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What Is Arbitrage? Hedge Funds Are Picking Up Pennies In Front Of A Steamroller

Hedge funds, especially “Relative Value” hedge funds, engage in something called financial arbitrage. Due to the sheer size of their exposure to currencies and bond markets, they put the entire financial system at risk. In normal market conditions, everything is fine. But rare events aren’t all that rare, and “risk-free” trades usually have the capacity to blow up. I recently posted a podcast episode about this, as well as a YouTube video which is embedded below.

Suffice it to say that, once again, hedge funds are engaging in a strategy that is like picking up pennies in front of a steamroller. It’s basically free money, until it blows up in your face.

If you aren’t familiar with the word “arbitrage”, Webster defines it as “the simultaneous buying and selling of [something] in order to take advantage of different prices for the same asset.” In the case of modern hedge funds, this something is usually either currencies or bonds.

If you can buy and sell something, at the same time, and there is a small difference in the price, you get to pocket a risk-free profit. So what is the problem? The profit is extremely small.

Enter leverage. If I only use my own money to participate in this arbitrage play, I might make less than 1% on my money. Not a good return. However, my trade is “risk-free”, right? So I go to the banks and show them what I’m doing. With the Fed keeping interest rates artificially low, banks are forced to lend in higher amounts to make up for what they aren’t getting in interest.

Lending to a hedge fund large amounts of money that they are using for a risk-free trade seems like the perfect destination for banks to deploy their cash. With the influx of other-people’s-money on top of their own, hedge funds multiply their own performance.

Cheap debt to get free money from risk-free trades seems like a great plan. Therefore, everybody does the same thing. Here’s where the steamroller comes in.

What happens when they need to unwind their positions? Theoretically, they will never have to. They are long and short (they own and owe) the exact same thing. Their positions are netted out against each other. So why would they have to close out the trade? Why not just let them the positions expire naturally?

Well it turns out they aren’t long and short the exact same thing. Only very similar things. Say, long US government debt which carries a positive interest rate, and short Denmark debt with a negative interest rate.

Let’s say there is a currency crisis, or a sovereign debt crisis, or even just a cash crunch that causes hedge funds to need to close out some of their positions early. What does that do to the prices? Well if I own a US treasury, I have to sell it to close it out. That will slightly drive down the price. Enough people doing that at the same time could drastically drive down the price.

Nothing fundamental has to change in the world at all, and you could have a domino-effect where hedge funds are forced to close out these massive positions, crushing the bond markets. As the prices move more and more, the losses look worse and worse for all the other hedge funds. That forces them to close some of their own. Which moves the prices even more.

Now you see why the Fed is dumping so much free money into the repo market. The repo market is where hedge funds go for daily cash needs. If they can’t get easy cash, they might have to close some of their positions to free up cash. If enough of them have to do that at the same time, the global bond markets might begin an avalanche.

Oh and one last thing. Just in case you think “well, that’s just the bond markets, at least it isn’t the stock market.” The total size of the stock market is about $30 trillion. The total size of the bond market is estimated at over $40 trillion. So if the bond market goes into turmoil, it’s not just pensions and 401(k)’s that get crushed. It’s sovereign funds, central banks, and global liquidity that gets crushed too.

Well, there you have it. That is arbitrage, and that’s how hedge funds have the markets near the edge of a cliff. It’s also how they have the Fed at their beck and call. The standing bailout waiting to happen for any institution that puts the system at risk is sure a nice safety net to fall back on.

Too bad we’ve been bailing out firms for decades instead of letting them collapse in isolation. The moral hazard caused by government support can never be regulated away. Much better to let them have skin in the game. If they take on too much risk, they fail in isolation. At this point though, if they do fail, they are taking us all with them.

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1 thought on “What Is Arbitrage? Hedge Funds Are Picking Up Pennies In Front Of A Steamroller

  1. Great content! Super high-quality! Keep it up! 🙂

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