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Trust TBAC to cut through the noise on niche but controversial market topics such as Treasury basis trading.
The Treasury Borrowing Advisory Committee, or TBAC for short, advises the Ministry of Finance on more than just obvious issues (borrowing practices). In addition, other niche topics are covered, e.g. B. which types of bonds should be introduced or discontinued, auction formats and market structure.
It's full of heavyweights who were there to watch basis trading, or arbitrage, between the U.S. Treasury's cash and futures markets explode during the early 2020 cash rush. So it's worth paying attention and seeing how they responded to the following question asked by the Treasury before its latest refund meeting:
“According to Treasury futures positioning data, long positions by asset managers and short positions by leveraged funds have increased significantly. Please discuss the factors that may be driving this dynamic. What are the reasons for asset managers to choose the treasury futures market over the cash market for their duration needs? What type of activity does leveraged short positioning reflect? For example, to what extent could this be a trading activity based on cash futures? What are the important factors to consider when monitoring changes in cash futures basis positions?”
Instead of focusing on the risks of arbitrage, which were very clearly demonstrated in 2020, the question prompts TBAC to look at what makes arbitrage so profitable.
One trend often blamed for hedge funds' increasing involvement in the Treasury market is supply growth. But higher supply doesn't exactly explain why futures trade at a premium to cash Treasury bonds. And it is this premium on futures that makes the arbitrage opportunity so attractive for hedge funds.
TBAC points to different market dynamics: simple asset managers tend to long treasury futures and leveraged fund managers tend to take short positions. As the presentation says:
. . . A permanent risk premium must be achieved on a treasury futures basis. It appears that asset managers are willing to pay this premium to invest in higher return products, while hedge funds earn the premium.
In other words, asset managers' demand for Treasury futures creates opportunities for arbitrage, and hedge funds provide liquidity in this trading. The talk calls it a “symbiotic relationship.”
The TBAC cites some interesting reasons why asset managers tend to go long futures, and the full report is definitely worth a look.
To summarize: Futures markets provide a cost-effective and efficient way to increase leverage and/or hedge interest rate risk compared to repo markets.
Remember that interest rates in the world were very low before 2022. As a result, asset managers seeking to maximize their fund's returns often maintained larger allocations to corporate bonds than the benchmark (often Bloomberg US Agg). But loans by nature have a shorter duration, meaning they don't carry as much interest rate risk as most funds' benchmark. So instead of changing the fund's entire strategy, a manager could maintain duration risk by taking leveraged Treasury positions.
In theory, this leverage could come from futures or repo markets, but the cost of repo transactions is recorded as interest expense, unlike repo futures markets. The TBAC presentation suggests that fund managers are discouraged from using this leverage in the repo markets.
TBAC believes this has several implications. Here are some of the most interesting:
First, “A reduction in credit risk by asset managers would of course facilitate the unwinding of basis trading by hedge funds.” This could conceivably already be happening if asset managers actually retreat from the pursuit of returns that characterized the post-GFC period. Pre-Covid time.
Second, “Treasury repo clearing could provide an opportunity to gain deeper insights in the coming years.” It will be interesting to see if (or how) the expansion of repo clearing impacts the opportunities that bond funds have use for leverage. If expanding clearing (a big problem) makes repo transactions more standardized and easier to execute, does this reduce some of the attractiveness of futures for fund managers?
The smartest thing, however, is that TBAC and the Treasury Department are investigating the conditions that create the arbitrage. Otherwise, it can be all too easy to get caught up in a dispute between competing retailers over who is allowed to provide the service.
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