Hedge funds drive Treasury market - Their behavior may create market dislocations

Solve one supposed problem and you may create another, the law of unintended consequences. Banks used to be the key driver of trading in Treasury, but that has changed with Dodd-Frank and other bank regulation. In its place, hedge funds have become the dominate player in active trading. A change in players with different capital commitments and trading objectives will spill-over to issues of pricing and liquidity. This switch to hedge funds has not been an overnight change, but hedge fund gross Treasury exposures have risen to $2.4 trillion in 2020 with a large focus on relative value arbitrage between cash and futures supported through repo funding. Treasury trades by hedge funds were crowded before the March pandemic. 

New analysis has found that hedge fund Treasury exposures declined significantly in March 2020 as returns from basis trading and RV trading declined. See "Hedge fund Treasury trading and funding fragility: Evidence from the COVID-19 Crisis". The threat to market liquidity from changes in hedge fund exposures is significant. Highly levered hedge fund trading will be sensitive to performance and will impact the trading of other Treasury market players when there are large position adjustments. The Treasury market may be more sensitive to macro surprises that impact the yield curve and financing. This places greater pressure Treasury dealers and increase risk premia especially for off-the-run Treasury issues. 

Market structure is a critical component for understanding the changing sensitivities of prices to market information.