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Securities and Exchange Commission (SEC) Chairman Gary Gensler is used to ruffling the feathers of some of the most powerful men in finance, if not the planet. There’s his well-reported unpopularity with the crypto crowd, for one, and there’s noted disagreements with figures such as Marc Andreessen over whether AI could cause a market crash. But now he’s locking horns with Ken Griffin, the founder of market-maker Citadel Securities, the hedge fund Citadel, and the owner of the best annual performances in hedge fund history. The billionaire has adamantly opposed rule changes proposed by Gensler for the world’s greatest safe haven market: the multitrillion-dollar trading of Treasurys.

Griffin believes some of the SEC’s new rules could end up costing taxpayers tens of billions of dollars while raising borrowing costs for businesses. “The SEC is searching for a problem,” he told the Financial Times on November 5. The comments follow the hedge funder’s rebuke of Gensler at the Robin Hood Investors Conference in New York in late October, where he described the SEC chair’s regulatory efforts as “utterly beyond me.”

Of course, if the SEC gets its way, it would also be a serious issue for one of Citadel’s most profitable plays, the so-called Treasury basis trade.

The shadowy, extremely profitable trade that can go very wrong

The crux of the argument between Gensler and Griffin has to do with hedge funds’ tactic of shorting Treasury futures and then buying the corresponding Treasury bond in order to profit from the small difference (called the spread) between the two using some serious leverage. This is called the Treasury basis trade.

The problem is that when the spread in this trade widens during times of economic stress, like it did in March 2020 due to COVID-19 as investors rushed to get cash by liquidating Treasuries, the cost of borrowing for hedge funds using the basis trade goes up. This forces many to exit their positions, which leads to a further increase in spreads and a negative feedback loop that can cause serious liquidity problems in the Treasury market.

Given these risks, Gensler is worried about the size of the basis trade and the leverage used by hedge funds to execute it—and so is the International Bank for Settlements. The international institution that facilitates transactions between central banks warned in a September report that the “current build-up of leveraged short positions in U.S. Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger.”

Griffin argues that the Treasury basis trade actually works to keep spreads low, enabling the Federal government to issue new debt at a lower cost. That’s because when hedge funds buy Treasuries to pair with their short positions in the basis trade, it puts downward pressure on spreads and yields.

Griffin told the Robin Hood Investors Conference in October that the SEC is “consumed with this theory of systemic risk from this trade,” but the reality is taxpayers save “billions of dollars a year by allowing this trade to exist.”

Citadel isn’t the only user of the Treasury basis trade; other major players in the market include Millennium Management, ExodusPoint Capital Management, Capula Investment Management, and Rokos Capital Management. And Griffin believes that if the SEC implements new rules that increase borrowing costs for these hedge funds’ favorite trade, it could cause a minor credit crunch.

Leveraged Treasury futures contracts enable hedge funds to gain exposure to the Treasury market without putting down as much initial capital. That leaves them with more cash to invest or loan out elsewhere.

“If the SEC recklessly impairs the basis trade, it would crowd out funding for corporate America, raising the cost of capital to build a new factory or hire more employees,” Griffin told the Financial Times.

Wider fears beyond Gensler

Still, it’s not just Gensler and the BIS who are worried about the Treasury market. The SEC, Treasury Department, Federal Reserve, Federal Reserve Bank of New York, and Commodity Futures Trading Commission have all been working together over the past two years to implement rule changes that are supposed to “enhance the resilience of the U.S. Treasury market.” The Inter-Agency Working Group gave an update on the measures they’ve implemented so far, as well as those they plan to implement, in a report on November 6.

In his November 7 speech at the Securities Industry and Financial Markets Association, SEC Chair Gensler detailed some of his thoughts on how the Inter-Agency Working Group could improve the “efficiency and resiliency” of the Treasury markets, including his views on four specific reform initiatives: the registration of dealers, the registration of trading Platforms, central clearing, and data collection.

Two out of the four initiatives Gensler discussed are likely to get Griffin up in arms. First, is a rule that the SEC finalized in May which requires hedge funds and private equity funds to make current reports on key trades in the Treasury market to the SEC. The goal is to make the market more transparent, but hedge funds have pushed back due to the expected costs of the reports and the already laborious standards in the bond market that require mountains of paperwork to be submitted to regulators.

Second, Gensler wants to make hedge funds that operate in the Treasury market register as broker-dealers in order to increase the regulatory oversight they face. But Griffin said that regulators should be looking into the banks that loan money to hedge funds to facilitate the Treasury basis trade instead of hedge funds themselves, arguing it would be “a much more cost-effective way to address any concerns that the SEC or other regulators in this space might have.”

“If regulators are really worried about the size of the basis trade, they can ask banks to conduct stress tests to see if they have enough collateral from their counterparties,” he told the Financial Times on November 5.

Despite the criticism from Griffin, Gensler was defiant in his November 7 speech. “We can’t stop our focus on reforms to bring greater efficiency and resiliency to the highly consequential Treasury markets,” he said.