Basis Trades: An In-Depth Exploration

What is the Basis Trade?

The Basis Trade, in simple terms, is an arbitrage strategy where traders exploit the price difference between two similar securities. It involves buying one security and selling short another akin to it, aiming to capture the spread between them. Specifically, in the case we're delving into, it's about buying a US Treasury (cash settled) and simultaneously selling a US Treasury (future settled). Traders engage in this when they observe a mispricing between the two securities, anticipating a correction that would result in a net profit.

Understanding the Basics with a Scenario:

• Spot Market: Let's say a 10-Year Treasury Bond is trading at $98.00.
• Futures Market: The corresponding futures contract for the same bond is trading at $99.00.

Basis Trade Setup:

1. The Basis: This represents the price difference between the spot market and the futures market. If the futures are trading higher than the spot price, the basis is positive, say $1.00 ($99.00 - $98.00).
2. Executing the Trade: Buy in Spot Market: Purchase the 10-year Treasury note in the spot market at $98.00, anticipating a rise in its price or a decrease in the basis. Short Sell Futures Contract: Simultaneously, sell short a 10-year Treasury futures contract at $99.00, expecting the futures price to fall or the basis to narrow.

Expectations and Possible Outcomes:

• Aim: The goal is for the basis between the spot and futures market to converge, achievable if the spot price rises, the futures price falls, or both.

1. Basis Converges (Profit): Over time, if the spot price increases to $98.50 and the futures price decreases to $98.50, the basis has converged to zero. Profit: $0.50 per Treasury note from the spot market and $0.50 per contract from the futures market, totaling $1.00 per combined position.
2. Basis Widens (Loss): If the basis widens (spot price decreases to $97.50 while the futures price remains at $99.00 or rises), this would cause a loss of $1.50 on the position.

The Reality of Basis Trades:

In real-world scenarios, basis trades operate with much tighter spreads, often measured in basis points or hundredths of a percent per trade. There are also additional costs associated with the trade, including borrowing fees and trading fees, which can eat into the basis.

As mentioned earlier, traders often resort to substantial leverage due to the minuscule difference and net profit from the cost of carry spread. They execute these trades on a large scale, with hedge funds going long on the basis trade by simultaneously purchasing Treasuries and shorting futures contracts.

Unpacking the Magnitude and Leverage:

• The profit from the trade boils down to the difference between the cash Treasury and futures Treasury prices, minus the interest cost on the repo loan and any trading costs. This often reduces the arbitrage to mere basis points, necessitating leverage to make it profitable in terms of actual dollars.

How Big is the Problem?

1. Identifying the Players: Hedge funds are the primary players in basis trades. Their ability to short against their positions distinguishes them from traditional long-only money managers.
2. Examining Borrowing Trends: Data from non-Fed private repo markets reveals a significant increase in borrowing by hedge funds to facilitate basis trades. Reports suggest these trades are on leverage of over 50 to 1.

The Role of Leverage:

• Leverage is a critical component, allowing hedge funds to execute these trades simultaneously and at scale. The leveraging aspect often involves executing the trade on a massive scale, with reports indicating leverage of over 50 to 1.

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?Addressing a Common Question:

1.?Question: Amidst the surge of Treasury debt auctions, it's evident that hedge funds are acquiring cash Treasuries. Given the ample availability in the market, particularly with older issues, why are hedge funds also shorting futures contracts, and who is on the other side of these transactions?

Insight from CFTC Data:

1.?Answer: Data from the CFTC reveals a fascinating interplay in the market dynamics.

Revealing the Participants:

2.?Question : Who, then, is stepping in to buy the futures contracts from hedge funds engaged in shorting activities?

Clarity on the Players:

2.?Answer : Simple long-only asset managers are the key participants acquiring futures contracts from hedge funds in a short position.

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Unpacking the Motivation:

3.?Question: What motivates long-only asset managers to buy futures contracts from hedge funds?

Understanding the Motivation:

3.?Answer: There are several reasons for this, with a significant one being the capital efficiency of futures contracts. Unlike directly buying the cash value, futures contracts necessitate less capital, offering a form of leverage.

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Leverage for Long-Only Managers:

4. Question: How do long-only money managers, such as pension funds or endowments, leverage futures contracts?

Leveraging with Efficiency:

4.?Answer: These long-only managers utilize futures contracts to access a straightforward form of leverage. For example, they can multiply returns on a bet predicting lower interest rates by the contract's expiration.

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The Hedge Fund Perspective:

5.?Question: On the flip side, what is the objective of hedge fund managers involved in the basis trade?

Hedge Fund Strategy:

5.?Answer: Hedge fund managers, in this scenario, are banking on the basis trade. Their hope is that the difference between the future and cash Treasury converges, presenting a lucrative opportunity.

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?Celebrating Efficient Capital Markets:

6. Question: How does this dynamic exemplify the efficiency of capital markets?

Efficiency in Action:

6.?Answer: The ability of long-only managers to leverage futures contracts and hedge funds playing the basis trade showcases the efficiency of capital markets. It allows diverse participants to engage based on their strategic objectives.

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Magnitude of Transactions:

7.?Question: In terms of financial exposure, how significant are these basis trades?

Grasping the Scale:

7.?Answer: Astonishingly, the cumulative financial exposure to the basis trade amounted to over a trillion dollars just last month, underlining the substantial scale and impact of these transactions.

?In summary, the intricate dance between hedge funds, long-only managers, and the massive financial exposure involved in the basis trade paints a vivid picture of the dynamic and nuanced nature of financial markets. As participants continue to navigate these waters, understanding these interactions becomes paramount for informed decision-making.

Current State and Unwinding:

• The recent interventions and rule changes by regulatory bodies, including SEC Chair Gary Gensler's introduction of new rules for 2025, suggest growing concerns about the oversight and potential systemic risks associated with these large-scale and highly leveraged basis trades.
• Despite the colossal exposure, these trades have begun to unwind. Reports indicate a reduction in gross short positions in two-year futures over consecutive weeks, signaling a potential peak in the record short positions.
• The aggregate short position of over $1 trillion across two, five, and 10-year futures has been cut to about $970 billion.

Remaining Risks:

• While the risk might appear to be subsiding, one lingering concern is the concentration of these trades. Almost 50% of all basis trades are held by just eight (or fewer) traders, raising questions about the potential risks associated with such concentrated leverage.

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Conclusion: As the financial landscape navigates the unwinding of these massive basis trades, caution is warranted. The sheer size and concentration of leverage in these transactions echo historical episodes like the Long-Term Capital Management crisis, emphasizing the importance of vigilance and prudent oversight to avert unforeseen consequences.

Source:- The Hedge Fund Traders Dominating a Massive Bet on Bonds, Hedge Funds’ Big Bet Against Treasurys Isn’t What You Think, Praying for 'soft landing' of $1 trillion basis trade,