The real regulatory risk highlighted by a booming US Treasury arbitrage

Some weird stuff is forbidden in the US. It is illegal to bring live snakes to Mardi Gras in Louisiana. North Carolina forbids drunken bingo playing. But no law yet prohibits “recklessly impair[ing] the basis trade”. This is the esoteric misdeed imagined by Ken Griffin, chief executive of hedge fund group Citadel in a recent Financial Times interview.

The basis trade is an arbitrage between the price of Treasuries and futures contracts on them. Watchdogs are worried hedge funds are basis trading so prolifically that snarl-ups could destabilise markets that help set the cost of US public debt.

A Securities and Exchange Commission plan to register hedge funds as Treasury dealers is gaining ground as a result. This would count as reckless impairment in Griffin’s view. He thinks tougher scrutiny of banks is a better solution. You cannot blame a person for talking their own book. But it is reasonable to scrutinise basis traders as well as banks serving them via their prime broking arms. A modest arbitrage has burgeoned into a behemoth.

Basis trading may now account for the bulk of record short selling of Treasury futures. Shorting in the key two, five and 10-year maturities hit around $660bn of underlying notional value last week, according to data from the Commodity Futures Trading Commission.

This is all thanks to the small premium, or “basis”, at which the future trades above the underlying security. This erodes and finally disappears when the futures contract expires. Hedge funds can make a turn by shorting the future and buying the underlying bond.

This may be worth tiny fractions of percentage points, according to Jens Foehrenbach of Man Group, a UK-based hedge fund group. For heftier returns, leverage is deployed. Basis traders transact in futures by posting slivers of margin and may borrow 100 per cent of their cost for Treasuries.

Basis trading is sometimes described as “riskless”. This is not strictly true. Traders may be exposed to fluctuations in short-term interest rates. They also shoulder the risk of margin calls if futures prices rise. The worry is that if basis trades go bad, hedge funds would dump Treasuries en masse.

It is a moot point how damaging this would be systemically. It is true that $660bn of short positions sounds like a lot. But outstanding Treasuries are worth some $26tn.

There are arguments on both sides on whether disorderly unwinds exacerbated wobbles dangerously in the Treasuries market in March 2020. Certainly, some basis traders lost their expensive shirts then. But as Foehrenbach wryly notes: “The world economy shut down around that time.” He adds: “Basis trades added to volatility. But they did not bring down the system.”

Regulators should consider curbing bank lending, as Griffin suggests. But they should also keep a close eye on big hedge funds such as Citadel. That is where the risk of basis trading is concentrated. If it turns toxic, volatility in Treasuries would be a bigger threat to financial stability than the risk of defaults to banks. These are, for the most part, well capitalised.

Taxpayers are more likely to foot a bill for intervention to stabilise Treasuries than for lender bailouts.

In 2015, the Volcker rule curbed proprietary trading by US investment banks. Trading-oriented hedge funds have expanded accordingly. Prime brokers supply credit, off-the-peg strategies and job-hopping recruits. Proprietary trading still makes a turn for Wall Street banks, albeit in interest and service income for prime brokerage rather than capital gains.

It makes little sense, however, to regulate larger hedge funds as dealers. This is not what they do, regardless of how brutally they stretch the term “investor”. Moreover, there is a size threshold for dealer status many hedge funds would take care to avoid breaching. That would distort market behaviour.

Hedgies are not, as a breed, strongly motivated by social mission. However, basis trading has some utility in preventing Treasury futures from trading wildly out of whack with underlying bonds. A big gap implies higher costs for fresh US debt.

The real challenge for watchdogs such as the SEC is to understand hedge funds and prime brokers as symbiotic organisms. Between them, they arbitrage regulatory risks every bit as skilfully as price discrepancies in Treasuries. This should not be forbidden in the way snakes at Mardi Gras are. But it should certainly be probed more closely.

john.guthrie@ft.com