Financial stability risks from basis trades in the US Treasury and euro area government bond markets
Published as part of the Financial Stability Review, May 2024.
Basis trades are arbitrage strategies which improve market functioning but are subject to specific risks, especially when excessively leveraged. Basis trades typically aim to exploit any mispricing between the spot price of a security (adjusted for the funding cost until the expiry of a futures contract) and its futures price – the difference being called the net basis. In order to do this, an arbitrageur needs to simultaneously conclude two opposing trades – one in the futures market and the other in the spot market. As the futures contract approaches its maturity, the futures price and the spot price converge, arguably making the basis trade return risk-free if held until the futures contract expires. In principle, therefore, basis trades are not speculative in nature and should have a beneficial impact on market efficiency and liquidity. Given that price dislocations are typically small compared with the market value of the relevant security, arbitrageurs often employ high leverage to enhance their returns. In the spot market, leverage is employed using repo funding (securities are pledged as collateral and the cash received is used to purchase more securities), while in the futures market, leverage is synthetic and stems from the obligation to post only a fraction of the nominal exposure as margin. This exposes basis trades to funding risks – the inability to roll over repo borrowing at an acceptable price – and liquidity risks – the inability to meet margin calls related to futures positions. Rapid unwinding of basis trades in response to forced deleveraging, for instance, could add to price dislocations. However, such a scenario is less likely for arbitrage strategies and would have less impact on prices than would be the case for leveraged directional positions.[1]
The build-up of hedge funds’ leveraged exposures in the US Treasury market has given rise to financial stability concerns.[2] Some evidence from the US Treasury repo market suggests that basis trades are behind the growing net short positions of these funds in US Treasury futures (Chart A, panel a).[3] Over the last two years, the deterioration of US Treasury market liquidity and increased volatility (Chart A, panel b) have made price dislocations more frequent and basis trades more attractive. In addition, fixed income funds have seen significant inflows and asset managers have preferred the futures market over the spot market to build their duration exposure more flexibly. This has put downward pressure on the net basis. Hedge funds have stepped in as a “counterparty” for those asset managers in the futures market (Chart A, panel a), at the same time buying US Treasuries in the spot market and using them as collateral in the repo market to increase leverage.
Disruptions in the repo market could still force some entities to unwind their basis trades, fuelling dislocations in the US Treasury market. The liquidity preparedness of basis traders to maintain their futures positions seems better now compared with previous stress events, as traders are expected to meet margin requirements that are close to historical highs (Chart A, panel c). This limits the maximum leverage deployed in the strategy. Still, disruptions in the repo market could lead to the forced unwinding of basis trades. Given the role of US Treasury bonds as global risk-free assets, a volatility jump in response to such unwinding may potentially be observed across asset classes and jurisdictions, as has been witnessed during some historical stress events.[4] The effect could be amplified by the high correlation between US Treasuries and euro area government bonds, and when the same counterparties are active in both markets. Sufficient liquidity in the spot, futures and repo markets in the United States is therefore crucial to contain vulnerabilities globally.
Chart A
Growing basis trade activity in the United States might be a symptom of deteriorating liquidity conditions, but vulnerabilities are partly mitigated by high margin requirements
a) Net exposures in US Treasury futures, by entity type | b) Illiquidity and volatility in the US Treasury market | c) Margin requirements in US Treasury futures most shorted by leveraged funds |
|---|---|---|
(Jan. 2019-Apr. 2024, USD billions) | (Jan. 2019-Apr. 2024, indices) | (1 Jan. 2019-1 Apr. 2024, percentiles) |
 |  |  |
Sources: Bloomberg Finance L.P., CME Group, and ECB calculations.
Notes: Panel a: entity types as reported in CFTC’s weekly Commitments of Traders (COT) Reports, where “Leveraged Funds” are typically hedge funds.* Panel b: “Illiquidity” proxied by the Bloomberg US Govt Securities Liquidity Index and “Volatility” by the MOVE Index. Panel c: distribution of margin requirements for front-month contracts relative to their market value. For “COVID-19 turmoil” and “Repo market stress”, highest observed margin requirements are shown. 2Y, 5Y and 10Y refer to two-year, five-year and ten-year T-Note futures contracts listed on the CBOT exchange.
*) See “Traders in Financial Futures - Explanatory Notes”, Commodity Futures Trading Commission (CFTC).
