Getting back to basis: Why the Treasury Basis Trade is in focus

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Kate Finlayson: Hi, you're listening to Market Matters, our market series here on J.P. Morgan's Making Sense. I'm Kate Finlayson from the FICC Market Structure and Liquidity Strategy Team, and in today's episode we'll be taking a look at the Treasury cash futures basis trade, an arbitrage strategy utilized by market participants that's been in keen focus lately. So naturally I'm delighted to have my colleagues at J.P. Morgan here with me to discuss these dynamics. Brian Fitzsimmons, head of North America rates securities trading, and John Schwartz, global head of sovereign financing trading. Hi, both. Thanks so much for joining me today.

John Schwartz: Thanks, Kate. It's great to be here.

Brian Fitzsimmons: Likewise, Kate. Always good to chat.

Kate Finlayson: Perhaps before we delve into some of the dynamics surrounding the basis trade, Brian, it'd be good to get your view on the use and relevance of this strategy in today's markets.

Brian Fitzsimmons: Sure. So very simply, the U.S. Treasury cash futures basis trade is looking to take advantage of the difference or the basis in the price of a Treasury security and the price of the corresponding futures contract. So the aim is to draw on any of the mispricings that occur over short periods and look to own Treasury versus futures in a convergence trade in order to make money. This type of trade is often most used by relative value traders, particularly at the multi-strat hedge funds, and while the pricing differential or returns may be quite small, estimates out there are that the range of leverage estimates can be between 15 to 20 times on these trades that really drive the returns. So in terms of how the basis opportunity comes to exist, it really largely starts with the buyers of Treasury futures, who in effect pay a premium for owning futures instead of owning Treasury bonds. The buyers are predominantly asset managers or mutual funds in addition to several other account types that can be long futures. The study performed by the TBAC in its deep dive as to why asset managers use futures, provides some fairly simple structural reasons. Some of them are simplified execution and operational flow of futures across many different sub-accounts, greater liquidity relative to some cash securities, and a big one is consideration around repo interest expense and reporting, and generally just flexibility to deploy Treasury risk quickly and anonymously to manage the risk. So a lot of the growth can be attributed to the use of asset managers buying spread product like U.S. high-grade corporate bonds to try to outperform their index. If you look at the Barclays Ag, for example, which includes Treasuries, which are growing share of the market, this is a common place in which analysis has shown this type of benchmark bet would be deployed. So futures come into play here because of many of the spread products have a shorter duration than the index, and so asset managers need to effectively replace the duration gap that's created by buying a shorter and shorter duration spread product in order to get back towards that index. And futures provide a very low cost quick and easy way to get that duration back. This was a key feature of the TBAC presentation that speaks very clearly to a specific reason about why asset managers can pay this premium and they still can achieve their target returns in their fixed income portfolios, which is important to know.

Kate Finlayson: The basis trade has been in the spotlight for a while now, most recently with the market volatility following Liberation Day in early April, when President Trump announced the tariffs.

