hedge funds and the treasury cash-futures disconnect
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Hedge funds and the Treasury cash-futures disconnect
Jay Kahn 1 Daniel Barth 2
1Office of Financial Research, U.S. Department of the Treasury2Board of Governors of the Federal Reserve System
2021 Financial Stability Conference
Disclaimer: The views expressed in this presentation are those of the speaker and do not necessarily representthe views of the Office of Financial Research, the U.S. Department of the Treasury or the Board of Governors of theFederal Reserve System.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
March 2020 disruption in Treasury markets
2006 2008 2010 2012 2014 2016 2018 2020
4
6
8
10
12
14
16 Treasury VIX (left axis)MOVE Index (right axis)
50
100
150
200
250
Jan Feb Mar Apr May Jun0.0
0.5
1.0
1.5
2.0
2.5
3.02-Year5-Year10-Year30-Year
I Most dramatic increase in Treasury volatility since at least 2009.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
During March, hedge fund Treasury exposure decreased by >$200BDocument a major shift in Treasury markets:I HF Treasury exposure increased by $960B between 2017 and 2019.
2016-01 2016-07 2017-01 2017-07 2018-01 2018-07 2019-01 2019-07 2020-01
−200
0
200
400
600
800
1000
1200
1400Yo
Y ch
ange
($ b
illion
s)Banks and dealersPension and insuranceAsset managersHedge funds
In this paper we ask three questions:1. Why were hedge funds holding so many Treasuries?
2. Why did they sell so many in March 2020?
3. What, if any, are the implications for financial stability?
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Why were hedge funds holding so many Treasuries?
1. >70% associated with disconnect of cash and futures prices.I Treasury futures overvalued to replicating cash portfolio.I Disconnect made arbitrage through the repo market profitable.I Rely on mixture of public aggregates and regulatory micro data to link to
hedge funds.
2. Model shows trade facilitates risk-sharing and economizes onbalance sheet costs between dealers and asset managers.I Basis traders act as warehouses for Treasuries.
I Exposed to both margin and rollover risk.I Present empirical evidence consistent with model.I Present evidence of effect on underlying cash securities.
3. Discuss how trade contributed to March illiquidty.I Roughly $100B in sales associated with basis trade.I However, prices of Treasuries associated with the trade rose during March.I Timely intervention by the Fed may have prevented further spillovers.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Cash and futures prices of Treasuries related through arbitrage
255075100Days to delivery
−2.0
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ad o
ver l
ast i
nvoi
ce FuturesCash
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Open
Inte
rest
($ b
illion
s)
5-Year
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020−0.5
0.0
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Spre
ad
2-Year arbitrage deviations
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020−0.5
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ad
5-Year arbitrage deviations
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Open inte
rest
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In a frictionless market:
Pt,τ︸︷︷︸Note price
=T∑
s=t
Bt,scs︸ ︷︷ ︸Intervening coupons
+ Bt,T Ft,τ,T︸ ︷︷ ︸Discounted futures price
.
Convergence only occurs for cheapest-to-deliver (CTD) Treasuries.
Establish empirical counterpart: cash prices from CRSP, futures pricesfrom Bloomberg.I Show that this relationship does not hold in recent years.
Non-convergence Deliverability premium Past crises
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
The cash-futures basis trade
Treasury market: Purchase Treasury
Deliver Treasury to repo lender
...
Futures market:
Repo market:
Short futures contract
Open repo trade
t = 0
Roll over repo
t = 1
Roll over repo
t = T − 1
Close repo trade
t = T
Deliver Treasury to futures
Receive cash from futures
In reality, arbitrageurs rely on repo financing to arbitrage this spread.I Short futures, long cash, funded using the cash note as collateral.I Borrowing appears to be largely overnight.
Trade is exposed to two sources of risk:1. Rollover risk on repo borrowing.
2. Margins on short futures position.
Risks compounded by leverage on the trade, in principle only limited byTreasury haircut.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
The basis trade and hedge fund Treasury exposure0
500
1000
1500
Trea
sury
Exp
osu
res
($ B
illio
ns)
2013 2014 2015 2016 2017 2018 2019 2020
Total Short (Form PF)
Short Futures (CFTC)
Total Long (Form PF)
Long Futures (CFTC)
-.2
0.2
.4.6
Spre
ad (%
)
-200
020
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0A
ggre
gat
e N
et R
epo E
xposu
re ($
Bill
ions
)
2014 2015 2016 2017 2018 2019 2020
Net Repo BorrowingArbitrage Spread
Form-PF data consistent with large basis positions.I In 2017, gross HF Treasury exposures were $1.06T and net repo
borrowing was -$49B.I In 2019, gross HF Treasury exposures were $2.02T and net repo
borrowing was $535B.Classify funds as “large basis traders” using their net repo borrowingand Treasury exposures.I In 2019, >$714B (60%) of HF gross Treasury exposure and $505B
(94%) of net repo borrowing was attributable to basis traders.I 30% of primary dealer repo lending against Treasuries.
