What The Hell is Basis Trading? (Vol. 11)

Oh yeah... let's bring it back to the good old days of financial alchemy.

Editor's Note: On vacation. STOP CALLING… Let’s talk basis trading instead. I’m flying home tonight…

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Dear Fellow Traveler:

Ever had a friend who told you that they have a “system” for picking stocks or beating Las Vegas blackjack tables?

That it’s mathematically guaranteed.

They use words like "arbitrage" and "market inefficiency…"

Or just say that they're “printing money.”

Ask them what happened in March 2020.

The conversation might turn to bankruptcy attorneys.

Ah, yes… let’s dig into basis trading… because this is the trade that can blow up the world (if the Fed doesn’t bailout the world, first.)

What the Hell Is Basis Trading?

Treasury bonds trade in two places at the same time…

You can buy the actual bond (the "cash" market)…

Or you can purchase a futures contract representing that bond.

In theory, these prices should be identical.

In practice, they're not.

You’ll see a small spread between them called the "basis."

What happened was that someone came up with this Basis Trade…

Basically, the trade is to buy the cheap one and sell the expensive one, pocketing the difference.

Then they just call it risk-free arbitrage.

Think of it this way.

You buy a $20 bill for $19.95 and sell it for $20.01…

But you do this… five million times.

The Leverage Amplifier

A 5-cent spread on a $20 bill isn't worth getting out of bed for.

But what if you could do this trade with massive borrowed money?

Hedge funds started levering up 50-to-1, sometimes 100-to-1, to amplify these tiny spreads into meaningful profits. (Yes, I know that ‘that not what happens all the time, and that you run a hedge fund differently over there in Geneva…’)

At normal leverage, you might make 10-20 basis points on a basis trade. Still boring.

At 50x leverage, that becomes a more attractive 5-10% annual return.

At 100x leverage? You're targeting double-digit returns on "risk-free" arbitrage.

That’s what’s on paper.

In practice, financing costs, bid-ask spreads, and slippage eat into those theoretical gains.

This is like placing long-odds bets with borrowed money, because the math usually works.

By late 2019, basis trade volumes exceeded $500 billion, per the Office of Financial Research.

That's a lot of leverage chasing tiny spreads.

When "Risk-Free" Meets Reality

For years, this trade worked beautifully.

Basis traders were popular at hedge fund conferences.

They’d tell us all how they discovered legal money extraction.

Then COVID showed up uninvited.

In March 2020, everything broke simultaneously.

Investors stampeded out of everything that wasn't cash.

They were selling Treasury bonds, supposedly the world's safest asset, just to get dollars.

The basis exploded.

The spread thatwas usually measured in pennies turned into dollars overnight.

Most basis traders were long cash bonds and short futures.

When the spread widened, both legs of the trade lost money. Fast.

The leverage that juiced the gains? It multiplied the losses.

Some of the world's most sophisticated, never-lost-a-quarter hedge funds faced margin calls that could end them in days.

This wasn't the first time.

In September 2019, overnight repo rates spiked from 2.4% to over 10% in a single day.

That event crushed basis trades that relied on predictable funding costs.

Back in 1998, Long-Term Capital Management imploded partly due to basis trades gone wrong during the Russian debt crisis.

Their bets got wider instead of narrower, amplified by 25-to-1 leverage.

But March 2020 was different.

There was a broader dash-for-cash as everyone wanted dollars, but basis trades amplified the chaos.

When leveraged arbitrage strategies that were supposed to be "risk-free" started contributing to Treasury market dysfunction, it revealed how these trades could threaten the entire financial system.

The Hedge Fund Defense

Now, any hedge fund manager reading this is probably rolling their eyes.

"We don't use 100-to-1 leverage anymore," they'll say. "Modern relative value funds use 15-25x with sophisticated risk management."

Fair enough.

But here's the thing…

Even 20x leverage turns tiny spreads into meaningful returns…

And meaningful losses when things go wrong. The exact number isn't the point.

The amplification is.

They'll also claim their strategies "provide essential liquidity" and "keep markets efficient."

True most of the time.

But in March 2020, basis trades didn't just lose money…

You couldn’t get out of it…

When leveraged arbitrage strategies need to exit simultaneously, they don't provide liquidity.

They consume it faster than dealers can supply it.

That's when "market neutral" becomes "systemically fragile."

And that's when the Fed has to step in with $1 trillion in emergency Treasury purchases to prevent a complete meltdown.

The risk isn't that basis traders are villains.

It's that they've become essential infrastructure in a system that can't afford for them to fail.

The Treasury market is the backbone of global finance.

When it starts malfunctioning, the Fed doesn't wait for academic debates.

The Fed flooded the system, buying massive amounts of Treasuries to stabilize prices.

This fixed the basis problem by providing artificial demand for bonds that basis traders were desperately trying to sell.

Crisis averted.

Hedge funds saved.

Lessons learned.

Just kidding about that last part.

Stay positive,

Garrett Baldwin