Cash Futures Basis Trade in the Government of Canada Bond Market: By Harbind Thapar

In 2021 and 2022, Canada saw its inflation rate soar, peaking at 6.2%. To counteract this surge and stabilize prices, the Bank of Canada (BoC) implemented a series of aggressive interest rate hikes. Alongside these rate hikes, the BoC embarked on a strategy of Quantitative Tightening (QT) to reduce the size of its balance sheet, which had ballooned during the pandemic era as the bank engaged in Quantitative Easing (QE) to support the economy. Quantitative Tightening involves reducing the central bank's balance sheet by selling bonds and other securities, effectively withdrawing liquidity from the financial system. The BoC’s reduction efforts have been substantial, yet their side effects are now becoming evident. One consequence the market has attributed to the excess QT is the persistent deviation of the Canadian Overnight Repo Rate Average (CORRA) from the BoC’s target rate. In an ideal market, the CORRA and the BoC’s target rate should align closely, as both reflect the cost of overnight borrowing. However, the CORRA has consistently trended above the BoC target rate, signaling a liquidity squeeze in the market. The BoC addressed these concerns by publishing an article attributing the widening spread between CORRA and the target rate to factors beyond Quantitative Tightening, specifically pointing to the rise of Cash Futures Basis Trades and the growing use of repurchase agreements (repos) to finance these positions?(Boran Plong, 2024). This article aims to provide an in-depth understanding of Cash Futures Basis Trades, the repo market, and their combined impact on the Government of Canada (GoC) bond market.

What is the Cash Futures Basis Trade?

The Cash Futures Basis Trade is a strategy designed to exploit the price differential between the spot price and the futures price of an underlying security, considering the financing costs. This trading strategy capitalizes on the profit opportunity that arises from these differences by simultaneously buying the cheaper security and selling the more expensive one. A trader implementing a Cash Futures Basis Trade can adopt a long basis position or a short basis position, depending on the relationship between spot and futures prices.

For example, if a GoC bond futures contract is trading at a premium relative to the spot price of the same bond, a trader could purchase the bond in the spot market and sell the futures contract. Upon the expiry of the futures contract, the trader would deliver the purchased bond, thereby profiting from the difference between the spot and futures prices. This is referred to as a long basis trade. Conversely, if the futures contract is undervalued compared to the spot price after adjusting for financing costs, the trader would short the spot bond and go long on the futures contract, resulting in a short basis trade.

Although the basis spread tends to be small, significant profits can be achieved by leveraging these trades. Traders employ substantial leverage, often using repos, to amplify their positions and maximize returns from minimal price differentials. Therefore, it’s crucial to understand the role of repos in facilitating these trades.

What is a Repo and How Does it Tie into Cash Futures Basis Trades?

A repurchase agreement, or repo, is a short-term borrowing mechanism commonly used in financial markets. It involves the sale of a security with a promise to repurchase it at a later date, usually overnight, at a slightly higher price, which incorporates the cost of borrowing (interest). In essence, a repo is a collateralized loan where the seller receives cash and the buyer holds the security as collateral until the repurchase.

For example, Bank A might need cash for overnight funding and would enter into a repo agreement with Bank B. Bank A would sell a GoC bond to Bank B, receiving cash in return, and would repurchase the bond the following day at a higher price, compensating Bank B for the use of its cash. The interest rate charged for the transaction generally aligns with the overnight borrowing rate, making the repo market a critical component of short-term liquidity management in the financial system.

The Cash Futures Basis Trade relies heavily on repos for financing. When a trader identifies a basis trade opportunity, they may purchase the bond in the spot market and sell the corresponding futures contract. The trader would then enter into a repo agreement, using the purchased bond as collateral to raise cash. This cash is reinvested in more bonds, which are then used as collateral for additional repo transactions, creating a leveraged position. By repeating this cycle, traders can significantly increase their exposure and potential returns. Below is an example of a Long Basis Trade.

Current Dynamics in the GoC Bond Market

The ongoing Quantitative Tightening in Canada have created a fertile ground for Cash Futures Basis Trades in the GoC bond market. With rising expectations of interest rate cuts following the initial tightening phase, the proposition of entering into basis trades has become increasingly attractive. The anticipation of cuts has led to a significant increase in trading volumes and open interest in GoC bond futures contracts.

In a recent study published by the BoC, it was highlighted that the open interest in the 10-year GoC bond futures contract reached $56 billion in April 2024, with the 2-year and 5-year contracts at $23 billion and $12 billion, respectively. These figures represent approximately 18%, 6%, and 7% of the outstanding amounts in these tenors. The surge in trading volumes related to basis trades has grown in tandem with overall activity in the GoC bond futures market?(Andreas Uthemann, 2024).

The expansion in basis trade volumes has also been mirrored in the repo market. The BoC reported that the share of GoC bond trading volumes related to basis trades increased from 2% in January 2016 to 9% in April 2024. Notably, most of the growth has occurred in shorter tenors, such as the 2-year and 5-year segments, while the longer 10-year segment has remained relatively stable. This increase in leveraged positions, financed through the repo market, has placed a strain on liquidity, leading to a higher demand for cash and pushing the overnight repo rate (CORRA) above the BoC’s target rate?(Andreas Uthemann, 2024).

Implications of Cash Futures Basis Trading on Market Liquidity and Stability

The interconnected nature of Cash Futures Basis Trades and the repo market means that any disruption in the repo market can have a ripple effect on the overall financial system. With the rising share of trading volumes attributed to basis trades, the demand for cash has also increased. Traders are willing to pledge bonds in exchange for cash, driving up the cost of borrowing (repo rates) and widening the spread between CORRA and the target rate. The BoC has intervened on several occasions through reverse repos, where it temporarily purchases bonds, injecting cash into the system to stabilize CORRA.

The heightened use of leverage in basis trades could potentially create vulnerabilities, particularly during periods of market stress. If a sudden shock were to lead to the unwinding of these trades, it could trigger a liquidity crunch, like the dislocation seen in the U.S. Treasury market in March 2020?(Andreas Uthemann, 2024). In such scenarios, the large-scale liquidation of bonds could lead to a sharp decline in bond prices, exacerbating the liquidity squeeze and necessitating central bank intervention to restore stability.

Conclusion

The Cash Futures Basis Trade provides traders with an opportunity to profit from pricing inefficiencies between spot and futures markets. However, the strategy is heavily reliant on leverage created through the repo market. While it can generate significant returns under normal market conditions, it also poses systemic risks in times of market stress, as the unwinding of leveraged positions can lead to liquidity dislocations.

The recent rise in basis trade volumes and the subsequent impact on the GoC bond market highlight the need for continuous monitoring of these activities. As the BoC continues to reduce its balance sheet, it remains crucial to assess the influence of such trades on market liquidity and overall financial stability. While the situation does not pose an immediate threat, policymakers and market participants must remain vigilant to avoid any potential disruptions that could arise from the unwinding of leveraged positions in the GoC bond market.