(Bloomberg) -- Top US regulators are zeroing in on dangers posed by highly leveraged hedge fund trades, and considering options to rein in risks to the broader financial system.

Regulators are especially concerned about the growth of one strategy known as the basis trade, which involves the use of leverage to profit from the price gap between Treasury futures and the underlying cash market. Borrowing in the repurchase market using US Treasuries as collateral has soared in recent years to almost $3 trillion.

Although hedge funds are subject to less direct regulatory oversight, they rely on highly regulated large banks to finance many of their trades. That gives several US agencies sway to limit the activity, and in early-stage plans, regulators are weighing options ranging from pushing banks to gather more data on exposures to pressing them to ramp up haircuts on some secured borrowing, according to people familiar with the matter.

Securities and Exchange Commission Chair Gary Gensler this week sounded the alarm bells. He said on Wednesday that the funding that prime brokerages provide to some hedge funds on a “very generous basis” is the biggest source of risk in the financial system. “If a problem happens, it’s going to be the public that bears the risk of any challenges in this market,” Gensler said in an interview.

Officials across Washington, including Gensler, have for months flagged significant blind spots into hedge fund trading. 

The SEC, which has jurisdiction over bond trading and oversees investment companies, is seeking rule changes to bolster visibility. The US Financial Stability Oversight Council, which is led by Treasury Secretary Janet Yellen, has formed a hedge fund working group. Last month, Federal Deposit Insurance Corp. Chairman Martin Gruenberg flagged high levels of leverage as a particular concern.

Representatives for the Treasury, FDIC and Federal Reserve, which is responsible for ensuring safety and soundness in the banking system, declined to comment.

Repo Borrowing

Some US officials have recently discussed a 2 percentage-point haircut on Treasury repo borrowing, according to one of the people, who asked not to be identified discussing private conversations. 

The idea of a hypothetical minimum haircut of at least that size was floated in a research note by two Fed staffers last month.

Under that scenario, the note suggested a prime brokerage would only extend $100 in financing if a hedge fund posted $102 of collateral in a Treasury repo transaction. The hedge fund would have to shoulder the remainder from its own capital, effectively increasing the cost of leveraged trading.

The Fed research found that most funds could handle the lower leverage levels. However, it could make trades less profitable and desirable, the research found.

Today, many hedge funds are able to borrow the full amount of their Treasury purchases by pledging the bonds as collateral in repo transactions, allowing the hedge fund industry to obtain an aggregate 56-to-1 leverage on $553 billion of Treasury repo borrowing as of December, the note said.

In addition to using existing bank supervisory authorities to make it more expensive for hedge funds to finance leveraged trades, officials have been discussing ways to press banks to require consistency in data they gather from counterparties like hedge funds, said another one of the people. Some officials also want FSOC to look for risks stemming from relationships between hedge funds and their prime brokerages, another person said.

Interest Rate Exposure

Advocates for hedge funds say the basis trade serves an important market function by allowing insurance companies and pension funds to manage their interest-rate exposure, and any moves to crack down on it could have unintended consequences.

“Leverage enhances market efficiency by increasing liquidity, dampening volatility, and enhancing capital allocation,” said Bryan Corbett, who leads the Managed Funds Association trade group. “Leverage, in and of itself, does not present a financial stability risk.” He added that clamping down could drive up government borrowing costs.

But regulators discussing options within their current powers over banks indicates they want to address the risks without having to wait for more sweeping proposals that face legal pushback and bureaucratic lags.

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Because the activity is being driven by investment firms that face less scrutiny than banks, regulators say it’s harder to know exactly how much risk is actually building up and where it lurks. 

The ultimate fear is a repeat of 2020, when the outbreak of the pandemic upended the Treasury market and caught hedge funds wrong-footed, eventually leading to an intervention by the Federal Reserve to restore normalcy.

“Regulators are right to focus on the relationship between leverage at nonbanks, especially hedge funds, and the banking system,” said Lev Menand, an associate professor at Columbia Law School, who teaches about financial institutions and administrative law. “Bank regulators can use their supervisory powers to examine and assess the safety and soundness of prime brokerage businesses and bank lending to hedge funds.”

Times of Stress

The hedge fund working group at FSOC, whose members include Treasury, the Fed, SEC and the FDIC, flagged the basis trade in April as a potential danger in times of stress. 

Data published by Treasury’s Office of Financial Research show that transactions of repurchase agreements secured by US Treasuries and settled in tri-party repo have surged in the past two years, an indicator of the basis trade’s surge in popularity, though the volume has declined in the last few months.

Meanwhile, a sweeping effort by the Biden administration to develop a blueprint for sticking firms other than banks, including possibly hedge funds, with the too-big-to-fail tag is underway. That bid, however, faces fierce legal challenges as industry titans are already preparing to fight any attempts to stick them with that systemically important label and Fed oversight. 

Karen Petrou, a managing partner at Washington-based consulting firm Federal Financial Analytics Inc., says that regulators are aware of the difficulties of imposing major rule changes or designating firms.

“The banking agencies know this,” she said. “Short of these new tools, then, regulators are hoping to reduce counterparty risk by using their existing powers.”

--With assistance from Hannah Levitt, Hema Parmar, Liz Capo McCormick, Edward Bolingbroke and Viktoria Dendrinou.

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