Brian Fitzsimmons: Yes, that's right. We have seen, over the last several years, each time the market hits a new bout of market volatility, focus again returns to the Treasury basis trade. And this really all stems from years of post-pandemic analysis on the trade with a view from regulators to fundamentally address how can they make the U.S. Treasury market more resilient and how can they increase intermediation and transparency. So all of this that has been written has really made the trade a well-known risk as well as a good metric, both of liquidity and stress in the market that gets attention when we hit these significant bouts of higher volatility. With that said, the basis trade itself did cheapen modestly, but it really did not show any signs of real stress through the post-Liberation Day market volatility. Additionally, there was very little position change in U.S. Treasury futures by levered accounts, suggesting that very little liquidation actually occurred. The place that was really the epicenter of stress in the rates market this time around was in swap spreads. Now, in terms of swap spreads, just briefly what we're talking about with the swap spread is the benchmark indexes SOFR for U.S. dollar swap rate transactions and a swap spread is gonna be the maturity-matched yield spread between a Treasury and that SOFR swap rate. So that's what we refer to when we talk about swap spreads. So before the volatility, what really I think was meaningful to note heading into April, the industry and the official sector were very heavily focused on enhancing liquidity and considering adjustments to aspects of the SLR or supplementary leverage ratio. This was a big focus for the general de-reg topic in markets under the new administration. And there was a view by some in the market that if treasuries were exempt from SLR this would increase bank demand for Treasuries. We heard public statements about SLR reform directly from Michelle Bowman, who's the nominee for Vice Chair of Supervision, Chair Powell, as well as Secretary of Treasury, Scott Bessent. So the markets were really pricing some expectation of SLR reform and relatively quickly. And you can see that in the spread move in Q1 where Treasuries richened up in a meaningful way relative to the swaps. And so with this focus, not only did the price change, but certainly risks were added to in which we certainly know there's a good portion of the market and some leverage that added to swap spread longs to express this view. So once we hit material market volatility in April, in which there were certainly gonna be questions about flows in Treasuries and as they relate to our general trade policy, that volatility was found most acutely in Treasury swap spreads and really very little to do with basis trades actually being unwound.

Kate Finlayson: That's helpful. Thanks, Brian. The Treasury futures basis trade is often a focus of research with the official sector zeroing in on that buildup of leverage in the Treasury market, and really here the concept of hidden leverage being the pertinent element. Why is that, John?

John Schwartz: Yeah, thanks, Kate. Leverage continues to be a focal point, right? Not only for traders, but for policymakers and regulators. The T-Backroad report last year, which looked at the leverage used in relative value strategies by hedge funds, and if you assume a leverage ratio of 20 times, the study concludes a generation of 9% to 10% of annualized excess returns. So I mean, leverage really is a critical component in achieving those returns. During heightened periods of market volatility, hedge funds look to unwind portions of their portfolio. It could be because positions are marked against them or they need to raise liquidity, but when risk taking diminishes and basis trades are unwound, the official sector has expressed concern about the potential financial stability risk posed by large and rapid unwinds of these portfolios. There has been a growing focus on non-bank financial intermediaries and the buildup of leverage associated with the MBFI sector, really specifically looking at a group of large hedge funds. The Financial Stability Board has highlighted the difficulty in really assessing the leverage in the Treasury market and exposures towards these hedge funds, who really spread their borrowing across both print brokers and repo desks.

Kate Finlayson: Thanks, John. Okay, so when we consider this hidden element associated with the leverage, there are various ways to track the basis trade and quantify volumes from various data sources. So how do regulators get further transparency or comfort around the amount of leverage in the system? Brian, maybe you could start us off.

Brian Fitzsimmons: Sure. So as you pointed out, there's already some data available to reflect the size of positions associated with the basis trade. You can look first at the CFTC short positioning report for levered funds as a general guide, but it lacks information or other components in terms of trade type to know exactly how much of this is basis. If you contrast the CFTC data with the trace data in which the cash market transactions are noted as those with having an offsetting futures leg, which we think is a clearer signal of a basis trade happening, those numbers are quite a bit lower. I think as we move towards the evolution of clearing regulators, we'll just continue to gain further insight into specifics and volumes of this trade.

Kate Finlayson: There's been record volume across U.S. Treasuries, almost $2.5 trillion in volume on April 9th alone. More volatility and volume than perhaps during COVID. And the DTCC announced that its clearing house, the Fixed Income Clearing Corporation, processed a series of record volumes in early April reaching an all-time high on April 9th. In terms of other periods of volatility and how the market coped with the record volumes, do you see this as a demonstration of the resilience of the Treasury market and it's a case of the system market infrastructure holding up well?

