Taming the Treasury basis trade

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If you haven’t seen Ken Griffin’s latest interview with our colleagues at mainFT, it’s worth checking out. Alphaville has some thoughts on it, which we’re going to subject you to.

The tl;dr is that Citadel’s founder really doesn’t like the US Securities and Exchanges Commission’s proposals for tackling the Treasury basis trade that has caused plenty of angst in regulatory circles in recent years:

“If the SEC recklessly impairs the basis trade, it would crowd out funding for corporate America, raising the cost of capital to build a new factory or hire more employees,” Griffin said. “It would also increase the cost of issuing new debt, which will be borne by US taxpayers to the tune of billions or tens of billions of dollars a year.”

To recap, the Treasury basis trade is when hedge funds like Citadel go short Treasury futures and buy the corresponding cash Treasury bond, making money from the (usually) tiny price differences between the two. The profits are juiced by massive dollops of leverage. We wrote a more fulsome explainer here, and you can see how it can go very wrong here.

To be fair to Kenny G, his position is more nuanced than this quote would suggest (even if we think there’s an element of Rorschach’s “you’re locked in here with me” vibe here).

For example, he suggests that if regulators want to reduce the size of Treasury basis trades the best way to do so is through banks that help finance them. That doesn’t seem entirely wrong to us, even if it is obviously self-serving.

And it’s correct that supersized Treasury basis trades means that hedge funds are supersized buyers of US government debt at a sensitive time. A decent chunk of the ca $1tn of Treasuries that US “households” have bought in 2023 was probably actually hedge funds (US data is weird). More ephemerally, there IS some vague value in ensuring that the difference between Treasury bonds and Treasury futures is small. Really!

However, the value of saving the US government a few theoretical basis points needs to be stacked up against the very real dangers that a huge Treasury basis trade entails.

Admittedly, it is the kind of risk that has so far mainly manifested itself in a once-a-century pandemic. But it is a potentially cataclysmic one, given the role of Treasuries in the global financial system.

And given various unhelpful Treasury market trends it might not take another shock of that scale to happen again. Trading conditions are OK, but well, not great, and the basis trade has (probably) hit new size records lately, as this Oxford Economics charts shows.

That’s more than $1tn of notional short exposure to Treasury futures for hedge funds, with the mirror image being a very long asset management industry.

It’s important to note that there is probably less leverage in these trades than there used to be, given the recent volatility. But it’s still easy to envisage ways that things could get . . . sloppy.

We’re just spitballing here, but what if some big investors that are leveraged long duration through futures get creamed by a violent sell-off? Their collateral — ie mostly cash US Treasuries — would get liquidated.

That could send yields even higher, trigger more margin calls, force hedge funds to ditch their own Treasury longs and risk a 2022 UK gilt market-style feedback loop that cascades through global markets — where everything is priced off the Treasury curve. There’s a reason why even the Bank of England is warning about this.

Griffin seems awfully confident that Citadel would still be able to HODL their Treasury basis trades. Given the hedge fund’s uncompromising approach to their prime brokers and risk management that is plausible. But a lot of players would probably be shaken out of the trade pretty quickly.

His suggestion for stress tests of banks to solve this is pretty weak. Banks are already routinely stress-tested, and we still suffer from all sorts of nasty surprises. Alphaville has sub-zero confidence that prime brokerage arms would run plausible scenarios and cut back on the leverage they offer some of their biggest clients as a result.

But Griffin’s openness to a hard cap on how much leverage you can use for Treasury trades is more interesting (even if it would probably widen the basis and make it more profitable for those able to stay in trade eg Citadel).

It’s not a solution, but this isn’t about ending the Treasury basis trade altogether. It’s about trying to tame it a little — ensuring that any spurts of violent deleveraging is primarily painful for the people caught up in it.

And if that costs the US taxpayers a few more basis points in borrowing costs, that seems clearly worth it?

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