(Bloomberg) -- A leveraged trade that's worrying regulators worldwide has caught the attention of the European Central Bank, which pointed to signs the strategy is gaining traction in the region.
The ECB noted a group of offshore hedge funds has become increasingly present in Europe's government bond repo market, suggesting growing use of the so-called basis trade. The strategy, which looks to exploit price differences between futures and bonds, has come under scrutiny in the US after it contributed to market turmoil at the start of the pandemic in 2020.
The hedge funds in question are mostly domiciled in the Cayman Islands and hold more than half of investment funds' positions on euro-area government bond futures, according to an ECB report published on Friday. They also account for almost all the activity of non-EU investment funds in the region's government repo market.
The ECB downplayed the potential threat posed by the basis trade, noting it was being conducted on a smaller scale, and with more balanced net futures positions, than in the US. That may reflect factors including the smaller market distortions required for the strategy to pay off, and the higher costs of arbitraging, according to the report.
The central bank analysts also warned that other hedge fund investment strategies could pose a greater danger. Those include leveraged directional trades, which can trigger price spirals as traders rush to unwind bets going the wrong way, they said.
Leveraged trades are “associated with higher financial stability risks than basis trades,” ECB analysts wrote. “Spillovers to the euro area government bond market could be amplified, should these entities face liquidity strains in the US Treasury market.”
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