How a Basis Trade Works

What do you do when you notice a price differential between the spot price of a commodity and the price of a futures contract? You do a basis trade (if you’re an eligible counterparty, that is).?

Basis = Spot Price of X - Futures Price of X

It’s a pretty neat way to make money, as long as you can. Basis exists even in the market for the safest, highest liquidity asset you can possibly think of - US Treasury bonds.?

But we need to understand why this opportunity for arbitrage exists in the first place - weren’t markets supposed to be perfect? The short answer is - a lot of people want to sell Treasuries and a lot of people want to buy Treasury futures. The long answer-?

1. Lots of treasury securities being issued - when the Fed is trying to ‘normalise’ its balance sheet. Higher supply >> Lower price for treasuries (compared to its futures contracts)
2. Huge demand for Treasury futures coming from long term asset managers. Why? Because it gives them leverage >> they can either achieve leverage through repos (in which case they’ll have to report interest expenses in their total expense ratios - making them look more expensive) OR through buying futures ( which looks like the more promising deal, expense-wise)

But there’s more to it. These guys want to buy Futures instead of the actual security itself because they want the best of both worlds - they want credit exposure (so they park their actual cash in things like corporate bonds) and they want duration (buying futures meets this need and bonus point-? they’re not required to put a lot of money upfront)?

So if all these asset managers want to buy US Treasury futures, somebody has to sell them? Enter hedge funds.?

• These guys buy a lot of Treasury bonds, with huge sums of borrowed money (thanks to repo markets).
• On top of that, they sell Treasury futures - with very little of their own money as margin. Think 50x leverage - they’ll put down down $10 of their own money as initial margin when initiating a futures position for $500.?

We have a story now.

So in effect you have

• Pension Funds, Mutual Funds etc >> Long on treasury futures
• Hedge Funds >> Short on treasury futures, Long on treasuries (this is the basis trade)?

Between 2017-2019: 91% of hedge funds’ Treasury purchase came from funds classified as ‘basis traders’?

As of Sep 2023 : Hedge funds had purchased, on net, $626 billion in Treasury securities since Sep 2017, with $478 billion by funds that were classified as likely basis traders

Essentially you have hedge funds sitting between the Fed and long term asset managers (think pension funds) and pocketing a nice profit.?

Nobody likes the L-word in finance. It looks very benign until it's time to unwind the levered positions. Back in 2020, when Covid spooked the markets - investors started selling off US treasuries for cash. Repo lending costs spiked up,? making the basis trade a losing game. Then everyone sold Treasuries and hedge funds sold Treasuries and everyone sold Treasuries even more in this doom loop. Leverage has its way of magnifying everything.?

If you want to go super technical, read this -

https://www.federalreserve.gov/econres/notes/feds-notes/quantifying-treasury-cash-futures-basis-trades-20240308.html#:~:text=The%20Treasury%20cash%2Dfutures%20basis%20trade%20is%20a%20convergence%20trade,be%20delivered%20into%20those%20futures .

Read this box excerpt from the BIS quarterly review by Fernando Avalos and Vladyslav Sushko here - https://www.bis.org/publ/qtrpdf/r_qt2309w.htm

Read Treasury Borrowing Advisory Committee’s report here - https://home.treasury.gov/system/files/221/TBACCharge1Q12024.pdf