battle3penn| ECB points out underlying trading risks in European government bond market

A leveraged trading that worries regulators around the worldbattle3pennAttention from the European Central Bankbattle3pennThere are signs that this strategy is becoming increasingly popular in Europe.

The European Central Bank pointed out that a group of offshore hedge funds are increasingly appearing in the European government bond repo market, indicating the increasing use of so-called basis transactions. The strategy, which aims to take advantage of price differences between futures and bonds, came under intense scrutiny in the United States after triggering market turmoil when the COVID-19 epidemic began in 2020.

A report released by the European Central Bank on Friday showed that most of the hedge funds are registered in the Cayman Islands, and more than half of the investment funds hold positions in euro zone government bond futures. They also dominate almost all activity by non-EU investment funds in the eurozone government repo market.

The ECB downplayed the potential threat posed by basis trading, pointing out that the ECB's basis trading is smaller and its net futures positions are more balanced than in the United States. This may reflect a number of factors, including the lower degree of market distortion required for the strategy to generate returns and the higher cost of arbitrage, the report said.

Central bank analysts also warned that other hedge fund investment strategies could pose greater risks. They said that includes leveraged directional trading, which could trigger a price spiral as traders rush to close their positions.

ECB analysts wrote that leveraged trading "poses a higher risk to financial stability than basis trading." "If these entities face liquidity constraints in the U.S. Treasury market, the spillover effect on the eurozone government bond market could be amplified."

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