with the interest bill, but it would make America’s debt far more vulnerable to changes in interest rates, known as “rollover risk”. If the Fed wanted to look less meddling, the natural thing to do would be to rejig its holdings to match the maturities of the overall stock of Treasuries outstanding. That would leave it holding less long-term debt and more bills. A retreat from long-term bonds would probably have the opposite effect to that of its buying spree: interest rates on such bonds would have to go up to persuade private investors to pick up the slack. The Fed’s share of the Treasury market has already been declining, from 26% of Treasuries in 2022 to just 12% today. (The Fed’s balance-sheet has shrunk too, as it has let bonds it holds mature without replacing them, at the same time as the federal debt has surged.) If the government’s borrowing costs rise, so do those of everyone with a loan in dollars. Researchers like Andrew Lee Smith of the Kansas City Fed and Victor Valcarcel of the University of Texas at Dallas have shown how reductions in the Fed’s holdings of Treasuries have led to higher long-term
interest rates, as investors face a less liquid Treasury market and a little less certainty about the future. The increase seems to have come through the term premium, a tough-to-measure residual that compensates investors for the various uncertainties of holding long-term bonds. Having a less active buyer in the Fed also increases risks to financial stability should there be a selling panic in Treasuries. Funding markets seized up in September 2019, causing the interest rates on overnight loans between large financial firms (known as the repo market) to spike dramatically, a problem which some economists attributed to the shrinking of the Fed’s balance-sheet. And the same market looked stressed again in the final quarter of last year, after the Fed had stopped shrinking its balance- sheet. In a moment of extreme dysfunction, most analysts believe the Fed would quickly reassert itself to bring stability back to the Treasury market. Mr Warsh himself has made clear that these moments are when the case for intervention is most compelling. “The Fed is always going to step in and do what it can, even if it blows up the balance-sheet,” says Darrell Duffie, an economist at Stanford University. “But even with all guns blazing it can’t stop Treasury-market dysfunction. It can only make it less bad.” Mr Duffie notes that despite the Fed’s intervention during the dash for cash in 2020, it took a number of weeks before the market returned to a state of relative normality. Nellie Liang, a Treasury official during the Biden administration, says that in a fresh crisis the Fed’s job would be complicated by a different set of economic conditions. When the Fed began buying Treasuries in huge volumes in March 2020, that suited both its monetary-policy and financial- stability objectives: soothing a chaotic market while boosting an economy in danger of freefall owing to the pandemic. Today, that would not be the case. Inflation remains stubbornly above the Fed’s target of 2%. If a Treasury-market blow-up were to come at the same time as a supply shock—a slump driven by sudden trade restrictions, or a surge in energy prices—the Fed’s goals would be in conflict.
Mr Warsh has talked about the Fed and the Treasury working together to avoid a clash of monetary and fiscal policy. That may mean a formal arrangement whereby they co-ordinate how much debt the Treasury plans to issue, at what maturities, and what debt the Federal Reserve plans to buy. But even without a formal understanding, there are ways in which the Fed’s and Treasury’s priorities may dovetail with one another. The Treasury debt held by the Federal Reserve has a much longer average maturity than the market more generally. If Mr Warsh nurses fears that the Fed is badly distorting financial markets, then holding more short-term Treasury debt and letting long-term bonds mature would more evenly spread the Fed’s large footprint. Although Mr Bessent criticised his predecessor, Janet Yellen, for raising the share of bills in total debt issuance from around 15% to 22%, the path he seems inclined to pursue looks likely to push it even higher still. If the amount of longer-dated debt issued by the Treasury does not increase, analysts at JPMorgan Chase, a bank, suggest that the percentage of issuance accounted for by bills would rise to 28% by the end of 2028. The share of bills was last so high in 2009 (see chart); the Treasury market was then around half its current size relative to the American economy.