Foreign Banks and Hedge Funds: The Fragile Plumbing of U.S. Treasury Markets – Diverting Capital from the Real Economy
JULY 14, 2025
By: Julie Wade | July 14, 2025
The U.S. Treasury market, often considered the bedrock of global finance, relies on a complex and fragile ecosystem of dollar funding and leveraged trading. Foreign banks and hedge funds play outsized roles in this system, not by facilitating productive investment in the real economy, but by channeling liquidity into speculative arbitrage that often diverts capital away from essential sectors like small businesses.
This article explores how foreign banks secure U.S. dollar funding, how hedge funds leverage these funds for Treasury arbitrage, and the systemic risks embedded in this dynamic, drawing on data from the Bank for International Settlements (BIS) and the New York Federal Reserve (NY Fed).
Foreign Banks: The Dollar Funding Conduit
Foreign banks are central to the U.S. dollar funding ecosystem, particularly in the interbank repurchase agreement (repo) market. Their reliance on USD liquidity stems from three primary sources:
Money Market Funds (MMFs): Foreign banks, such as BNP Paribas, Nomura, and Société Générale, tap U.S. MMFs through tri-party repo markets, pledging Treasuries as collateral to secure overnight funding. In 2024, foreign banks accounted for approximately 20% of tri-party repo volumes, with their share spiking during stressed conditions (NY Fed, 2024).
Foreign Exchange (FX) Swaps: Non-U.S. banks swap local currencies for USD to meet their dollar-denominated obligations, a practice that surges at quarter-ends when the cross-currency basis widens. BIS estimates show these banks held $15 trillion in USD liabilities in 2024, much of it funded via FX swaps.
Federal Reserve Swap Lines: During crises, such as the March 2020 pandemic shock ($450 billion in swap line usage) and the April 2025 collateral crunch ($200 billion), Fed swap lines provide critical USD liquidity to foreign central banks, which then on-lend to their domestic banks (Federal Reserve, 2025).
This USD liquidity is recycled into the U.S. financial system, particularly through repo agreements that fund leveraged players like hedge funds. BIS and NY Fed reports highlight that foreign banks dominate Treasury repo intermediation, handling ~60% of volumes during stress events (2020, 2023, April 2025), making them pivotal yet vulnerable nodes in the market.
Hedge Funds: Leveraged Arbitrage, Not Productive Investment
Hedge funds have become significant players in the Treasury market, holding over 10% of outstanding U.S. Treasuries, with up to $550 billion tied to cash-futures basis trades in 2024 (BIS, 2024). Contrary to narratives of passive yield-seeking, their activity is driven by arbitrage, specifically the cash-futures basis trade:
How It Works: Hedge funds go long cash Treasuries, funded through repo borrowing, and short Treasury futures to capture the spread (typically 5–20 basis points). Leverage of 50–100x is common due to the trade’s tight margins.
Counterparties: Foreign banks often provide the repo funding and serve as clearing members for the futures leg, creating a tight linkage between the two.
Market Impact: These trades create a long-only bias in Treasuries. Crucially, this activity represents capital being locked into financial arbitrage rather than being intermediated into productive credit channels, such as loans for small businesses, which are vital for economic growth and job creation. Hedge funds, by their nature, are engaging in speculative arbitrage, effectively competing with the real economy for scarce capital and financial capacity. Their large footprint amplifies yield shocks during deleveraging events, as seen in the September 2019 repo crisis, March 2020, October 2023 selloff, and April 2025 liquidity withdrawal.
This leveraged activity is not stabilizing demand but a pro-cyclical force that exacerbates volatility when repo conditions tighten or margin calls hit.
Systemic Risks and Fragility
The interplay between foreign banks and hedge funds creates a fragile architecture for Treasury market liquidity:
Dependence on Foreign Banks: Their reliance on Fed swap lines and MMF repo funding introduces moral hazard and vulnerability to global liquidity shocks.
Leverage Amplifies Volatility: Hedge fund basis trades, while profitable in stable conditions, unwind rapidly during stress, amplifying yield spikes and market dysfunction.
Opportunity Cost of Capital: The significant capital and financial plumbing dedicated to these highly leveraged arbitrage strategies represent an opportunity cost. This capital, rather than being deployed to support lending to small and medium-sized enterprises (SMEs) or other productive investments, is instead consumed by a low-margin, high-volume trading strategy with limited societal benefit beyond maintaining market liquidity in a specific, sometimes fragile, segment.
Regulatory Gaps: Current rules, including exemptions under the Volcker Rule, allow foreign banks to engage in proprietary repo activities, while hedge funds face minimal oversight for systemic risks.
These dynamics were evident in recent crises, where foreign bank intermediation and hedge fund deleveraging exacerbated Treasury market strains.
Policy Solutions
Addressing these risks requires targeted reforms:
Strengthen Oversight:
Tighten Volcker Rule exemptions to limit foreign banks’ proprietary repo activities.
Impose leverage caps on hedge funds’ basis trades through SEC or CFTC regulations, targeting those with systemic exposures (e.g., >$100 billion in Treasury positions).
Enhance Market Structure:
Expand central clearing for Treasuries (per the SEC’s 2023 proposal) to reduce reliance on bilateral repo chains and foreign intermediaries.
Establish a standing repo facility for non-bank institutions, allowing direct access to liquidity and bypassing foreign banks (NY Fed, 2023).
Limit Swap Line Dependence:
Restrict Fed swap line access during non-crisis periods to reduce moral hazard and encourage onshore USD funding.
Improve Transparency:
Mandate reporting of hedge fund leverage and foreign bank repo exposures via the Financial Stability Oversight Council (FSOC) or Office of Financial Research (OFR).
Conclusion
The U.S. Treasury market’s reliance on foreign banks for dollar funding and hedge funds for leveraged arbitrage creates a fragile, pro-cyclical system. While foreign banks channel USD liquidity through MMFs, FX swaps, and Fed swap lines, hedge funds’ basis trades amplify volatility rather than stabilize demand. This is not sound fiscal intermediation aimed at supporting broad economic activity, but rather a speculative loop that diverts capital and financial capacity from productive uses, such as lending to small businesses, and is prone to disruption. Targeted reforms—tighter oversight, central clearing, and reduced dependence on foreign intermediaries—can mitigate these risks, but implementation requires regulatory and political resolve.
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