Fed’s intervention in basis trading last spring may have ensured financial stability, OFR brief states

“Timely intervention” last spring by the Federal Reserve in repurchase agreement and Treasury markets may have limited spillover effects from liquidity risks that could have affected financial stability, according to a report issued Thursday.

The Treasury’s Office of Financial Research (OFR), in the first “brief” it has published in nearly two years (the last was published in August 2018), summarized evidence on the size and extent of basis trading by hedge funds. OFR said its brief (Basis Trades and Treasury Market Illiquidity) “assesses the possibility that the trade’s exposure to financing and liquidity risks contributed to Treasury market illiquidity in March 2020.”

“While we find that Treasury illiquidity in March placed stress on Treasury basis trades, the evidence casts doubt on the theory that stress in these trades amplified Treasury market illiquidity,” the paper states. “Intervention by the Federal Reserve in the Treasury and repo markets may have limited spillovers that could affect financial stability.”

The paper explains that basis trading is a form of “near-arbitrage” between the cash and futures prices of Treasury securities — which it calls a usually small difference known as the basis. It notes that if the difference is bigger than the cost of buying the Treasury and financing that purchase in the repurchase agreement (repo) market, then the trade is profitable. “Traders rely on repo markets for financing to achieve high leverage for these trades,” the paper states. “In early March 2020, stress in Treasury markets led to large basis trade losses for some relative value hedge funds.”

The Fed’s actions, the paper states, may have been crucial in limiting the extent of hedge fund losses in the basis trade and “in preventing broader spillovers.”

“Following March 16, returns on basis trades began to move back into line with the returns on Treasury bills, and came closer to the cost of borrowing in the sponsored repo market,” the brief states. “Several Fed actions on March 16 and 17 may have contributed to this easing of pressure on hedge funds. In particular, Federal Reserve expansions of Treasury purchases provided an additional source of demand for off-the-run Treasuries, while expansions of the central bank’s repo facility reduced financing risks associated with providing liquidity to Treasury markets. It is difficult to know exactly which of these actions was most important, in particular because they were mutually reinforcing.”

The brief warns, however, that risks of basis trades persist, asserting that hedge funds still hold large short Treasury futures positions. The OFR paper states that relatively high costs of funding for hedge funds, combined with low returns on the basis trade, could lead to further sales of the basis and reduce the liquidity these trades provide to longer-term Treasury notes and bonds.

“The high leverage of hedge funds involved in basis trades continues to be a cause for concern,” the brief states. “These funds remain exposed to sudden bouts of illiquidity in Treasury and repo markets.”

Basis Trades and Treasury Market Illiquidity