For now this is just a personal bookmark but somewhere down the road we may be referring back to it.
From The European Central Bank's Financial Stability Review, May 2024:
Basis trades are arbitrage strategies which improve market functioning but are subject to specific risks, especially when excessively leveraged. Basis trades typically aim to exploit any mispricing between the spot price of a security (adjusted for the funding cost until the expiry of a futures contract) and its futures price – the difference being called the net basis. In order to do this, an arbitrageur needs to simultaneously conclude two opposing trades – one in the futures market and the other in the spot market. As the futures contract approaches its maturity, the futures price and the spot price converge, arguably making the basis trade return risk-free if held until the futures contract expires. In principle, therefore, basis trades are not speculative in nature and should have a beneficial impact on market efficiency and liquidity. Given that price dislocations are typically small compared with the market value of the relevant security, arbitrageurs often employ high leverage to enhance their returns. In the spot market, leverage is employed using repo funding (securities are pledged as collateral and the cash received is used to purchase more securities), while in the futures market, leverage is synthetic and stems from the obligation to post only a fraction of the nominal exposure as margin. This exposes basis trades to funding risks – the inability to roll over repo borrowing at an acceptable price – and liquidity risks – the inability to meet margin calls related to futures positions. Rapid unwinding of basis trades in response to forced deleveraging, for instance, could add to price dislocations. However, such a scenario is less likely for arbitrage strategies and would have less impact on prices than would be the case for leveraged directional positions.[1]
The build-up of hedge funds’ leveraged exposures in the US Treasury market has given rise to financial stability concerns.[2] Some evidence from the US Treasury repo market suggests that basis trades are behind the growing net short positions of these funds in US Treasury futures (Chart A, panel a).[3] Over the last two years, the deterioration of US Treasury market liquidity and increased volatility (Chart A, panel b) have made price dislocations more frequent and basis trades more attractive. In addition, fixed income funds have seen significant inflows and asset managers have preferred the futures market over the spot market to build their duration exposure more flexibly. This has put downward pressure on the net basis. Hedge funds have stepped in as a “counterparty” for those asset managers in the futures market (Chart A, panel a), at the same time buying US Treasuries in the spot market and using them as collateral in the repo market to increase leverage.
Disruptions in the repo market could still force some entities to unwind their basis trades, fuelling dislocations in the US Treasury market. The liquidity preparedness of basis traders to maintain their futures positions seems better now compared with previous stress events, as traders are expected to meet margin requirements that are close to historical highs (Chart A, panel c). This limits the maximum leverage deployed in the strategy. Still, disruptions in the repo market could lead to the forced unwinding of basis trades. Given the role of US Treasury bonds as global risk-free assets, a volatility jump in response to such unwinding may potentially be observed across asset classes and jurisdictions, as has been witnessed during some historical stress events.[4] The effect could be amplified by the high correlation between US Treasuries and euro area government bonds, and when the same counterparties are active in both markets. Sufficient liquidity in the spot, futures and repo markets in the United States is therefore crucial to contain vulnerabilities globally....
....MUCH MORE