A build-up of hedge fund exposure has also been observed in the euro area government bond market, but the size of basis trade activity seems contained. Offshore hedge funds, believed to also be involved in basis trades in the United States, have become increasingly present in the euro area government bond repo market, with their positions growing up to threefold since the beginning of 2021 (Chart B, panel a).[5] At the same time, these funds have also been active in the euro area government bond futures market, albeit to a lesser extent. A strong negative correlation observed when matching these positions suggests some short basis trade activity (Chart B, panel b). In other words, these funds have mostly taken long futures positions at the same time as borrowing underlying bonds in the repo market and presumably short selling them. While the direction of these basis trades is the opposite to what has been observed in the US Treasury market, in principle it is subject to similar risks. That said, what limits the financial stability implications is the small scale of these trades and more balanced net futures positions (Chart B, panel c). This might be reflective of smaller market distortions in the euro area government bond market than in the US Treasury market or higher costs of arbitraging. Nevertheless, it appears that the growing presence of offshore hedge funds in the euro area government bond market is also related to other investment strategies, potentially including leveraged directional trades, associated with higher financial stability risks than basis trades. Spillovers to the euro area government bond market could be amplified, should these entities face liquidity strains in the US Treasury market.
Chart B
The increased presence of non-euro area hedge funds in EGB repo and futures markets can be partly linked to basis trade strategies
a) Gross exposures of selected offshore hedge funds in EGB repo and futures markets | b) Basis trades of selected offshore hedge funds in EGB markets, by issuer country | c) Net exposures of selected offshore hedge funds in EGB futures market, by issuer country |
|---|---|---|
(1 Jan. 2021-25 Apr. 2024, € billions) | (1 Jan. 2021-25 Apr. 2024, € billions) | (1 Jan. 2021-25 Apr. 2024, € billions) |
 |  |  |
Sources: ECB (EMIR, SFTDS), sector enrichment based on Lenoci and Letizia* and ECB calculations.
Notes: “Selected offshore hedge funds” refers to investment funds domiciled in the Cayman Islands. EGB stands for euro area government bond. Panel a: “Repos” refers to the sum of repo and reverse repo exposures. Repo and reverse repo positions are at the counterparty and collateral level. “Futures” refers to the sum of absolute net long and net short positions at counterparty and contract level. Panel b: negative exposures in the repo market indicate borrowing of the collateral that is eligible for delivery for the corresponding position in the futures contract. Smaller absolute values on average for repo exposures in comparison with the corresponding futures positions might stem from the lack of data on securities financing transactions concluded between selected offshore hedge funds and non-EU entities, which might also be the lenders of the relevant bonds. Total reflects aggregated exposures in bonds issued by all three countries listed. Panel c: the sample of EGB futures includes futures on German, French and Italian government bonds traded at Eurex, which is the most traded and liquid EGB futures market. Futures positions are netted at counterparty and contract level.
*) See Lenoci, F.D. and Letizia, E., “Classifying Counterparty Sector in EMIR Data”, in Consoli, S., Reforgiato Recupero, D. and Saisana, M. (eds.), Data Science for Economics and Finance, Springer, Cham, 2021.
While the funding risk and the risk of a sudden increase in margin requirements are present for both leveraged directional trades and arbitrage strategies, another reason for the forced closure of trades are the mark-to-market losses on the strategy. Arbitrage strategies incur such losses in the event of deeper price divergences between the spot and the futures markets, which might happen if, for instance, other arbitrageurs limit their activity. For directional trades, the likelihood of mark-to-market losses is larger, as it only takes prices to move into the opposite direction than assumed. In addition, while unwinding of arbitrage trades feeds into price divergences, it should not have directional impact, as unwinding also means trading into the opposite directions (in the futures and the spot markets). Unwinding of directional bets, however, has strong directional impact on the underlying prices and fuels an already ongoing trend, making disorderly price movements and volatility spirals much more likely.
See, for example, Avalos, F. and Sushko, V., “Margin leverage and vulnerabilities in US Treasury futures”, BIS Quarterly Review, Bank for International Settlements, September 2023.
See, for example, Barth, D., Kahn, R. and Mann, R., “Recent Developments in Hedge Funds’ Treasury Futures and Repo Positions: is the Basis Trade ‘Back’?”, FEDS Notes, Board of Governors of the Federal Reserve System, August 2023, or Glicoes, J., Iorio, B., Monin, P. and Petrasek, L., “Quantifying Treasury Cash-Futures Basis Trades”, FEDS Notes, Board of Governors of the Federal Reserve System, March 2024.
Some studies, however, question the impact of forced unwinding of basis trades on price dislocations in the US Treasury market in March 2020. See, for example, Barth, D. and Kahn, J., “Basis Trades and Treasury Market Illiquidity”, OFR Brief Series, Office of Financial Research, July 2000.
These funds are mostly domiciled in the Cayman Islands. They account for more than half of investment funds’ positions on euro area government bond futures and for almost the entire euro area government bond repo activity of non-EU investment funds.