What Is the 'Basis Trade' Behind Stock and Crypto Turmoil? [News Seolcham]

'Basis Trade' Warned by Fed Governor
Hedge Fund Treasury Trading Strategies Involving Leverage
Overheated Positions Lead to Financial Instability
"A Prudent and Well-Planned Shift in Direction Is Needed"

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The investment strategy of global hedge funds in U.S. Treasury bonds, known as 'basis trade,' is being cited as one of the reasons for the recent poor returns in risky assets such as global stocks and cryptocurrencies. While hedge fund trading of government bonds is necessary for smooth market operations, excessive activity can cause shocks that lead to declines in other financial asset prices. As a result, warnings about the risks of basis trades have also been raised within the Federal Reserve (Fed).

'Basis Trade' Warned by Fed Governor

Lisa Cook, Federal Reserve Governor. Photo by Yonhap News

On November 20 (local time), Lisa Cook, Governor of the Federal Reserve, gave a speech at Georgetown University's McDonough School of Business in Washington, D.C., stating, "The likelihood of a decline in overvalued asset prices has increased," and warned, "Derivative contracts such as basis trades are more exposed to margin calls, which can lead to Treasury sell-offs and a lack of market liquidity."

During Governor Cook's speech, the three major U.S. stock indices quickly reversed their gains from over 2% shortly after the market opened to around 0.5%, increasing volatility. Major Asian stock markets, including those in South Korea, Taiwan, and Hong Kong, also weakened the following day. The asset hit hardest was cryptocurrency, which is sensitive to liquidity. At that time, the price of Bitcoin, which had been trading below $90,000, plummeted to $80,000 in an instant.

The reason investors dumped risky assets at the time was due to diminished expectations for a U.S. benchmark interest rate cut. Major foreign media outlets analyzed Governor Cook's remarks, noting, "Investors believe the Fed may delay rate cuts because it is more concerned about financial instability than inflation." MacAlvany Group, an asset management firm, explained, "Volatility has increased and the market has become fragile," adding, "Concerns over leveraged speculation have led to liquidity instability."

Trading Strategy Targeting the Price Gap Between Treasury Futures and Spot

The British Overseas Territory of the Cayman Islands is considered an offshore fund hub where tens of thousands of hedge funds are registered. Screenshot from Trip.com

Basis trade, identified as a threat to financial stability, is a U.S. Treasury trading strategy mainly used by hedge funds, exploiting the 'basis'-the price difference between the spot and futures. Hedge funds profit by simultaneously buying Treasury bonds in the spot market and selling futures, or vice versa.

Typically, the price difference between Treasury spot and futures is minimal, so hedge funds usually employ leverage for these trades. They use the repo (repurchase agreement) market, where they can borrow dollars using their Treasury holdings as collateral, to expand their investment scale to many times their own capital.

Basis trades usually enhance liquidity in the U.S. Treasury market, but during times of economic instability, they can become the epicenter of crises. If there is a sudden fluctuation in Treasury prices, banks that lent dollars to hedge funds may demand additional margin. To maintain their accounts, hedge funds must quickly raise cash, leading them to sell off their Treasury holdings to buy dollars. This process further intensifies volatility in Treasury prices. In particular, price swings in the 10-year Treasury, which serves as a benchmark for capital markets, can shock not only the bond market but also real estate, equities, and the entire financial system.

Financial Instability When Overheated..."A Prudent Shift Needed"

New York Stock Exchange during the COVID-19 pandemic in 2020. Photo by Reuters

While basis trades at moderate levels can be managed, the recent surge in hedge funds speculating in the Treasury market has raised concerns at the Fed. According to a report released by the Fed in October, hedge funds based in the Cayman Islands held the largest share of U.S. Treasuries issued from 2022 through December of last year. The proportion of long-term U.S. Treasuries held by hedge funds reached 10.3%, surpassing the pre-pandemic average of 9.4%.

Overheated basis trades have previously been the starting point for several episodes of financial instability. In March 2020, at the onset of the COVID-19 pandemic, heightened market volatility triggered a wave of basis trade liquidations, prompting Fed intervention. In 2019, when the Fed attempted quantitative tightening (QT), hedge funds rapidly unwound their basis trades, causing a sharp rise in Treasury yields. The Fed also had to intervene directly to stabilize the market at that time.

There is a growing argument within the Fed for moderating the pace of rate cuts, as excessive liquidity from premature rate reductions could further overheat hedge funds' basis trade positions. In her speech, Governor Cook emphasized, "While the financial system remains resilient, rising asset values, the complexity of private credit markets, and hedge fund activities could increase turmoil in the Treasury market," adding, "It is a time for a cautious and well-planned shift in direction."

This content was produced with the assistance of AI translation services.