LONDON — International watchdogs, led by the Bank for International Settlements and the Bank of England, have warned that the skyrocketing use of the Treasury basis trade by hedge funds is adding dangerous leverage to sovereign bond markets and risks triggering disorderly moves in yields. The highly leveraged arbitrage that connects the cash Treasurys, futures, and repo markets could exacerbate shocks if margin calls or funding strains push funds to shed bonds in a hurry.
Regulators name alarm over Treasury foundation commerce leverage.
Speaking at the London School of Economics, after taking his seat at the BIS last month, new general manager Pablo Hernández de Cos said efforts should now be made to “curb hedge funds’ capabilities” of “wagering through high leverage on relative-value trades in government debt, which could now spoil financing for companies and households”. March warned that high levels of public debt and the unrestrained use of leverage by nonbank financial institutions are creating new risks to stability in core bond markets.
One day later, the Bank of England has turned up with its latest Financial Stability Report showing a similar dynamic this time in the gilt market, where hedge funds’ gilt repo borrowing (which now totals almost £100bn) is similarly concentrated across just a few firms all running basis strategies at very short maturities and near-zero haircuts. In a Bloomberg recap of the report, the central bank implores funds and dealers to ensure they can weather an unexpectedly sharp move in funding conditions related to trades known as the Treasury basis trade and the gilt basis.
How the Treasury basis trade concentrates risk
At its simplest, a Treasury basis trade involves a hedge fund going short a Treasury futures contract while buying the associated cash bond, with repo funding. The gain is from earning the spread between the implied repo rate in the futures price and the cost of repo funding over a trade’s life. The U.S. Financial Stability Oversight Council has sounded the alarm that this species of investment, which is frequently low-volatility in tranquil markets and relies on enormous leverage and daily rollovers of repos, hangs folks out to dry when correlations falter or repo dries up. According to the FSOC’s 2024 annual report, the proliferation of this trade has “raised leverage in the Treasury markets and poses a risk that adversely affects financial stability.”
That vulnerability is amplified further on the futures side. A 2023 BIS study of margin leverage revealed that leveraged investors had actually rebuilt net short U.S. Treasury futures positions to around $600 billion, with over 40% centred in two-year contracts, readings similar to those seen before both the September 2019 repo turmoil and March 2020’s “dash for cash.” The authors cautioned that abrupt hikes in initial margins can force unwinds of underlying Treasury basis trade positions, creating destabilising “margin spirals” and dislocating core fixed-income markets.
PAST SHOWS T-BASIS TRADE CAN MULTIPLY SHOCKS.
Regulators have been grappling with the issue for years. Markets Media in late 2023 noted that the SEC, Federal Reserve, Bank of England, and BIS had all flagged the Treasury basis trade as a potential source of fragility, with large, leveraged short positions in Treasury futures dovetailing with stressed conditions during 2019 and 2020. The article said that supervisors had identified the accumulation of hedge fund basis exposures as a financial stability “vulnerability worth monitoring,” even though some market participants maintain that it enhances liquidity.
By 2024, FSOC believed that hedge fund leverage had increased by 54% from 2022 levels to over $5 trillion, and a significant proportion was tied to the Treasury basis trade, where asset managers went long futures and hedge funds shorted them while funding cash bonds through repo. The council warned that a forced unwind — triggered by a shock to Treasury prices or a jump in haircuts — could once again disrupt market functioning, as in March 2020, when leveraged selling of Treasuries exacerbated liquidity strains before central banks intervened.
From niche arbitrage to systemic issue
Now, what officials fear is that the convergence of a surge in public debt issuance, the heavy use of the Treasury basis trade by hedge funds, and the pervasiveness of zero-haircut short-term repo funding leaves bond market liquidity far more reliant on borrowed money. BIS and BoE officials say that without stronger constraints, the arbitrage that normally keeps futures and cash markets on the same page in good times may become a powerful amplifier of stress, as funds, dealers, and even pension funds are forced to deleverage simultaneously.
Regulators are considering a raft of fixes, such as more centralised clearing in government bond and repo markets and levelling floors for minimum margin or haircut levels on trades that aren’t centrally cleared, even though some in the industry caution that tighter rules could dampen liquidity. In the meantime, watchdogs say the message to hedge funds and their lenders is clear: treat today’s rich profits from the Treasury basis trade as cyclical, not guaranteed — and ensure that positions can survive the next bout of volatility without again turning a useful arbitrage into the bond market’s newest flashpoint.
