By Federico Bardelli and Ivan Brambilla – Market Hub, IMI Corporate & Investment Banking Division, Intesa Sanpaolo.
Introduced in the second half of the 19th century, financial derivatives represent one of the most significant innovations in the history of financial markets. Initially designed to address the growing need for hedging against price fluctuations in agricultural commodities, they have since evolved to serve speculative and arbitrage purposes, becoming essential tools for the functioning of modern markets. Among the strategies that use derivatives, basis trading holds a prominent position, due to its widespread use and the level of technical sophistication it demands.
This article examines the evolution of basis trading, exploring its principles, technical aspects, and challenges, with a particular focus on its application in the fixed income markets, where this strategy has found its most natural and productive use.
The concept of basis trading and the logic of the spread
The basis trade is an arbitrage strategy where a trader simultaneously takes opposing positions in a physical asset and its derivative, either going long on one and short on the other, or vice versa. The primary objective of this strategy is to exploit the price difference, known as the basis spread, between two instruments. This spread arises due to various factors such as market fluctuations, liquidity fragmentation, or macroeconomic conditions.
At the core of the basis trade is the basis spread, which can generate consistent returns while minimising directional risk. The scope of these strategies is broad, as there are numerous instruments – such as ETFs, futures, and swaps – that are correlated with the underlying physical assets. This analysis focuses specifically on basis trades involving futures contracts.
Futures contracts, the most commonly used derivative in basis trades, possess distinct characteristics that make them ideal for this strategy. These contracts are quoted with different expiration dates and can trade either above or below the spot price of the underlying asset. The futures curve typically manifests in two primary configurations:
- Contango: This occurs when futures prices are higher than the spot price of the underlying asset. It typically happens in markets with significant holding costs, such as storage and insurance, or when there are bullish expectations about future prices.
- Backwardation: This happens when futures prices are lower than the spot price of the underlying asset. It is commonly seen in markets where short-term demand for the asset exceeds its immediate supply. As the futures contract approaches expiration, its price generally converges with the spot price (ceteris paribus), offering an arbitrage opportunity for traders who can identify and exploit such market discrepancies.
Basis trading in fixed income: A key strategy
The fixed-income market has long been the preferred venue for implementing basis trading. Bond instruments, with their predictable cash flows and fixed maturities, offer an ideal environment for this strategy. Traders can capitalise on price differentials between bonds and their derivatives, which are quoted in key markets such as treasury futures or bund futures. A key feature of basis trading in fixed income is leverage, which is applied through two main tools:
- Repo financing: Traders can access additional liquidity by using physical assets as collateral to enter new basis trades. Of course, leverage is only effective when the repo rate is lower than the expected return on the trade.
- Margining in futures: When trading futures contracts, an initial margin must be deposited with the clearing house. This margin requirement enables traders to take large positions with relatively minimal capital commitment.
The combination of repo financing and margining allows traders to maximise the potential return on basis trades, though it also introduces significant market risk. Adverse market movements can quickly deplete margin deposits, potentially forcing traders to liquidate positions or meet margin calls.
Risks and operational challenges
Basis trading is undoubtedly a complex strategy that demands a thorough understanding of the markets, the mechanics of the instruments involved, and the risks associated with their use:
- Market volatility: A sudden surge in volatility can lead to increased margin requirements for futures, compelling traders to address margin calls. Failure to meet margin calls promptly may result in the premature liquidation of positions, adversely affecting the overall portfolio.
- Liquidity: The ability to buy or sell an asset at the desired price is crucial for the success of a basis trade. In illiquid markets, spreads tend to widen, making it more challenging to close positions effectively.
- Macroeconomic environment: Decisions made by central banks—such as adjustments to interest rates or interventions in the bond markets—can significantly influence the prices of cash assets and futures, potentially undermining the profitability of such trades.
- Operational risks: The selection of the underlying instruments in a basis trade demands precision and expertise. Mistakes in instrument selection or trade management can jeopardise the entire strategy. Moreover, costs associated with off-exchange trading and clearing can erode profit margins.
Despite these risks, basis trading has seen steady growth in recent years, accompanied by increased scrutiny from regulators who have tightened rules to enhance transparency in trading.
Execution and brokerage activity
In addition to the technical aspects related to strategy implementation, executing basis trades also involves a practical component, typically carried out by brokers. A broker such as Market Hub, part of Intesa Sanpaolo’s IMI Corporate & Investment Banking Division, offers execution and clearing services for basis trades on markets, where it holds clearing membership. Execution typically occurs via an off-exchange process, essential for registering the trade and informing the market. One of the two counterparties, referred to as the “initiator,” creates the block by entering all relevant trade details, including those for the derivative and cash instrument. This block is then sent to the market identification code of the counterparty, known as the “reactor,” who is responsible for verifying and confirming the trade.
Impact of the Covid-19 crisis
The Covid-19 pandemic marked an unprecedented period of stress for financial markets, which also had a significant impact on basis trading. During the March 2020 sell-off, global uncertainty and a flight to liquidity led to massive selling pressure in the markets, particularly affecting U.S. Treasuries. This crisis drove bond yields higher, bid-ask spreads wider, and margin requirements for futures to increase.
Despite these challenges, basis trading showed remarkable resilience. Several studies have indicated that the cash securities involved in basis trading strategies maintained higher levels of liquidity compared to those that were not included in such trades. This helped support market stability during a critical period.
Technological innovation and regulation
Recent technological advancements have revolutionised basis trading. The integration of sophisticated algorithms, artificial intelligence models, and big data analytics has enabled traders to identify arbitrage opportunities with increased precision and speed. Additionally, trading platforms and exchanges are working on operational solutions that minimise execution times and reduce operational risks associated with basis trading strategies and workflows. Moreover, the introduction of new products like micro-futures, as well as the expansion of asset classes to include cryptocurrencies, has provided traders with new arbitrage opportunities and increased liquidity in these market segments.
On the regulatory front, authorities have implemented stricter requirements to enhance transparency and mitigate systemic risk. Tighter margin rules, leverage limits, and reporting requirements have contributed to greater market resilience, though they have also led to a reduction in overall trading volumes.
Conclusion
Basis trading remains one of the most complex and sophisticated strategies in financial markets due to its capacity to create multiple arbitrage opportunities and manage risk effectively. Despite the operational and market risks involved, its role in institutional portfolios and trading operations continues to be crucial. Looking ahead, technological innovations and evolving regulations are expected to further redefine basis trading strategies, expanding their applications and enhancing efficiency in navigating the challenges of an ever-evolving financial landscape through the increased automation of operational processes.
Sources:
1. Daniel Barth & Jay Kahn, “Basis Trades and Treasury Market Illiquidity” (Office of Fin. Research, Brief Series No. 20-01, 2020), available at https://www.financialresearch.gov/briefs/files/OFRBr_2020_01_Basis-Trades.pdf.
2. Annette Vissing-Jorgensen, “The Treasury Market in Spring 2020 and the Response of the Federal Reserve”, (Nat’l Bureau of Econ. Research, Working Paper 29128, © 2021), available at https://www.nber.org/papers/w29128.
3. Avalos, F. and Sushko, V., “Margin leverage and vulnerabilities in US Treasury futures”, BIS Quarterly Review, Bank for International Settlements, September 2023.
4. Committee on Capital Markets Regulation, “An Overview of the Treasury Cash-Futures Basis Trade”, December 20, 2023
5. Jonathan Glicoes, Benjamin Iorio, Phillip Monin, and Lubomir Petrasek “Quantifying Treasury Cash-Futures Basis Trades” March 08, 2024.
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