Basis traders have median leverage of 17.6 and average leverage of 21.Repo detail Futures
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Evidence from hedge fund repo
Intermediaries:I Broker dealersI Large banks
Cash Lenders:I Money market fundsI Pension and insurance fundsI Small banks
Cash Borrowers:I Hedge fundsI Others
DVP Interdealer
DVP Sponsored Lending
Uncleared Bilateral Lending Uncleared Bilateral Borrowing
DVP Sponsored Borrowing
Average rate: 0.44
Average rate: 0.39
Average rate: 0.33
Hedge funds borrow in two repo markets:I DVP sponsored borrowing (cleared bilateral).I Uncleared bilateral repo.
Use OFR DVP repo data for additional evidence.I All trades since October 2019.I Provides detail on collateral, rates, counterparties.I Hand-mapped to hedge funds.
Data on DVP important since repo markets are segmented.I Compare to tri-party repo rate of 0.34.
Sponsored repo
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Evidence from hedge fund repo
Intermediaries:I Broker dealersI Large banks
Cash Lenders:I Money market fundsI Pension and insurance fundsI Small banks
Cash Borrowers:I Hedge fundsI Others
DVP Interdealer
DVP Sponsored Lending
Uncleared Bilateral Lending Uncleared Bilateral Borrowing
DVP Sponsored Borrowing
Average rate: 0.44
Average rate: 0.39
Average rate: 0.33
Hedge funds borrow in two repo markets:I DVP sponsored borrowing (cleared bilateral).I Uncleared bilateral repo.
Use OFR DVP repo data for additional evidence.I All trades since October 2019.I Provides detail on collateral, rates, counterparties.I Hand-mapped to hedge funds.
Data on DVP important since repo markets are segmented.I Compare to tri-party repo rate of 0.34.
Sponsored repo
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Data from DVP repo also consistent with large basis positions
2021-01 2022-01 2023-01 2024-01 2025-010
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2 year 5 yearPrior to Dec. 1, 2019
Kernel density
Deliverable set
2021-01 2022-01 2023-01 2024-01 2025-01Maturity date
0
1
2
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2 year 5 yearAfter and including Dec. 1, 2019
All outstanding hedge fund Treasury position by collateral maturity.I Deliverable maturities shaded gray.I Borrowings using the cheapest-to-deliver are particularly high:
I ≈ $4.5B, or 10% of outstanding. Reduced directly prior to first delivery date.
Especially large given only fraction of trades likely to be funded in DVP.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Model of the cash-futures disconnect
Show disconnect results from limits to arbitrage & segmented markets.
Hedge Funds
Repo dealer Treasury dealer
Money market fund Treasury seller
Clearing house
Asset manager
Repo market Treasury market
Futures marketI Emphasizes HF role in risk sharing
between asset managers anddealers.I Hedge funds act as warehouses
for Treasuries.I Limits to arbitrage mean
warehousing is imperfectI Dealers face more risk than optimal.
I But basis trades also exposeTreasury market to potential risks.I Margin constraints and repo
market tightening→ suddendecreases in prices.
I Can be triggered by sales by noisetraders.
Model detail
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Empirical evidence on limits to arbitrage
Univariate regressionsCF Disconnect 2-Year 5-Year 10-Year BondGCF - IOER 0.30∗∗∗ 0.36∗∗∗ 0.52∗∗∗ 0.30∗∗
Dealer exposure 1.13∗∗∗ 1.74∗∗∗ 2.23∗∗∗ 1.44∗∗∗
Multivariate regressions|CF Disconnect| 2-Year 5-Year 10-Year BondMaitenance margins 0.051 0.450∗∗∗ 0.214∗∗ 0.070∗∗∗
VIX 0.665∗∗∗ 0.271 0.640∗∗∗ 1.555∗∗∗
Regressions use second-to-deliver.I GCF-IOER as proxy for repo spread.I Net Treasury exposure from primary dealer statistics.I Use VIX because Treasury volatility measures tied to futures.I Maintenance margins from CME group.I Fixed effects to control for distance to delivery.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Onset of March illiquidity
May 2018
Sep 2018
Jan 2019
May 2019
Sep 2019
Jan 2020
May 2020
Sep 2020
Jan 2021
−200
−100
0
100
200
Diff
erence from
2
/2
6/2
0 ($
billions)
March, 2020Foreign official Treasuries
Foreign repo pool
I Dealer balance sheets saturated withTreasuries. (top)
I Large sales from foreign officialaccounts and mutual funds inresponse to COVID-19. (bottom)
I Cost of making markets rose, leadingto rising volatility.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Basis trade unwind
Jan 01 Feb 01 Mar 01 Apr 01 May 01−1000
−750
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0
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1000Futures value
5-year futures margin95% of price changes 2018-2019
Jan 15 Feb 01 Feb 15 Mar 01 Mar 15 Apr 01
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2-year futures-implied yield
5-year futures implied yield
DVP sponsored borrowing rate
2-month Treasury yield
As volatility rose, margins were breached in early March. (left)I Moves large relative to 95% of movements 2018-2019 (green area).I CBOT responded by raising margins, increasing cost of basis trade.
