The US government is strengthening supervision of the $26 trillion US Treasury bond market.

On Tuesday, February 6, local time, the US Securities Regulatory Commission (SEC) passed the new regulations with three votes in favor and two votes against, requiring hedge funds and proprietary trading companies that regularly trade US Treasury bonds to register as traders. The new regulations will also apply to participants in other securities markets such as government bonds and stocks. This means that such agencies will face stricter regulations and higher compliance costs.

According to the media, the new regulations show that the SEC believes that the US treasury bond market and private equity industry need more “guardrails”. The new regulations may force dozens of institutions to register as traders and face new regulations that they were unable to face before. SEC Chairman Gary Gensler said that institutions registered as traders will be subject to various important laws and regulations that help protect the public, promote market integrity, and drive capital formation.

This new regulation will apply to many trading institutions that earn income through trading price differences, or companies interested in the best price or close to the best price of the same securities in both markets. Companies with assets under management of up to $5 million can be exempted from the new regulations. Since the relevant draft of the new regulations was proposed in 2022, the private equity industry and high-frequency trading institutions have been lobbying the National Assembly to oppose the new regulations. Some industry groups claim that the requirements of the new regulations pose an “existential threat” to certain trading strategies, and once the new regulations are implemented, they may prompt relevant financial institutions to flee the US market to avoid increased costs.

The final version of the new regulations introduced on Tuesday removed some of the most dissatisfied provisions in the industry, such as setting a monthly securities transaction scale of 25 billion US dollars as a condition to trigger registration as a trader, and so-called cumulative clauses that are more likely to be mandatory to register as a trader. However, companies that mainly profit by capturing the spread between trading prices will still be listed as traders by the SEC.

It is unclear whether the new regulations will be sufficient to avoid legal challenges. The private equity industry is already seeking to sue the SEC over the new regulations. The Alternative Investment Management Association (AIMA), an alternative investment industry organization, said it will review the final version of the new regulations and then consider what to do next. Jack Inglis, the head of the organization, said that although SEC American Oil has adopted some problematic provisions in the new draft regulations, the final version may still affect certain funds and strategies, so it may be necessary for relevant agencies to register as traders and government securities dealers.

According to some commentators, the introduction of the new regulations is not surprising, because in September 2019 and March 2020, base difference trading all triggered the Federal Reserve to take urgent action to bail out the market, and regulators have been looking for ways to resolve the problems of such transactions. Hedge funds and other institutions included in the SEC's category of traders this time usually use leverage of 20 times or more to exaggerate fluctuations as low as 1 basis point.

Financial blog Zero Hedge points out that some of the most aggressive hedge funds engaged in margin trading are those multi-strategy funds and so-called POD funds, or multi-manager strategy funds, such as Millennium, Citadel, Balyasny, Point73, and Exodus Point. The chart provided by it shows that the total assets managed under the supervision of the top five such funds exceed 1 trillion US dollars, which is equivalent to the underlying net assets using 6.3 times leverage.

The US Treasury Treasury Advisory Committee (TBAC) warned in a report released on January 30 this year that the hedge fund industry's margin trading leverage ratio is soaring, and concluded: “Relative value trading strategies are the most likely driving factor for structurally leveraged fund bears in US Treasury futures. It is recommended that the Treasury monitor some of the correlates reflected in treasury futures basis trading.”

According to the report, it was found that the leverage involved in hedge funds was as high as 20 times. The report acknowledged that repurchases and futures guarantees did allow funds to use higher leverage. Because “using this framework, 20 times leverage can generate an annualized excess return of 9% to 10%”, if nothing goes wrong. As in the early days of the COVID-19 pandemic in March 2020, this leveraging strategy exhausted equity, leading to financial pressure on the US financial market during that period.

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