Basis trade#
A simple model of US Treasury bonds[1] could go something like:
The US government borrows a lot of money and has a very long time horizon, so it wants to borrow a lot of money for terms of 10 or 20 or 30 years.
Lots of asset owners — pension funds, university endowments, people saving for retirement — also have a long time horizon and want to earn a safe return, so they want to lend the government money for terms of 10 or 20 or 30 years.
This is a nice and simple story. Pensions have long-dated liabilities (future pension payments), so they buy long-dated assets (long-term Treasuries) to match them, which means that they can buy Treasury bonds for long periods and hold them until they mature.
It is not a perfect story. If you run a pension fund, you probably do not just buy long-term Treasuries to cover your future liabilities. Treasuries are very safe assets, which means they don’t pay that much, and you want to get paid more. You probably invest in other stuff — “credit,” corporate bonds and private credit and asset-backed securities — to earn a bit more yield.
Much of this credit stuff, though, has shorter terms than 30 years; there is not that much 30-year corporate borrowing. If you buy a lot of seven-year corporate bonds, and you have very long-dated liabilities, there will be a mismatch. You are taking a lot of interest-rate risk: Sure those bonds pay a lot of interest now, but they mature in seven years, and if interest rates are lower in seven years you will earn less interest. If your liabilities are long term, you want to earn a lot of interest over the whole term. You want the duration of your assets to match the duration of your liabilities.
So you buy more duration with Treasury futures. Treasury futures are synthetic contracts that give you the interest-rate exposure of Treasury bonds but without putting up much cash upfront. You put up about [\(3,900](https://www.cmegroup.com/markets/interest-rates/us-treasury/30-year-us-treasury-bond.margins.html) and get economic exposure to \)100,000 of Treasury bonds: If long-term Treasury prices go up by 1%, you make \(1,000 on your initial \)3,900. If interest rates go down, the price of Treasury bonds will go up, and you will make money, which will compensate you for your reduced future interest earnings.
This is a more nuanced story of what pension funds and other long-term asset managers do.[2] But our original simple story described a whole trade: Pensions bought Treasuries, and the government sold them, and the trade made sense for both of them. Now we have a trade that makes sense for pension funds, but who is on the other side? The government is not selling them Treasury futures.[3]
Instead, you need some intermediary to provide the service of transforming Treasuries (sold by the government) into Treasury futures (bought by pension funds). This service is called the “basis trade,” and the intermediaries are usually hedge funds and proprietary trading firms.[4] Here is a Wall Street Journal article about the basis trade, which has caused problems in recent years and is now making a comeback:
A popular way for hedge funds to profit from bond trading while minimizing their exposure to swings in the market, the basis trade exploits the price difference between Treasurys and Treasury futures. The resurgence is attracting fresh scrutiny from Wall Street because previous meltdowns have rattled global markets. …
Hedge funds buy Treasurys, then bet against Treasury futures by selling contracts promising delivery of a bond on a specific date at a preset price. Instead of betting on the direction of bond markets, the trade seeks to take advantage of small differences in the securities’ prices.
The trade works because large asset managers like pension funds often prefer buying Treasury futures that require less up-front cash than actual bonds. That tends to make the contracts slightly more expensive than the bonds, creating a window for speculators to take advantage.[5] Futures prices typically converge toward bond prices as their settlement date approaches.
The differences are small, so hedge funds juice returns by borrowing from big banks in the overnight funding markets—often putting little, if any, cash up front. Leverage can reach extreme levels: Hedge funds had more than \(550 billion of Treasury trades at the end of last year backed by just \)10 billion of their own money, Fed research found.
The obvious objection is that if you have \(550 billion of Treasuries backed by \)10 billion of your own money, and the value of Treasuries drops by 2%, then all of your money is gone, you have to dump Treasuries, everyone else is dumping them at the same time and there is a crisis. This is an exaggeration, because if the value of Treasuries drops by 2% then probably you made 2% on your futures and you’re more or less fine, but still there is not a ton of margin for error, and mistakes have been made:
The basis trade had been subdued since a dash for cash in March 2020 forced hedge funds to rapidly unwind their positions, straining the market for Treasurys — meant to be the world’s easiest investment to buy and sell. …
During the 2020 Covid market crash, hedge funds’ unwinding of leveraged strategies including the basis trade spilled across markets, helping send the Dow Jones Industrial Average to its worst losses since 1987 and forcing the Fed to step in.