Hedge funds exited the basis trade:I $105B decrease in hedge fund short futures exposure.I $104B decrease in large basis trader long Treasury exposures.
As a result, cash-futures disconnect increased. (right)Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Deliverability premium during MarchPremium on CTDs suggests trade continued to provide liquidity tounderlying.
Jan 01 Feb 01 Mar 01 Apr 01 May 01 Jun 01 Jul 01
−0.025
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Delivera
bilit
y p
rem
ium
2-year
5-year
Bond
10-year
2022 2023 2024 2025 2026 2027 2028 2029 2030 2031Maturity date
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Yie
ld
Fitted yieldActual yieldDeliverable yields
Cheapest-to-deliver
I Despite selling pressure, CTD price particularly high during March. (left)I Especially high for the more popular securities (2-year, 5-year).I Concentrated in the CTD in a snapshot on March 11. (right)
Suggests dealers more willing to hold CTDs during March.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Federal reserve may have intervened at exactly the right time
Jan 15 Feb 01 Feb 15 Mar 01 Mar 15 Apr 01 Apr 15 May 01−0.2
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idpoin
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ON-RRP facility
InterdealerSponsored lenderSponsored borrower
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y v
olu
me
RRP FacilityRP Facility
Days RP capacity exceeded
RP facility
Date Jan 01 Feb 01 Mar 01 Apr 01 May 01
0
2
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82-Year CTD5-Year CTD10-Year CTDBond CTD
Support was provided to dealers on two fronts:I Expansion of the repo facility lowered borrowing costs and made
carrying Treasuries less expensive.I Inclusion of CTD in purchasese made it easier for dealers to wait out
stress.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Conclusion
In the wake of March stress, focus on hedge fund holdings ofTreasuries.I A sizeable amount of these holdings are associated with the
cash-futures basis trade.I Show this trade became profitable because of a disconnect between
Treasury cash and futures prices.
We emphasize this trade is popular because of broad changes inTreasury market structure.I Hedge funds act as warehouses for Treasuries when dealers and asset
managers find them costly to hold.I Consistent with empirical evidence on the behavior of the cash-futures
disconnect.
The model also emphasizes the risk that the trade amplifies dashes forcash.I While basis trading appears to have decreased, this risk is still present.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Appendix
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Size of hedge fund sales over March
Combine data figures from OFR annual report derived from PF and from theCFTC Traders in Financial Futures:
Long Short Feb-MarFeb Mar Feb Mar Long Short
Exposure (OFR AR) 1,406 1,164 905 735 242 170Less derivatives (TFF) 311 275 721 618 36 102
Cash estimate 1,095 889 184 116 206 68Price adjustment (VBILX) 30 5
Cash sales 236 73
Compare to:
I $35 billion estimated decrease in flow of funds.I $250 billion decrease from Cayman islands in TIC data.
Of a similar size to sales by foreign official accounts and mutual funds.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Non-convergence of cash and futures prices for other deliverable Treasuries
20406080100120−2.0
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Spre
ad o
ver l
ast i
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1st cheapest-to-deliver
FuturesCash
20406080100120−2.0
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1.02nd cheapest-to-deliver
20406080100120Days to delivery
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3rd cheapest-to-deliver
20406080100120Days to delivery
−2.0
−1.5
−1.0
−0.5
0.0
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1.04th cheapest-to-deliver
Arbitrage requires that cash and futures prices convergeI Show deviations from final invoice price for 5-year deliverables:
P̃t,τ,T − FT ,τ,T Ft,τ,T − FT ,τ,T
Back Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Deliverability premium
Convergence solely for the CTD provides a close link between arbitragetrades and the CTD.I How does this affect cash prices of the CTD?
