To understand and anticipate liquidity risk events, we believe it is critical to understand and track (to the extent possible) hedge fund repo borrowing in global markets.

This is because hedge funds are the largest drivers of the carry trade focused on the S&P 500 index and its associated VIX volatility index. And the VIX carry trade (selling VIX options with moderate implied volatility, while buying back those options as the option expiration date draws close) provides structural support for sustained growth of the S&P 500, almost irrespective of interest rates or any other factors.

Validation for this statement can be seen from comparing the VIX index for 2023–low volatility–with the S&P 500 index for the same period–continuing to chug upwards. This is the carry trade in action!

Where do hedge funds access the capital required for large-scale VIX carry trades?  Almost certainly through the non-cleared bilateral (unregulated) repo markets.

However, hedge fund borrowing is not well understood by regulators or the investing public, since data is kept closely guarded. What regulators do know is that hedge fund borrowing in the cleared (transparent) portion of the repo markets is but a small fraction of total hedge fund repo borrowing. The vast majority of hedge fund repo borrowings are in the non-cleared bilateral (opaque) repo markets.  See chart, below ↓

As shown by the chart above, cleared reverse repo borrowing–shown in dark blue–is but a tiny fraction of estimated total hedge fund borrowing.

The Treasury Dept. Office of Financial Research (OFR) assesses that daily repo borrowing in all repo markets is $4 trillion per day, and that the non-cleared (opaque) bilateral market makes up over half of total repo borrowing — or $2 trillion per day.

[Latest (March 2023) data from a survey of repo lenders conducted by International Capital Market Association (ICMA) shows that the cleared repo segment has dropped significantly in the last year, while the OTC non-cleared market has risen substantially. This means that unregulated and unreported repo borrowing is, by far, now the largest segment of repo.]

This is a massive amount of unregulated borrowing that receives almost no attention in the press or scrutiny from regulators. Regulators and press seem to focus on the cleared portion of repo that is visible, and ignore the very large portion of repo that is not visible, that they cannot control.  But this is a flawed approach to reporting risk. The risk of non-cleared repo is a very real and very large one, even if regulators do not address it.

The biggest problem in the non-cleared bilateral repo market is that repo borrowing can be supported by low-quality collateral (unlike trades in the cleared markets). And so, hedge fund borrowers are allowed to post sketchy collateral, with dubious fair market value, including structured products and other questionable derivatives. Failure of low-quality collateral has been directly responsible for liquidity crises, including those in 2007-08 and 2019-2020.


In our analysis:

→ sustained growth of the S&P 500 index supports practically the entire US economy, both through direct investment and through hedging activities for other investments

→ the “carry trade” is the biggest driver of S&P 500 index growth

→ hedge funds are the biggest speculators in the carry trade and

→ hedge fund borrowing comes largely from the repo markets

Therefore this chain of causality assists in understanding and prediction of liquidity risk.  At Tidepool, this chain of causality remains an important focus of research and regular updates.