Thinly capitalized hedge funds’ growing role in the enormous and rapidly expanding market for US Treasury securities poses a clear and present danger to financial stability that warrants a new approach from the Federal Reserve during times of extreme market stress, according to a paper from Brookings.
The Federal Reserve, in periods of extreme stress, should be prepared to take over the hedge funds’ positions. As before, the Fed could stand ready to purchase Treasury securities but it would also, as the hedge funds do, take offsetting short positions in derivatives.
The primary advantage of that approach for the Fed, according to the paper, is that the purchases would be self-liquidating because the reversal of the securities purchases would be embedded in the short positions in derivatives. The Fed would not, as it has had to do during the COVID-era, worry about how to reduce its holdings once market stress subsides. And, because the purchases would be hedged, the Fed would not have to take a loss on those holdings if it has to raise interest rates to quell inflation, as it did in the aftermath of the pandemic.