Exploring the Impact of Basis Trading in Financial Markets

The SEC is about to pass new rules impacting basis trading in US Treasuries. Why should you care? First, let me give you a little background on basis trading.

In the complex world of finance, the concept of basis trading plays a pivotal role. The ‘basis’ refers to the difference between an asset’s current market price (spot price) and its corresponding futures contract price. Traders utilize this strategy primarily for arbitrage opportunities, exploiting mispricing between the spot and futures markets. By buying low in one market and selling high in the other, they lock in a risk-free profit. This strategy is commonly used in commodities markets but can apply to any asset class with spot and futures markets, like currencies, bonds, or stocks.

Basis trading is a form of arbitrage. Arbitrage trade opportunities primarily exist when there is a lack of liquidity. In liquid markets, the spread is so narrow there is not enough spread to make a profit. Basis trading provides market liquidity, but this liquidity can quickly disappear in volatile markets. US Treasury market liquidity dried up in March of 2020. 

The circles above show increasing liquidity and then liquidity significantly declines going into 2022. Hedge funds have significantly increased their net short position since July 2022, according to the CTFC’s weekly COT data. 

The root cause of the problem is not the basis trade in US Treasuries but the lack of liquidity that makes this trade possible. Further regulating the US Treasury basis trade may cause liquidity to decline, making matters worse. In an interview with FT, Citadel’s founder Ken Griffin has to say about the regulation:

“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.”

Markets are so interconnected that the law of unintended consequences could make the liquidity issue in US Treasuries much worse than it is today. 

The US Treasury market has traditionally been considered one the most liquid markets in the world, so what changed? Before 2008, banks were large liquidity providers for US Treasuries. After the Volker Rules were passed, it became difficult for banks to make a market in US Treasuries, impacting market structure.

Another significant impact is Japan. Japan is a massive player in the US Treasury market and thus impacts US Treasury market liquidity. When Japan increases its holdings of US Treasures, liquidity increases. The opposite occurs when they reduce US Treasury holdings. Japan has recently become a net seller of US Treasuries, which should continue for some time. The Bank of Japan is on the path to minimize and possibly eliminate yield curve control. If this occurs, expect fewer US Treasuries to be purchased by Japan. 

In summary, basis trading significantly contributes to market dynamics. It enhances liquidity and stability and drives up trading volume. By narrowing the bid-ask spreads, aligning futures with spot prices, and stabilizing volatile markets, basis traders play an instrumental role in ensuring that financial markets operate efficiently and stably. They also facilitate hedging activities and encourage broader market participation.

The US Treasury is issuing record amounts of debt, Japan is buying fewer US Treasuries, and liquidity is declining. The SEC is over their skis and is about to pass regulations that may jeopardize one of the most important financial markets in the world. The unintended consequences of a highly complex interconnected market are about to raise its ugly head.

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