The Treasury basis trade plays an important role in US bond markets, finance industry executives told an ISDA conference on Tuesday, arguing the popular hedge fund arbitrage strategy increases price discovery for Treasuries and helps trading desks manage client flows.
The comments follow growing regulatory scrutiny of the Treasury basis trade, where hedge funds look to profit from small differences in the prices of Treasuries and futures contracts using borrowed money. A steep rise in net short positions in Treasury futures suggests the size of those positions has expanded considerably this year, sparking fears that a sudden, widespread unwinding of the trades could trigger the kind of wild swings seen in Treasury markets in March 2020 at the start of the pandemic.
“The Treasury basis trade has been around at least for four decades and during this time it has performed a very important function connecting the cash and futures market, helping to enhance liquidity and price discovery,” said Agha Mirza, global head of rates and over-the-counter products at CME Group, operator of the exchange where Treasury futures trade.
Regulators including the Bank for International Settlements have flagged concerns over the growth in the Treasury basis trade this year and the potential for these highly leveraged bets to cause disruption in the US bond market.
Hedge funds implement basis strategies by buying Treasury bonds and placing short positions through futures contracts to take advantage of price discrepancies between the two markets. The BIS said in a September paper that leveraged funds had built up net short positions in Treasuries of about US$600bn, with more than 40% of the exposure concentrated in two-year contracts.
The concern is that hedge funds may have to sell large quantities of Treasuries if they start to lose money on the trades and need to unwind them quickly. That happened in March 2020 when markets swooned at the start of the pandemic, prompting the US Federal Reserve to step in and calm markets.
Mirza said the pandemic was “perhaps the biggest shock in a century”, with sharp downgrades to economic growth forecasts triggering a sell-off in riskier assets and a dash for cash. “The Treasury basis trade was also part of the market that was impacted. But that doesn’t mean that its usefulness is diminished,” he said.
Mirza said that bets against Treasuries in futures markets, as measured by net short positions, have risen to about 5% of marketable Treasury debt. That compares with previous highs of more than 6% in 2019 and 2020. The value of marketable Treasury debt has roughly doubled over the past decade to US$23.2trn, according to the St Louis Fed.
“A marketplace is formed by various trading strategies, various types of participants doing what they need to do and all of that collectively leads to price discovery and liquidity,” said Mirza. “As the marketable debt is increasing, each of those components needs to commensurately increase.”
Valuable mechanism
James Hodges, head of US Treasury trading at Citigroup, said it was a “very short period of time” when there was "some sense of disorder" in Treasury markets in March 2020. He also said that the basis trade is a “very valuable” part of these markets.
“The Treasury basis offers a very important transformation mechanism between the [bond] issues that the Treasury wants to sell and the issues that our customers want to buy,” said Hodges.
He said many of the bank’s clients want to own the most liquid Treasury bonds and “extend along the curve” by buying longer-dated securities. To do so, investors will sell their older “off-the-run” bonds to dealers.
This is where the basis trade becomes very useful, Hodges said, because dealers can sell these off-the-run bonds to hedge funds. These bonds typically trade at a small discount to “on-the-run” securities to compensate for their lower liquidity, making them appealing to hedge funds wanting to place basis trades where they buy bonds and sell futures.
“That in itself offers a very important mechanism that allows us to intermediate risk, it allows levered accounts to make money, it allows the market to function well,” said Hodges.
Potential reforms to the Treasury market dominated many of the panels at trade body ISDA’s derivatives trading forum in London on Tuesday, including talk of moves to force more firms to clear their trades through central counterparties. That follows a number of severe bouts of Treasury market volatility in recent years.
“The simple fact is there’s no silver bullet – there’s no one change … [that] is going to free ourselves from these periods of volatility,” said Hodges.
“This is a very complex and nuanced problem. The Treasury market ... is very deep and very liquid, but it is also a very complex set of interconnected, disparate parties trading across numerous different regions and time zones and products."