2008 2010 2012 2014 2016 2018 2020
0.0
0.2
Yield
spre
ad (
%)
Cheapest-to-deliverOn-the-run
2008 2010 2012 2014 2016 2018 2020
−0.10
−0.05
0.00
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spre
ad (
%)
2008 2010 2012 2014 2016 2018 2020
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spre
ad (
%)
2008 2010 2012 2014 2016 2018 2020
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Yield
spre
ad (
%)
I Calculate error from a fittedyield curve spline.
I Compare to the error for asimilar maturity on-the-run.
CTD premium2-year 5-year
OTR prem. 1.167∗∗∗ 0.492∗∗∗
R2 0.832 0.532
10-year BondOTR prem. 0.115∗∗∗ 0.631∗∗∗
R2 0.044 0.109Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Cash-futures disconnect: past crises
1998-01 1998-04 1998-07 1998-10 1999-01 1999-04 1999-07 1999-10 2000-01−1.5
−1.0
−0.5
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Spre
ad
Ruble devaluation LTCM bailout
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Open
inte
rest
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Lehman Brothers' Bankruptcy
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rest
Cash-futures disconnect responds to stress in financial marketsI LTCM: Price of futures rose relative to cash (left).
I Liquidity crisis, similar to March 2020.I LTCM had non-trivial bond basis positions.
I Lehman Brothers: Price of cash rose relative to futures (right).I Dash to safety rather than cash.
Both suggest the importance of limits to arbitrage in the disconnect.Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Hedge fund net repo40
060
080
010
0012
0014
00A
ggre
gat
e Rep
o E
xposu
re ($
Bill
ions
)
2013 2014 2015 2016 2017 2018 2019 2020
Total Repo BorrowingTotal Repo Lending
Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Large Treasury futures positions0
200
400
600
800
$ Bi
llions
2013 2014 2015 2016 2017 2018 2019 2020
Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Hedge fund participation in sponsored repoI Classification of hedge funds part of broader OFR effort on mapping
cleared repo.I Hedge funds represent the major source of sponsored borrowing:
I Over 2020, sponsored lending made up around 20% of all DVPtransactions, sponsored borrowing around 13%.
Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Model of the cash-futures disconnect
Show disconnect results from limits to arbitrage & segmented markets.
Hedge Funds
Repo dealer Treasury dealer
Money market fund Treasury seller
Clearing house
Asset manager
Repo market Treasury market
Futures market
Four assets: bills (PN,t ), notes (PN,t ),repo (BRR,t ) and futures (Ft ).
Four agents:I Dealers: Mean-variance preference,
choose portfolio of bills and notes.I Speculators: Mean-variance
preference, hold futures to delivery.I Money market funds: Liquidity
tradeoff between bills and repo.I Hedge funds: Risk neutral, subject
to margin constraints, fund basispositions in the repo market.
Futures deliver at time 2, at time 1 the note market has net supply, S.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Model equilibrium
Margin E [Futures return]
E [Cash return]
No arbitrageNo arbitrageArbitrage capacity
Risk sharing
More risk to speculators
I Given a supply of notes, there is a fixed amount of short-rate risk att = 2 that must be split between dealers and speculators.
I As more risk is allocated towards speculators, futures prices fall whilecash prices rise (mean-variance preferences).
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Model equilibrium
Margin E [Futures return]
E [Cash return]
No arbitrageNo arbitrageArbitrage capacity
Risk sharing
More risk to speculators
I In absence of limits to arbitrage, HFs act as perfect warehouses forTreasuries:
E [Cash return] = E [Futures return]
I Risk shared optimally between dealers and speculators, no disconnectbetween cash and futures prices.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Model equilibrium
Margin E [Futures return]
E [Cash return]
No arbitrageNo arbitrageArbitrage capacity
Risk sharing
More risk to speculators
I In presence of limits to arbitrage, HFs act as imperfect warehouses forTreasuries:
E [Cash return] > E [Futures return] (cash undervalued)
I Dealers end up with more risk than optimal, disconnect results betweencash and futures prices.
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
Risks of the trade can impact the cash market
Increase in net supply
Margin E [Fut return]
E [Cash return]
Arbitrage capacity
Risk sharing
Risk sharing′′
Risk sharing′
Increase in margins
Marg E [Fut return]Marg′
E [Cash return]
Arbitrage capacity
Risk sharing
I Increase in net supply can lead to large increase in prices.I Increases in margins shift in arbitrage capacity, force sales by HFs.I Repo illiquidity increases disconnect and leads to sales by HFs.
Back
Introduction Cash-futures disconnect Hedge fund basis trades Limits to arbitrage March 2020 illiquidity Conclusion
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