Why this Treasury market trade continues to draw scrutiny

Inside the $26 trillion Treasury market, perhaps the deepest and most liquid place for government debt in the world, a particular trade continues to draw scrutiny ahead of year-end.

It’s the “basis trade,” a way of profiting on the differences in prices between Treasurys and Treasury futures. While such differences can be relatively tiny, one’s potential profit or loss can be exponentially magnified when leverage is involved.

In a nutshell, the basis trade takes an arbitrage approach: It involves borrowing from the repo market for leverage and financing, and then taking a short Treasury futures position and a long Treasury cash position in order to profit from the price gaps between the two. Futures contracts tend to trade at a premium to cash Treasurys, opening a window of opportunity.

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Now, the Securities and Exchange Commission, led by Gary Gensler, is attempting to bolster its oversight. The SEC voted last week to require that transactions involving repurchase agreements use a clearinghouse, which sits between buyers and sellers, with the goal of eliminating systemwide risk.

In August, the staff of the Federal Reserve warned that the use of leveraged Treasury trades by hedge funds needed diligent monitoring, and said an unwinding of those trades likely contributed to market instability seen in March 2020. Less than a week after the Fed staff’s conclusions, strategist Steven Zeng of Deutsche Bank
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also expressed concerns about what might happen if basis trades are rapidly unwound.

For now, the environment of high U.S. interest rates hasn’t deterred the use of the basis trade, and any rapid unwinding of the position is most likely to occur as the result of forced selling by a particular firm, other strategists said.

“The SEC and Fed Reserve have been looking at this very carefully because these trades are too levered,” said Ben Emons, senior portfolio manager and head of fixed income at NewEdge Wealth in New York. While he agreed that a rapid unwinding of the basis trade could be idiosyncratic in nature to some extent, Emons said it might also end up being driven by the SEC’s new central-clearing requirement.

Not everyone has been critical of the basis trade. On Monday, the Committee on Capital Markets Regulation — a group backed by the financial industry — wrote that concerns about the basis trade “are arguably exaggerated,” and that current trading activity is below the peaks seen in 2019-2020 when measured relative to total Treasury debt outstanding.

And in November, Ken Griffin, the head of multibillion-dollar investment fund Citadel, said regulators should focus on banks instead of hedge funds in trying to protect the financial system against risks stemming from arbitrage trading of U.S. government bonds. 

Meanwhile, Rostin Behnam, chairman of the Commodity Futures Trading Commission, described the media’s focus on the basis trade as “breathless,” and said the sizes of the futures and cash market for Treasurys are consistent with historical patterns.

Earlier this week, Bloomberg identified a number of firms with traders who are considered to be among the top players in the basis trade. Those firms included Citadel, Tudor Investment Corp., Balyasny Asset Management, and Kedalion Capital Management, all of which declined to comment when reached by MarketWatch.

The remaining firms mentioned by Bloomberg didn’t respond to requests for comment. They were: ExodusPoint Capital Management, Millennium Management, Capula Investment Management, and Symmetry Investments.

During Friday’s pre-holiday shortened session, Treasury yields finished little changed on the day.