A recent proposal from a former Federal Reserve official has sparked intense debate within financial circles: should the Fed establish a bailout mechanism for a select group of hedge funds deeply entwined in the U.S. Treasury market? The idea, outlined in a Brookings Institution paper co-authored by Harvard’s Jeremy Stein, a former Fed Governor, suggests that such a facility could prevent a repeat of the chaos seen in March 2020, when Treasury market liquidity evaporated amid soaring interest rates. But beneath the surface of this technical fix lies a far more troubling story—one that the Fed and its allies seem reluctant to confront. This isn’t just about hedge funds or market mechanics; it’s about a recurring, systemic flaw in the global financial system: the persistent shortage of dollars.

The Surface Proposal: A Hedge Fund Lifeline

The proposal focuses on roughly ten hedge funds heavily engaged in what’s known as the “basis trade”—a sophisticated arbitrage strategy exploiting price differences between Treasury futures and cash Treasury securities. In March 2020, these funds faced a liquidity crunch that forced them to unwind positions rapidly, exacerbating a broader Treasury market meltdown. The Brookings paper argues that a Fed facility to purchase Treasury securities and offset them with futures sales could stabilize the market during such unwinds, easing pressure on bond dealers overwhelmed by sudden transaction volumes.

Jeremy Stein’s involvement lends the idea credibility. Having served on the Fed’s Board of Governors until 2014, his voice carries weight, suggesting that discussions within the Fed may already be underway. The basis trade, now ballooning to an estimated $1 trillion—double its size in 2020—has become a recurring concern, with studies and official comments since then repeatedly flagging Treasury market fragility. But is this bailout plan a genuine solution, or merely a distraction from a deeper, more intractable problem?

The Basis Trade Explained

At its core, the basis trade is straightforward. Hedge funds exploit a pricing mismatch: Treasury futures are often more expensive than their cash equivalents. To profit, they short the futures and buy the underlying Treasuries, funding the purchases through the repo market—a short-term lending system where securities serve as collateral. With well-connected funds securing “zero haircuts” (no upfront equity required), the leverage is immense. A few basis points of profit, amplified by this leverage, translate into substantial returns with seemingly minimal risk, as futures and cash prices converge over time.

Yet this strategy hinges on the repo market’s stability. When repo funding dries up—as it did in March 2020—funds must liquidate their Treasury holdings en masse. This fire sale, combined with rising bond yields during a supposed “flight to safety,” baffled observers at the time. The Fed stepped in with emergency interventions, but the episode exposed vulnerabilities that linger today. The proposed bailout facility aims to address this symptom, but it sidesteps the root cause.

Beyond Hedge Funds: The Dollar Shortage Dilemma

Dig deeper, and the real story emerges—not in the hedge funds’ selling, but in what triggered it. In March 2020, the global financial system faced an acute dollar shortage. As pandemic fears gripped the world, lockdowns loomed, and uncertainty spiked, the demand for dollars—the lifeblood of international trade and finance—surged. Foreign central banks and asset managers, desperate to secure dollars for their local systems, began offloading U.S. Treasuries. These weren’t the highly liquid, newly issued “on-the-run” securities, but older, less-traded “off-the-run” ones, which flooded dealer balance sheets.

Dealers, in turn, relied on the repo market to finance these purchases, but that market was seizing up amid the same dollar scarcity. Unable to roll over their funding, they too began selling Treasuries. Hedge funds, caught in the same repo squeeze, added to the deluge. The result? A cascade of sales that overwhelmed the Treasury market, driving yields up when they should have plummeted. The Fed’s own March 15, 2020, meeting minutes acknowledge this: “An acute decline in market liquidity” stemmed from “sales of off-the-run Treasury securities” and “deteriorating conditions in short-term funding markets”—code for a dollar shortage.

A Pattern of Denial

This wasn’t an isolated incident. Rewind to October 2008, during the depths of the financial crisis. As Lehman Brothers collapsed and global markets imploded, Treasury yields defied expectations. From mid-September to late October, the 10-year Treasury yield spiked from 3.41% to over 4%, despite a supposed flight to safety. Why? Foreign reserve managers, facing another massive dollar shortage, dumped Treasuries en masse. The Fed’s dollar swap lines—touted as a lifeline—ballooned from $62 billion to $407 billion, yet the selling persisted. The Treasury market didn’t break; it was choked by a dollar drought the Fed couldn’t quench.

Fast forward to late 2024 and early 2025. Between November and January, 10-year Treasury yields climbed from 4.15% to nearly 4.8%, puzzling analysts who blamed inflation fears or Fed policy shifts. Yet Federal Reserve Bank of New York custody data tells a different tale: foreign-held Treasuries dropped sharply, mirroring patterns from 2020 and 2023. Another dollar shortage, quietly unfolding, forced reserve managers to sell again. The Fed’s tools, from swaps to QE, failed to stem the tide once more.

The Fed’s Blind Spot

Why does this keep happening? The Fed’s inability to address dollar shortages reveals a stark truth: it’s not the omnipotent central bank it’s portrayed to be. The global dollar system—built on Eurodollars and shadow banking—operates beyond its control. When crises hit, foreign entities don’t hoard liquid Treasuries; they sell what they have, often illiquid securities, to raise dollars the market can’t provide. The Fed’s response—be it swaps, QE, or now a hedge fund bailout—treats symptoms, not the disease.

The basis trade itself is a symptom of this broken system. Post-2008 regulations constrained bank balance sheets, limiting dealers’ ability to absorb Treasury issuance. Hedge funds stepped in, leveraging the basis trade to fill the gap. But their reliance on repo—and repo’s vulnerability to dollar shortages—creates a feedback loop of instability. Bailing them out might delay the next crisis, but it won’t prevent it.

A Call for Reckoning

The Brookings proposal, while well-intentioned, is a Band-Aid on a gaping wound. It focuses on the endgame—hedge fund sales—rather than the trigger: a dollar system prone to shortages. A true central bank would tackle the source, stabilizing global dollar flows before they spiral into Treasury market chaos. But the Fed, as history shows, lacks the tools or will to do so. Instead, it opts for optics—PR campaigns disguised as policy—to mask its limitations.

This isn’t just a technical debate; it’s a systemic crisis begging for a reset. The dollar’s dominance, once a strength, now breeds fragility. Until policymakers confront this—rather than scapegoating hedge funds or tinkering with bailouts—the next March 2020 looms inevitable. For now, the Fed prepares to mop up the mess, but the real question remains: who’s brave enough to fix the plumbing?

Conclusion

As the Fed weighs its next move, the public deserves more than jargon-laden distractions. The hedge fund bailout debate is a sideshow; the dollar shortage is the main act. On March 29, 2025, with the global economy still haunted by 2008’s ghosts, it’s time to stop papering over cracks and start asking why they keep appearing. The Treasury market isn’t broken— the system sustaining it is.