Brian Fitzsimmons: Absolutely. We view these very high volumes as a positive sign during periods of volatility where people are able to hedge their risk and do so in a meaningful way. And if you think back to early 2020, what really happened after some extreme volatility was that market depths dropped off so substantially that the market really sort of ceased to function, just the Treasury market itself. And so we definitely view these types of volumes that we can have such an unexpected vol shock to the market that substantial volumes can still go through as a very positive sign. And so while we do see that market depths did drop, that's always gonna be something that is counter cyclical to volatility. It was very far from the depths of the COVID levels, and it was also still above market depth that we saw in March, 2023 during the regional banking crisis. So market handled it pretty well from a volume and liquidity perspective, I would say.

John Schwartz: Yeah, and even on the financing side, Brian, I do think that the financing markets were technically set up in April very constructively. But even on the market infrastructure side, it held up pretty well. If you look at the DTCC data, there's been meaningful growth in cleared activity over the last five years, both dealer-to-dealer type activity as well as client-to-dealer activity. I'm sure you'd find that non-centrally cleared U.S. Treasury repo activity also increased meaningfully during this period. I think some of that clearly just the functioning of the market repositioning around that period. But really the driver of growth across cleared and non-clear activities really driven by the significant growth in outstanding U.S. Treasury issuance.

Kate Finlayson: Exactly, John. Putting this into context, the amount of Treasury debt outstanding has grown significantly, issuance has gone up threefold, and according to the non-partisan Congressional Budget Office, there's the expectation that U.S. public debt will exceed $50 trillion in the coming decade, doubling in size. So how does the market and official sector look to adjust in line with this growth?

Brian Fitzsimmons: That's the billion-dollar question, Kate. And it's really the key reason that policy makers have been focused on improving Treasury market resilience and increasing intermediation capacity for the last several years already. For now, in addition to these efforts, if we look to what the market is doing, what's very clear, particularly through the month of April and where we sit now, is that the market as a whole has been building in more term premium into the U.S. Treasury market. And we're seeing that both in terms of swap spread levels, but as well as other term premium models like the Fed's own ACM model, as well as various swap spread models that you can read about in our own JPM research. I would say overall key concern has been that intermediation in general has not kept pace with the growth of the U.S. Treasury market. And so the Treasury Fed and other bodies are really working hard to try to address this issue to ensure resiliency and liquidity in the years ahead.

Kate Finlayson: There's been various proposals or thought pieces published on the topic. A FEDS Notes in September 2023, concluded that financial stability risks were facilitated by low or zero haircuts on Treasury repo borrowing. And that FEDS Notes theorized about a 200 basis point minimum haircut and what that could do to reduce leverage, albeit of course recognizing the potential negative impact on pricing. This would arguably reduce the appeal of the basis trade. a recent TMPG paper looks at risk management best practices, including non-zero haircuts. So while minimum haircuts haven't been implemented in any major jurisdiction yet, they continue to be part of this policy debate at both a global and local level. John, in your opinion, what would minimum haircuts do? And what could their potential impact be from a financing perspective?

John Schwartz: The debate around minimum haircuts I think in the U.S. Treasury market is a real important one to have, particularly in light of both the SEC's U.S. Treasury clearing mandate, but more relevantly I think just given the growth that we've seen in the U.S. Treasury market over the last number of years. Prudent credit risk management practices are clearly critical to the functioning of the U.S. Treasury market, and certainly haircuts are a tool available to dealers to really mitigate counterparty credit risk. However, we should also recognize that haircuts on a standalone basis is a relatively blunt tool to manage exposures. In other words, they do not account for risk-reducing activity elsewhere in a client portfolio. For example, the basis trade where a repo borrower has an offsetting position in the futures market. In practice today, the borrower already pays a CCP mandated haircut on the futures leg. So if they pay an additional minimum haircut on the repo leg, presumably they're over-margined relative to the risk in that transaction. So I do think regulators have a lot to think through. And they've certainly grappled with this issue for many years now. Minimum haircuts on non-sovereign SFTs was supposed to be implemented as part of the Basel III process. But as you say, Kate, up until now no major jurisdiction has yet to adopt it. I think one of the reasons is really the complexities of accounting for these netting and portfolio effects across client positioning. In addition to the concern around potential repricing of sovereign debt markets to factor in the cost of this haircut. Nevertheless, we do continue to hear minimum haircuts raised as a potential policy tool. Most recently, the Bank of England exploring this tool in the context of the gilt repo market. And then again by the FSB and their work on addressing the risks of non-bank leverage across the system.

