Streetwise Professor: The Basis For the Treasury Basis Trade: Leverage Laundering?

November 7, 2023

The Basis For the Treasury Basis Trade: Leverage Laundering?

Filed under: Clearing,Derivatives,Economics,Regulation cpirrong @ 3:11 pm

The Treasury basis trade continues to be in the news, with one of the biggest basis tradersCitadels Ken Griffincomplaining that the SEC should regulate hedge fund basis trading, but should instead make sure that banks arent supplying too much leverage to . . . well, hedge funds mostly. This seems like a raising rivals costs gambit. No doubt restrictions on leverage would hit Griffins competitors harder, whereas SEC regulation might have a more even impact.

Regardless, one question that hasnt been asked in all the to-ing and fro-ing about Treasury basis trades is why they exist at all, let alone why they get so big. This graph (courtesy of FTAlphaville, based on CFTC data) provides a major clue:

Note the mirror image between leveraged funds (mainly hedged funds) and asset managers (ostensibly non-leveraged fundsthe reason for the ostensibly will become clear shortly).

To the extent that hedge funds short positioning reflects basis trades, the graph suggests the following. Hedge funds take a leveraged market neutral position, buying bonds, funding them via repo, and selling futures. Futures are in zero net supply: the graph shows that the longs on the other side of the hedge funds futures...