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CME Group, one of the world’s largest derivatives exchanges, is launching a new product designed to simplify and lower the cost of a popular but controversial hedge fund bet known as the basis trade, potentially opening it up to a broader range of investors.
The Chicago-based firm said it would launch a new feature called Treasury Link, which will turn what is currently a multi-step process — buying a US Treasury bond and placing a short bet on the equivalent future — into a single, electronic transaction. By eliminating the risk of a market move in between transactions, and reducing the need for a broker, CME expects Treasury Link to open the market up to a wider pool of investors.
The basis trade has boomed in recent years, with big hedge funds using leverage — sometimes more than 100 times — to try to profit from minuscule discrepancies in the price of a Treasury bond compared with its corresponding futures contract. As of September last year, the Federal Reserve estimated there were $830bn in such bets, double the last peak hit in 2020.
Expanding investor access could fuel a trade that has added to market volatility and prompted warnings from regulators. A rapid unwind of the basis trade shook the Treasury market during the market collapse in March 2020 triggered by the coronavirus pandemic and has since attracted regulatory scrutiny.
Regulators including the Federal Reserve, the Securities and Exchange Commission and the Financial Stability Oversight Council have all issued warnings about the basis trade. The trade has enormous concentration risk: a handful of big hedge funds control the majority of the basis trade and regulators fear a liquidity crisis among those funds could lead to a rapid unwind in positioning — as was seen in March 2020. The trade is also highly sensitive to geopolitical shocks, such as the US tariff announcement last year, which led to a dramatic unwind of positions that moved the 10-year Treasury yield by 0.6 percentage points over the course of a week.
But the immediate effect of the launch is more likely to make the market less risky, CME argues. By decreasing the risk of a multi-part trade and expanding the investor base, the product should make pricing in both markets more efficient and narrow the difference, or basis, between them.
It could also make it easier for traders to jump into the trade when the spread expands, as in March 2020 and other events, potentially reducing market contagion from a rapid deleveraging.
Moving more of these trades to a fully electronic platform would also increase transparency in the still-opaque Treasury cash market, says CME. The electronification of the trade means buyers and sellers are matched transparently and automatically through an algorithm, in a development that could appeal to smaller funds with fewer broker relationships across markets.
“We believe this is positive structurally for the liquidity and transparency of the market. It adds to the integrity of the Treasury system, which is important given the increasing size of the market,” said Matt Gierke, global head of BrokerTec, the cash Treasuries trading platform owned by CME.
“We believe that there is a high chance of attracting customers who were not previously clients, or only clients in one market.”
Traders must use both BrokerTec and CME’s Treasury futures platform to have access.
BrokerTec, which CME bought in 2018, is the largest electronic Treasury trading platform in the US. But it has been losing market share to rivals Dealerweb and FMX in recent years, according to Crisil Coalition Greenwich data, which some traders attribute to a lower cost per trade or allowing traders to place bets in smaller price increments.
CME, which has not announced the cost of using the new instrument, has started to offer smaller trading increments at its new Chicago exchange, which will be mirrored in Treasury Link.
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