Hedge funds and the Treasury cash-futures basis trade

The U.S. Treasury market is the deepest and most liquid fixed-income market in the world, yet in March 2020 it experienced unprecedented dysfunction—widening bid-ask spreads, skyrocketing repo rates, and diverging arbitrage spreads that prompted massive Federal Reserve intervention. This paper documents the rise and near-collapse of the Treasury cash-futures basis trade—an arbitrage strategy among hedge funds exploiting a persistent disconnect between cash Treasury prices and futures prices—as a central feature of that episode. Using regulatory datasets on hedge fund exposures and repo transactions, the authors show that at its peak the basis trade accounted for an estimated $400–$500 billion in positions, constituting more than 60% of total hedge fund Treasury exposure, more than 70% of hedge fund repo borrowing, and more than 25% of primary dealers’ repo lending. A model and empirical evidence link the trade’s growth after 2016 to broader Treasury market developments, and show how the trade’s reliance on short-term repo financing creates both margin risk and rollover risk. In March 2020 many of these risks materialized, though the unwinding of basis positions was likely a consequence rather than the primary cause of the stress; prompt Federal Reserve intervention may have prevented a liquidity spiral.

R. Jay Kahn | Macro Paper Warehouse

Hedge funds and the Treasury cash-futures basis trade