Research Summary
The report discusses the resurgence of a risky trade in the world’s most systemic bond market, known as the Treasury Market Unwind. This trade involves asset managers shifting from cash bonds to long positions of associated Treasury futures, creating an arbitrage opportunity. Hedge funds, primarily relative-value funds, exploit this opportunity by going “long the basis,” which involves shorting Treasury futures and buying the underlying securities in the cash market. However, the profits from this nearly risk-free trade are minimal, leading hedge funds to employ significant leverage, often through the bilateral repo market.
Key Takeaways
The Treasury Market Unwind
- Resurgence of a risky trade: The Treasury Market Unwind, a trade known for its riskiness, is gaining popularity again. This trade involves asset managers shifting from cash bonds to long positions of associated Treasury futures.
- Arbitrage opportunity: The intense reallocation from cash bonds to Treasury futures has caused prices to diverge, creating an arbitrage opportunity. Hedge funds, primarily relative-value funds, have been exploiting this opportunity.
- Going “long the basis”: Hedge funds go “long the basis” by shorting Treasury futures and buying the underlying securities in the cash market. This strategy allows them to profit from the difference in price between cash and futures.
Leverage and the Bilateral Repo Market
- Use of leverage: Due to the minimal profits from the nearly risk-free arbitrage, hedge funds have to employ significant leverage. They achieve this through the bilateral repo market, where they borrow cash against the Treasuries they use to deliver into futures contracts.
- Uncleared bilateral repo market: Hedge funds borrow in either uncleared, cleared, or sponsored bilateral repo markets. The uncleared repo market, officially known as NCCBR (non-centrally-cleared bilateral repo), offers superior leverage and has swamped cleared repo in size and activity.
- High leverage: By 2019, hedge funds were regularly borrowing up to a hundred times the capital they committed to Treasury basis trades, achieving in most cases more than 99:1 leverage.
Actionable Insights
- Monitor the Treasury Market Unwind: Given the resurgence of this risky trade, it’s crucial to keep a close eye on the Treasury Market Unwind and its potential impacts on the bond market.
- Understand the role of leverage: The use of significant leverage in these trades can amplify both potential gains and losses. Understanding the role of leverage and its risks is essential.
- Consider the implications of the bilateral repo market: The bilateral repo market plays a significant role in these trades. Understanding its dynamics and potential risks can provide valuable insights.