But now it is back:
The Fed’s fight against inflation and the U.S. government’s wave of borrowing reignited the trade, analysts say. Higher yields and worries about a recession have asset managers scooping up long-term bond futures. …
Given those uncertainties and with a potential recession up in the air, “it’s natural to see record hedging in the Treasury market,” said Agha Mirza, global head of rates and OTC products at CME Group.
If you are a pension fund, the 10-year Treasury is at a high-relative-to-recent-history 4.25%, and you worry it will go back down if there is a recession, then you will want to lock in a lot of that rate while earning more today on corporate credit. So you will load up on Treasury futures. And someone will sell them to you.
But you are a pension fund. The people selling you these futures are not. You have a long time horizon. They are doing this as a trade. They are in the business of buying a ton of Treasuries and selling a ton of Treasury futures when there is demand for the futures, and not doing that when there isn’t. They don’t have a giant pot of long-term locked-up pension money to buy Treasuries with. They have a little bit of their own cash (\(10 billion), and a lot of borrowed money (\)540 billion), to buy the Treasuries that they transform into futures.
So there is another intermediary here: When pensions are buying Treasury futures, they are buying them from hedge funds and prop trading firms that own the underlying raw materials (Treasuries) used to manufacture the futures. But those hedge funds need another raw material: the cash they use to buy the Treasuries. That money is mostly borrowed, in the repo market, where the hedge funds put up their Treasuries as collateral for short-term cash loans from banks and money-market funds and other investors looking to park cash somewhere safe for the short term.
Again, our simple model at the beginning was that long-time-horizon pension funds buy and hold long-term bonds from the long-time-horizon government. The more accurate model is:
The long-time-horizon government sells long-term bonds.
Those bonds are bought by short-time-horizon hedge funds using borrowed money.
The money is borrowed from short-time-horizon repo lenders.
The hedge funds use the bonds to manufacture Treasury futures, which they sell to long-time-horizon pension funds.
It all kinda works! The beginning makes sense, and the end makes sense, and the middle is efficient. It lets the pension funds be nimbler with their cash and lend to real businesses and get higher yields. But that efficiency comes with risk. The long-time-horizon government and the long-time-horizon pensions don’t really have a care about market movements; if they dealt with each other directly, they could just do the trade once and wait for it to mature 30 years later. Once you introduce highly leveraged short-term intermediaries, market movements can blow up the trade and lead to margin calls and forced selling.
We talked last year about “liability-driven investment” at UK pension funds, which led to a brief meltdown in the gilt (UK government bond) market. The story there is different, but it has similar features: Pension funds, rather than matching their liabilities with long-dated gilts, bought things with higher returns and hedged their interest-rate risk with derivatives. This meant that if interest rates moved, the pensions got margin calls and could get blown up. I wrote:
This all makes total sense, in its way. But notice that you now have borrowed short-term money to buy volatile financial assets. The thing that was so good about pension funds — their structural long-termism, the fact that you can’t have a run on a pension fund: You’ve ruined that! Now, if interest rates go up (gilts go down), your bank will call you up and say “you used our money to buy assets, and the assets went down, so you need to give us some money back.” And then you have to sell a bunch of your assets — the gilts and stocks that you own — to pay off those margin calls. Through the magic of derivatives you have transformed your safe boring long-term pension fund into a risky leveraged vehicle that could get blown up by market moves.
I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.
Finance really does do that!
But this is not just finance being a clever little scamp; there is something essential about it. Last week, Lev Menand and Josh Younger published a fantastic paper titled “Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon.” Alexandra Scaggs wrote about it at FT Alphaville, and Adam Tooze discussed it in his newsletter, and I cannot really do justice to everything that is in it, but it is a good thing to read if you are thinking about the basis trade.[6]
It is basically a history of the US Treasury market from the perspective of how Treasuries are turned into money. The very simple story of Treasuries is “the government wants to borrow long-term, some people want to lend long-term, and they get matched up.” But that story has never been completely true: Treasuries are not just a long-term investment for pension funds and retirement savers; they are also the preeminent safe asset, which means that a lot of people who own Treasuries will have occasion to sell them to raise cash. There needs to be a buyer: When everyone wants to sell Treasuries for cash, there needs to be someone who can quickly come up with a lot of cash to buy all the Treasuries. Menand and Younger write:
The high degree of convertibility between Treasury securities and cash — the market’s “liquidity” — depends upon entities that can create new, money-like claims to buy Treasuries. Sometimes the government’s central bank has issued these claims directly, as in March 2020; other times these claims were issued by central bank-backed instrumentalities, such as banks and select broker-dealers.
