Basis Trades: Treasury Market Lubricant or Systemic Risk?

At the most recent Federal Reserve Bank of New York Treasury Market Conference, an annual check-in on risks and resilience in “the deepest and most liquid government securities market in the world,” leverage was one of the top talking points. Caution was in the air around basis trades as a source of leverage and potential systemic instability.

“I want to recognize that leveraged trading, including in the so-called basis trade, can play an important role in capital markets,” Federal Reserve Board Vice Chair for Supervision Michael Barr said at the November 2023 event. “Basis trading serves a valuable function of market efficiency, improving the connection between cash and futures pricing and facilitating access to futures for investing and risk management.

“Leverage allows market participants to arbitrage away relatively small pricing discrepancies, enhancing the integration of prices across economically equivalent instruments and markets,” Barr continued. “But leverage can also increase risks to both market participants and to Treasury market functioning and must be managed appropriately by both investors and their...