Basis trades: a test case for regulating risky activities

FSOC is right to focus on dangerous behaviour, but Treasury meltdown reveals a complex chain of actors

At the end of last year, the Financial Stability Oversight Council voted unanimously to change the way it does its job. That job – for anyone who needs reminding – is to spot and neutralise threats to the US financial system.

Rather than looking for firms that could endanger the system, the FSOC decided to root out risky activity instead.

It was the right decision. But this year’s meltdown in the US Treasury market is a difficult test case.

Reviewing that episode, some observers – including Bank of England deputy governor Jon Cunliffe and former US Federal Reserve chairs Ben Bernanke and Janet Yellen – have pointed to the unwinding of cash/futures basis trades by highly leveraged hedge funds as the source of the problem.

The funds were trying to make money from a structural difference between US Treasury futures and the underlying bonds – futures are typically richer than the cash instrument, so funds capture this spread by selling the futures and buying US Treasuries with repo funding. The prices converge as the futures reach maturity, allowing the funds to cash out and pocket the difference.

It became a hugely popular trade. Data from the US Securities and Exchange Commission shows the gross sovereign debt exposures of relative value fixed income hedge funds climbed by 45% during 2018 and 2019, from $496 billion to $717 billion.

Rather than looking for firms that could endanger the system, the FSOC decided to root out risky activity instead. But this year’s meltdown in the US Treasury market is a difficult test case

What the data does not show is that these funds were hedging their US Treasury futures positions with less liquid off-the-run bonds purchased with overnight funding. The resulting liquidity and maturity mismatches may have exacerbated the violent selloff in March. If regulators had more detailed information on hedge fund exposures and funding terms, they might be able to address these risks before they become a problem.

Like many financial market activities, though, this one does not begin and end with the hedge funds. It is enabled by other participants, each with their own distinct set of incentives.

Clearing houses have been criticised for lowering margin levels when markets are stable, only to hike them at the first sign of trouble. At CME, maintenance margin for 10-year US Treasury futures contracts jumped 50% between March 3 and March 12. Some have also argued the design of CME’s futures contracts makes it economically attractive to hedge them with less-liquid off-the-run bonds.

Regulators may also want to examine the role of prime brokers. The cross-margining models of prime brokers, which offset the long bond and short futures positions in a basis trade, can allow hedge funds to take more leverage than would be permitted by clearing houses. According to Andrew Hauser, executive director for markets at the Bank of England, leverage rates of 40–60 times “were common” among hedge funds involved in the basis trade in March.

The cash/futures basis trade has all the hallmarks of a systemically risky activity. To contain it, regulators must look not only at the role of hedge funds, but also the leverage afforded to them by prime brokers and the margin practices of central counterparties. That will take close co-ordination between the US regulatory agencies.

In short, the basis trade that blew up the Treasury market demonstrates the wisdom of the FSOC’s new approach to dealing with systemic threats. It also illustrates how difficult it will be to apply.