Official data dramatically underestimates hedge funds' involvement in the Treasury market, Fed paper finds

By Vivien Lou Chen

Treasury Department data does not reflect how much hedge funds domiciled in the Cayman Islands are dominating the so-called basis trade, according to a team at the Federal Reserve.

Data from the U.S. Treasury Department is failing to capture Cayman Island hedge-fund exposures to Treasury securities.

Key Treasury Department data is massively underreporting the amount of U.S. government debt held by hedge funds registered and incorporated in the Cayman Islands, and is failing to reflect their heavy reliance on a controversial leveraged trade that has repeatedly alarmed regulators.

In a note released on Wednesday, a team at the Federal Reserve found that U.S. Treasury International Capital data appears to be "severely" undercounting the amount of Treasurys held by those hedge funds, to the tune of about $1.4 trillion as of the end of the 2024. In addition, the Fed team concluded that TIC data is not capturing just how much Cayman-domiciled hedge funds are dominating positions in the so-called basis trade.

Since at least 2018, U.S. regulators have periodically expressed alarm over the possibility that the basis trade could trigger wider financial instability during market downturns. The Treasury Department's press office did not immediately respond to a request for comment on Thursday. The U.S. government has been in a partial shutdown since Oct. 1.

The basis trade uses leverage to arbitrage the price differences between Treasury futures and cash Treasurys. It involves simultaneously buying a Treasury cash position and selling a Treasury futures position, and financing the trade by borrowing in the repo market to provide leverage. The unwinding of the basis trade was seen as a likely contributor to Treasury-market instability in March 2020, and the risk of a possible repeat following hedge funds' increased reliance on leverage drew scrutiny from the Fed's board of governors and the Treasury in 2023.Read: Hedge funds' use of leveraged Treasury trades needs 'diligent monitoring,' Fed paper says

TIC data is the main source of data on capital flows in and out of the U.S. It is used by policymakers, investors and researchers to understand the catalysts and impacts of cross-border flows and asset allocations among various countries and investor types.

The severe underreporting of Cayman-domiciled funds' Treasurys holdings presents "a major impediment for researchers, policymakers, and other data users seeking to analyze cross-border flows and their effects on the U.S. economy and financial markets," according to the note written by Daniel Barth, principal economist for the Federal Reserve Board; Daniel Beltran, a deputy associate director; Maria Perozek, chief of the board's Flow of Funds section; and others. The authors estimate that holdings of Treasury securities of Cayman-domiciled hedge funds stood at $1.85 trillion by the end of 2024, having climbed by $1 trillion since 2022.

"Our findings suggest that Cayman Islands hedge funds are, increasingly, the marginal foreign buyers of U.S. Treasury notes and bonds," the authors said. After factoring in an estimated underreporting of roughly $1.4 trillion, they wrote, the Cayman Islands "is in fact the largest foreign holder of U.S. Treasury securities - holding significantly more than China, Japan, and the United Kingdom," which currently rank as the three largest holders.

Hedge funds domiciled in the Cayman Islands held an estimated $1.85 trillion in Treasurys at the end of 2024, according to a note from the Federal Reserve.

Meanwhile, the gap between what's being reported in the Treasury Department's TIC data versus what's reported to the Securities and Exchange Commission has widened to almost $1.4 trillion as of the end of last year. "TIC data on Cayman Islands holdings of Treasuries do not appear to be picking up the Treasury transactions associated with the basis trade activity" that can be seen on the hedge funds' filings to the SEC, according to the Fed note.

While this roughly $1.4 trillion gap is not solely attributable to the basis trade, "the puzzling disconnect between the TIC and [SEC's] Form PF data on Cayman Islands' holdings of U.S. Treasuries is under active investigation," Barth and the other authors wrote.

The amount of Treasurys held by hedge funds domiciled in the Cayman Islands is far greater than what is being reported in the Treasury Department's TIC data, according to a note from the Federal Reserve.

On Thursday, investors digested a mix of worries about trade tensions between the U.S. and China, the partial government shutdown, and bad loans in the bank industry. U.S. government debt rallied, pushing the 2-year Treasury yield BX:TMUBMUSD02Y to a three-year low of almost 3.43% and sending the benchmark 10-year rate BX:TMUBMUSD10Y down to a one-year low of around 3.98%, as of 3 p.m. Eastern time. All three major U.S. stock indexes DJIA SPX COMP finished lower.

-Vivien Lou Chen

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10-16-25 1607ET