The Biggest Trade in the World?

Humungous Cash/Futures basis trade piles up.

Public expressions from regulatory authorities about the cash/futures basis suggests this trade is something to worry about. The Fed, the BIS, the Bank of England, and others, have publicly aired concerns since early-2023 that highly leveraged non-bank financial intermediaries (i.e. hedge funds) control an essential channel of finance; namely, the conduit between futures prices and cash Treasury bonds. In a time of large funding demands, uncertainty over deficit finance and recurring debt ceiling problems this is, er, worthy of attention. Dislocation of trade in Treasuries could be ‘interesting’, which is not a word regulators like to hear. Indeed, it is possible this trade is the biggest trade in the world currently held by leveraged accounts, or anyone else. A not-to-be-relied-upon estimate suggests exposures may have a face value approaching US$ 1 trillion, possibly more. That should make us sit up and take notice. The fascinating aspect from a regulatory standpoint is the emergence of hedge funds in the cash/futures basis is partly a consequence of prescriptive rules imposed on banks after the GFC. Which is almost funny. Be careful what you wish for.

Source: Photo by Photoholgic on Unsplash

There are two publicly available measures to gauge the size of the cash/futures basis trade. The first looks at transaction changes in Delivery versus Payment (DVP) repo. The second is the CFTC’s weekly Commitment of Traders report which details size of holdings in futures by investor type.

There are some ways to cross-reference data to estimate the size of the trade, especially in the repo market. According to the Fed: “Hedge funds borrow in repo almost exclusively through two venues: FICC's sponsored DVP repo service (a centrally cleared bilateral market) and the non-centrally cleared bilateral repo market.”

The same report went on: ‘hedge fund borrowing in sponsored repo (DVP) should correlate with rising hedge fund net repo demand due to increasing basis trade positions. Between the beginning of October 4, 2022, and May 9th, 2023, sponsored repo borrowing from hedge funds increased by $119 billion, from $114 billion to $233 billion. These figures look wildly out of date.

Indeed, the report acknowledged the trade was much higher exposure than DVP suggested. It concluded leveraged fund Treasury futures shorts amounted to US$715 billion face value, as at mid-May 2023. Which suggests only ⅓ of funding comes from DVP. A lot more funding for the long cash leg was provided outside DVP sponsored repo.

Source: https://www.federalreserve.gov/econres/notes/feds-notes/recent-developments-in-hedge-funds-treasury-futures-and-repo-positions-20230830.html#fig2

The Office of Financial Research wrote in August 2022: “on average throughout this period (December 2019 till September 2021), the Fixed Income Clearing Corporation’s (FICC) DVP service only accounted for 8% of hedge fund repo borrowing, and the remainder is likely primarily through non-centrally cleared repo borrowing.” And “there is no central source data on the non-centrally cleared bilateral market”, though OFR has proposed attempting to collate this data.

Recently, DVP reported volumes have averaged approximately ~US$1.5 trillion per day. A not-especially-wild-guess suggests about ⅓ of this daily volume may be related to funding for leveraged accounts in the basis trade. That is over double the volume reported in the Fed report in May 2023. No doubt there is a sizeable additional funding component provided outside DVP, as the OFR report above suggests.

The behaviour of DVP loosely matches the rise in futures shorts by leveraged accounts, which the Fed highlighted, and our charts show (see above versus below, with matching dates on x-axis).

If the Fed were worried at the end of May, leveraged positions have increased their shorts since. Since May-2023, 2-year futures shorts rose by 35%, 5-year shorts by 26%, 10-year by 7% and 30-year by a whopping 66%. In terms of market risk, by far the largest DV01 exposure in the basis trade resides in the 10-year sector.

Futures shorts are not the whole story. A variant of the basis trade uses Interest Rate swaps instead of futures. The size of this trade is difficult to estimate. However, the curtain occasionally twitches to reveal simultaneous transaction moves in repo and OIS swaps. This happened around year end. The swap exposures do not appear be anything like the size reported in the futures market though they are probably more highly leveraged.

A degree of conjecture is acknowledged here, but it is possible the Face Value exposure in the cash/futures basis trade approaches US$ 1 trillion or more. This compares to total outstanding marketable Treasuries of US$ 27 trillion and average daily turnover of the Treasury market of US$ 700 billion. The DV01 (daily risk held by leveraged accounts) is clearly what we should be focussed on and is undoubtedly in the region of, a very-large-amount.