Citadel Draws Fresh Scrutiny from SEC in New Risky Bets

Citadel amongst other hedge funds is under fresh scrutiny from the SEC due to risky bets that are heightening systemic risk in an already shaky economy.

Officials at the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about leveraged trading as “the dangers have been heightened due to political brinkmanship around the debt ceiling that has threatened to sink the US into default and unleash chaos in financial markets”, per Bloomberg.

“Several of the hedge funds that have recently pursued the so-called basis trade were also active in 2020, when the outbreak of the pandemic upended the Treasury market and caught them wrong-footed until Fed officials intervened to restore normalcy.”

Basis trading is a trading strategy that seeks to profit from perceived mispricing of securities, capitalizing on small basis point changes in value.

The list includes Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, according to people familiar with the matter.

“Opaque and risky, the strategy has long spooked watchdogs. It involves borrowing heavily in the repurchase market and using that leverage to exploit the price gap between Treasury futures and the underlying cash market.

The trades, in some cases, have been levered 50-to-1, according to two of the people,” says Bloomberg.

The strategy’s popularity is alarming to SEC Chair Gary Gensler, who is on a mission to subject large speculators to more regulations.

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

The Fed Has Gotten Involved

The New York Fed said in a statement that it “regularly reaches out to a wide range of market participants to gather information on financial market developments, and this outreach is consistent with typical market intelligence gathering.” 

Officials have been asking about current margin requirements and how a default, or a downgrade to the US’s credit rating, would impact the market plumbing including the value of collateral, the people said. 

“Financial watchdogs are under pressure after having been blindsided repeatedly by instability in the bond market since the pandemic erupted”, says Bloomberg.

Fed officials at the policy meeting earlier this month expressed concerns about the risks lurking outside the banking system in light of recent financial stresses. 

Minutes released Wednesday singled out “hedge funds, which tend to use substantial leverage and may hold concentrated positions in some assets with low or zero margin.”

This means hedge funds such as Citadel and Millennium have been able to short the markets with unlimited leverage and low to zero margin to hold them accountable for any particular losses.

The question is why have regulators allowed this risky strategy to occur in the markets for too long.

Hedge funds such as Citadel have been targeting small cap companies in efforts to profit big from the possibility of bankruptcy.

The hedge fund recently became known for shorting and capitalizing from a cancer research company.

Northwest Biotherapeutics sued Citadel for market manipulation entering the new year.

Will Anything Be Done About Citadel’s Risky Bets?

ExodusPoint and Capula were caught out while Millennium closed several so-called trading pods in the crisis.

“For Citadel, the impact was smaller. The firm’s current positioning in the trade isn’t the largest it’s been historically,” one of the people told Bloomberg.

Representatives for Citadel, Millennium, ExodusPoint and Capula declined to comment on their current exposures.

The increase in short-futures positions by hedge funds that use massive leverage is hitting records.

“That’s a sign speculators are seeking to profit from a mismatch in pricing between Treasury futures and the cash market. Since the strategy typically yields minuscule returns, hedge funds borrow in the repo market to amplify gains,” says Bloomberg.

A new intraday margin call rule is hitting Wall Street hard as the SEC plans to bolster the resiliency and integrity of the market.

The U.S. Securities and Exchange Commission last week voted on the proposal that would require clearing houses to monitor margin exposures on an ongoing basis and give them the authority to make intraday margin calls as frequently as circumstances warrant, per Reuters.

The new intraday margin call rule was inspired by the ‘meme stock’ frenzy of 2021.

Specifying the ongoing monitoring of intraday exposure, and under what circumstances intraday margin calls would be made, would strengthen clearing houses’ risk management and give greater transparency around how they manage intraday risk, the SEC said.

“Intraday margin calls have been important in our markets just in the recent past,” SEC Chair Gary Gensler said during a SEC open meeting ahead of the vote on the proposal.

However, that regulation won’t go into effect until the end of the year.

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