Goldman Sachs splits with regulators on risk that basis trade poses

By Edward Bolingbroke

Growth in the Treasury bond basis trade is less likely to de-stabilize the financial system than it has in the past, according to interest-rate strategists at Goldman Sachs Group Inc.
 

That’s in contrast with regulators including the Federal Reserve and the Bank for International Settlements, which have been sounding alarms. The cash-futures basis trade by some measures is as big as it was in 2019 and early 2020, when the onset of the pandemic sparked a rush for the exits that required a bailout by the Fed. The leveraged trade involves capturing small price differences between Treasury futures and deliverable securities.

While leveraged funds’ exposure to the basis trade in dollar terms is near record levels, the amount of leverage in the system “is materially lower than it was” in 2019-2020 because of increased margin requirements on futures and lower prices as bonds have sold off, Goldman strategists led by Praveen Korapaty say in a Sept. 22 report.

“Although the buildup in basis positions bears watching, it does not appear particularly concerning to us at the moment,” Korapaty’s team writes. “We do not think the trade poses a major risk to Treasury markets in the near term.”

The latest weekly positioning data from the US Commodity Futures Trading Commission shows asset managers had a near-record net long position in interest-rate futures, while leveraged funds had a near-record net short.

Treasury and SOFR Futures Positioning | How investors stand overall in terms of 10-year future equivalents

Rapid growth in the supply of cash Treasury securities is fueling growth in the basis trade because many asset managers prefer to use more-liquid futures contracts for risk management. That tends to drive up the value of futures relative to cash in a way that encourages growth in the basis trade, the Goldman strategists write. 

It’s “the result of structural mismatches between the form in which duration is supplied versus the format in which it is desired, and is unlikely to be eliminated.”

Fed researchers in August said regarding basis trades that “sustained large exposures by hedge funds present a financial stability vulnerability.” A BIS report published last week discussed the potential for liquidations and increased margin requirements to spiral.

The Goldman strategists say that with lower leverage levels, margin increases “will mean the magnitude of unwinds that are triggered will likely be smaller” and “simply mean a wider basis.”