Who can “create new, money-like claims” to quickly buy any Treasury supply? The most obvious answer is “the central bank”: The Federal Reserve (1) creates dollars and (2) buys Treasuries, so it is a natural supplier of Treasury liquidity. But that is sort of a disfavored answer: Everyone understands that it is bad for a government to finance itself by printing money (it’s inflationary), so a system in which the Treasury sold all of its bonds directly to the Fed for newly created dollars would be bad.
But Menand and Younger argue “that American public finance has long been closely intertwined with the American monetary framework,” and they trace the history of (1) who could issue “money-like claims” to buy Treasuries and (2) how the government and the Fed supported those buyers and markets. The history has four parts:
The national banking system, in which Congress chartered national banks to print money and use the money to buy Treasuries; here, “fiscal-monetary entanglement was relatively transparent.”
The Federal Reserve system, in which the Fed printed the actual dollars, while banks issued deposits (money-like claims) and, for some time, used a lot of the money to buy Treasuries.
The primary dealer system, in which banks stopped buying so many Treasuries, but primary dealers (investment banks) bought Treasuries and funded them in the repo market. Repo, Menand and Younger argue, is a money-like claim, a short-term safe place for cash investors to park their money, and it was created and supported by the Fed to allow primary dealers to efficiently provide liquidity for Treasuries.
The current system: After 2008, the primary dealer system atrophied (many big dealers became banks), and now Treasury liquidity comes from a combination of (1) actual banks, which can fund Treasuries by issuing deposits, and (2) hedge funds, prop trading firms and other not-quite-primary-dealers that use the repo market to finance their Treasury trades.
In all of the later configurations, the Fed sits somewhere behind the market: When things go wrong, the Fed supports whoever (banks, primary dealers, now hedge funds) provides Treasury liquidity. They write:
Subsequent changes to market structure pushed substantial Treasury dealing further beyond the bank regulatory perimeter, leaving public finance increasingly dependent on high-frequency traders and hedge funds — “shadow dealers.” The near-money issued by these intermediaries proved highly unstable in 2020. Policy makers are now focused on reforming Treasury market structure so that Treasuries remain the world’s most liquid asset class. Successful reform likely requires a legal framework that, among other things, supports elastic intermediation capacity through balance sheets that can expand and contract as needed to meet market needs.
Treasuries can never be a pure long-term buy-and-hold investment for everyone; somebody needs to be ready to buy and sell them. That somebody will need short-term funding, and that short-term funding will create risks, and the Fed will have to stand behind the market to sort out those risks.
[1] Boringly 10-year Treasuries are called “notes” and 20- and 30-years are called “bonds” but let’s not worry about that.
[2] It is not, like, accurate in all respects or anything; this is still a very stylized version of one portion of what is going on with the basis trade.
[3] Not only because, like, that would be weird, but because the government is in the Treasury market to borrow actual money, and the point of Treasury futures is that they do not involve much upfront cash. If you sell \(100,000 of Treasury bonds you get \)100,000; if you sell $100,000 of Treasury futures you don’t really get any cash to use immediately.
[4] Again, I am writing a very stylized schematic story of the basis trade. In the real world futures are used by lots of investors for lots of reasons, people are naturally long futures while others are naturally short, etc.; this is really only part of it. But I think the intuitions here are interesting.
[5] The phrase I would use here is not “a window for speculators to take advantage” but rather “a form of compensation for people who do the work of manufacturing futures out of Treasuries.”
[6] This is a bit tangential to the main points in the text, but the paper explains the basis trade as a way for hedge funds to, like, reserve bank balance sheet: “Second, to the extent that SLR and other regulations drove their internal economic incentives when managing balance sheet capacity, bank-affiliated intermediaries often allocated it on a ‘use it or lose it’ basis. In other words, leverage budgets that were allocated to specific entities but, if they were left underutilized, were downsized in favor of more active clients during regular reviews. That motivated hedge funds and other major consumers of leverage to find ways to utilize leverage allocations without taking much market risk. In other words, it became costly not to use one’s access to bank balance sheet, for fear that access would not be available when needed. Cash/Treasuries basis trades, which are most commonly constructed as a ‘short’ in futures and a repo-financed ‘long’ in one or several bonds from that contract’s deliverable basket, rely on leverage but have a theoretically bounded payoff with minimal market risk in a relatively wide range of market conditions. That made them fit for purpose as a placeholder position to secure future access to balance sheet as needed.”