By Daniel Kruger

One hurdle to a possible fix for recent volatility in the short-term cash markets: hedge funds.

Federal Reserve officials are considering a new tool to ease stresses in the market for Treasury repurchase agreements, or repos. Through the repo market, banks and hedge funds borrow cash overnight, while pledging safe securities such as government bonds as collateral. In September, an unexpected shortage of available cash to lend sparked a surge in the cost of repo-market borrowing, prompting the Fed to intervene for the first time since the financial crisis.

One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market's clearinghouse, the Fixed Income Clearing Corp., or FICC.

Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations -- repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower's default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.

The Fed's aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September's volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.

Yet the new approach could also create political problems for policy makers, analysts said. The problem centers on the central bank lending directly to hedge funds, the little-regulated investment vehicles that tend to serve wealthy or institutional investors.

The political backlash that followed crisis-era bank rescues hangs over policy makers' approach to the current problem, analysts said, even as officials work to ensure the smooth functioning of a key piece of the infrastructure underpinning financial markets. Some fear that lending directly to hedge funds could lead to the perception the Fed is fueling risky bets.

"There's a strong aversion to fat cat bailouts," said Glenn Havlicek, chief executive of GLMX, which provides technology to repo trading desks.

Many hedge funds trade in the cash market through sponsored repos. The clearinghouse sits between buyers and sellers to ensure that neither party backs out of the transaction. Records of cleared trades also are publicly available, improving the market's transparency.

The idea of using the clearinghouse appeals to some investors and analysts because the Fed has had trouble getting cash into the hands of the smaller banks, securities dealers and investors who need it the most.

That is because the Fed trades exclusively with a small group of large banks and securities firms, known as primary dealers. Even among these firms, activity is tightly concentrated. A study recently published by the Bank for International Settlements said that liquidity in the repo market rests in the hands of the four largest banks in the U.S. system.

Though hedge funds are key participants in the market -- where they both borrow and lend cash -- lending to them directly through the FICC would raise questions about whether the government was backstopping their bets, analysts said.

Hedge funds often use borrowed money to increase potential gains from investments, but that strategy can also magnify losses. Policy makers typically haven't encouraged the use of levered investment strategies. During the financial crisis, many said bets using borrowed money worsened the downturn.

Some investors say the connections between firms involved with sponsored repos make the distinction between lending to one or the other meaningless.

Gang Hu, a hedge-fund manager at WinShore Capital Partners, said he borrows cash in the repo market to increase the impact of his investments in Treasury-bond futures and other interest-rate products.

"They are reluctant to provide a tool that would allow" overall leverage to increase beyond current levels, Mr. Hu said. "The system cannot work without leverage, but a system with too much leverage is unstable."

Write to Daniel Kruger at Daniel.Kruger@wsj.com

Corrections & Amplifications

This article was corrected at 8:35 p.m. ET to reflect that hedge funds are little-regulated investment vehicles. The original version of this article incorrectly stated that they are unregulated in the sixth paragraph.