From Bloomberg, December 19:
A small bunch of hedge fund traders dominates the massive basis trade. They’ve made billions for their firms — and alarmed financial supervisors.
Jonathan Hoffman, John Bonello and Jonathan Tipermas share more than just similar first names. They’re the driving force behind a gigantic wager on government debt that’s been giving regulators sleepless nights.
They and their teams are top players in the “basis trade,” a bet by a few of the world’s biggest hedge funds that profits from the tiny price gaps between Treasuries and derivatives known as futures, people active in the market say. That makes them some of the most important individuals in finance today.
As part of a core group of 10 or so firms, they rely on vast sums of money borrowed from Wall Street banks — often 50 times what they invest themselves — to pump tens of billions of dollars into the trade and supercharge returns. So colossal are their bets that some say they’ve become central to the buying and selling of Treasuries, itself the cornerstone of global capital markets.
Hoffman, 51, of ExodusPoint Capital Management, Bonello, 52, at Millennium Management and Tipermas, 41, at Citadel have used the wager for years to produce gains that run into the billions, according to several people familiar with the traders who requested anonymity as the details aren’t public.
Others also do the trade at a vast size, the same people say, including Yan Huo and Ryan Letchworth at Capula Investment Management, Citadel’s Ivan Chalbaud, founder of Symmetry Investments Feng Guo and Steve Brown at Balyasny Asset Management. Lorenzo Rossi of Kedalion Capital Management is active, too, as is Alexander Phillips at Tudor Investment Corp.
This group is rarely in public view. But interviews with more than a dozen market participants and documents reviewed by Bloomberg point to their dominance of a wager that’s roared back to life this year. A senior Wall Street figure who’s worked for years with the core players estimates they account for roughly 70% of hedge fund basis-trade bets.
The firms and traders named in this piece all declined to comment.
Now regulators have the hedge funds in their sights, fearing a repeat of March 2020 when the bet blew up spectacularly — just before the Federal Reserve had to jump in to resuscitate the Treasury market. Last week the Securities and Exchange Commission, alarmed by the sheer scale of borrowing involved, voted in new rules that may make the economics of the trade less enticing.
But regulators are in a bind. Crack down too hard and they could threaten the orderly running of a US Treasuries market that’s ballooned to $26 trillion since the pandemic. Go too easy and there’s the threat of too much financial leverage building up at these hedge funds. The size of the traders’ positions means the Fed may have to intervene if they hit trouble again.
“There are only a couple of players and these players have made themselves too big to fail,” says Kathryn Kaminski, chief research strategist at AlphaSimplex Group, a Treasury investor. “If you limit this arbitrage, you weaken market liquidity.”
Market Makers
Unlike other vaunted hedge fund traders who make splashy bets on the direction of currencies or interest rates or wage high-profile campaigns against companies, Hoffman, Bonello and others quietly target differences in price between Treasuries and Treasury futures — closely linked derivatives that give investors the right to buy or sell the debt in the future.For a mix of reasons the futures price is often higher than the bond’s, so the trader sells the former, buys the latter and pockets the difference. Because the gap is usually mere fractions of a penny this is only worth doing at scale, ramping up returns through the use of leverage. That largely limits the activity to a few trusted individuals at hedge funds with enough clout to borrow big from banks in overnight money markets.
What’s the Basis Trade? Why Does It Worry Regulators?: QuickTake
As the availability of this short-term lending has surged
this year, the basis trade has boomed. The net short position on Treasury futures, a reasonable proxy for the wager’s popularity, has spiked to $800 billion from $650 billion in July, the Bank of England said on Dec. 6.
While it’s difficult to tell how much of this is held by the core trader group, the wager has become more concentrated this year. Eight or fewer traders are behind almost half of all bets against two-year Treasury futures, compared with 29% a year ago, data from the Commodity Futures Trading Commission shows.
A Small Group of Traders Dominates Basis Trade
Eight or fewer traders are behind almost half of all the bets made against two-year Treasury futuresDefenders of the trade such as Citadel’s Ken Griffin say the enormous volume of buying and selling by hedge funds means they’re helping to make the Treasury market efficient. Wall Street banks used to perform this critical “market making” role but have retreated because of new leverage rules imposed after the financial crisis.
Critics ask whether it’s wise to lean so heavily on a few hedge funds, pointing to Covid’s early days in March 2020 when market turmoil forced them to rapidly unwind their positions. That may have added to a sudden drying up of Treasury liquidity, and it left the basis traders staring at huge losses. The Fed had to intervene to keep markets running, pledging trillions of taxpayer dollars.
The Fed’s rescue mission calmed the Treasury market and helped the traders recover. Bonello’s team at Millennium generated nearly $1.5 billion of profit in 2020, a record, and that year’s basis trade contributed to the $1 billion Hoffman has generated since joining ExodusPoint in mid-2018. Rossi, then at LMR Partners, turned millions of losses during that March into profit.
The 2020 episode may have fed a belief among some in the group that the central bank will always ride to the rescue, market participants say. “There’s an implicit ‘Fed put’,” says Eric Rosenfeld, formerly of Salomon Brothers’ government-arbitrage desk in the 1980s and a cofounder of Long-Term Capital Management, a hedge fund that imploded in 1998. But it’s not a question of “too big to fail,” he asserts, more that the “Fed is responsible for maintaining a liquid, free-flowing Treasury market.”
Gary Gensler, the SEC chair, told Bloomberg in October that if another meltdown happens, “It’s going to be the public that bears the risk.”
Lehman Roots
The group traces its roots to the same Wall Street banks that dominated the trade before the financial crisis. Some overlapped at the same firms and learned the wager from each other or the same mentors, people familiar say....
....MUCH MORE, it gets worse.