Kate Finlayson: Thanks, John. There was a recent Brookings Institute paper that asked the question about how the Fed Reserve could best address market stress events such as those associated with the basis trade. So for example, adjusting regulations thought to restrict dealer capacity like SLR, creating a broad-based standing Fed repo facility so the Fed can lend to hedge funds directly, imposing minimum haircuts that we've just been talking about, introducing central clearing as well. But it's clearly not a case of having a silver bullet to mitigate risk or account for unexpected volatility. Or, here we go, could you introduce haircuts and do away with clearing?

Brian Fitzsimmons: Yes, just to speak to, I'd say first the Brookings Institute paper, I think what's more important than the proposal from this paper about the Fed being able to trade cash and futures in case levered funds come under stress from this trade is just a larger picture of what has been going on in the last several years. They're certainly now looking at ways to change SLR. The Fed has SRF in place and continues to look at ways to make it a more powerful tool and we're obviously getting closer to central clearing. I would say for that paper, we think it's very unlikely that this would be deployed by the Fed currently. I think it certainly introduces concern of a moral hazard of the Fed underwriting one very specific trade of cash versus futures in which these really are risk trades at the end of the day and the market should be in the position of trying to properly size and understand the risks that they undertake. So these risks should not come for free. The idea of the Fed holding futures is one that we just don't see as plausible. In terms of SLR, which I think is much more important, our research team actually stated it quite well in a recent publication, which they titled “Helpful, But Not A Panacea.” Overall, the banking system does not currently appear to be leverage-constrained. So we do not think it materially changes bank's appetite for treasuries in the near term with a changed SLR. One scenario for SLR relief though would be removing reserves as well as dealer holdings of U.S. Treasuries from the SLR calculation, which may help dealer intermediation capacity, which is quite critical at periods of high volatility when the system as a whole starts to become more leverage-constrained. But without a major change to demand and Treasuries, it will not simply solve all policymakers concern about both leverage as well as the gross of the U.S. Treasury market that we're looking at in the next several years.

John Schwartz: Yeah, you almost need to take a step back and kinda consider the impact of all these measures more broadly. And I think when you do, it's clear that there isn't a single solution that's going to address liquidity and/or risk concerns that may be pervasive across the market. I think those that do materialize should work in harmony with one another. Whether it's a clearing mandate, minimum haircuts or changes to bank capital regimes, they all typically really involve trade-offs. And on one hand I think goals of increased stability and risk reduction need to be weighed against concerns around really their impact on capacity, liquidity, and pricing. For the U.S. Treasury market, the deepest and most liquid market in the world, achieving this balance is super critical, not just for clients and participants, but certainly for the dealers and banks. It's important for market functioning and at the end of the day, I think the ultimate beneficiary is really the U.S. taxpayer.

Kate Finlayson: Yeah, what we do know is that the first few months of 2025 has been interesting to say the least. Given the size of the market, this topic will no doubt remain front and center. Really great to have spoken with you both today. Thank you Brian and John for your insights.

Brian Fitzsimmons: Thank you, Kay.

John Schwartz: Thanks, Kate.

Kate Finlayson: To our listeners, please stay tuned for more FICC market structure and liquidity strategy content here on J.P. Morgan's Making Sense. If our clients have any questions or would like to discuss any information on the topic in this episode further, please reach out to your J.P. Morgan sales representative.

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