Treasury Futures Net Basis, Repo Funding, and Bank Leverage Constraints
Summary
The document explains how bank balance-sheet costs can affect Treasury futures net basis trades. In a long basis position, the investor buys a Treasury bond, finances it through repo, and sells conversion factor weighted futures. The trade depends on actual funding terms, while regulatory exposure limits can add a capital cost beyond the repo rate itself.
It illustrates the Basel III leverage ratio with a bank holding a bond position funded in repo, and shows how required Tier 1 capital and a target return on capital translate into a minimum net basis for the trade to be worthwhile. Exposure netting may reduce the capital requirement, but the applicable rules depend on documentation. The discussion also notes that banks may contract leverage near reporting dates, reducing liquidity and potentially amplifying price moves or liquidations. These examples are simplified: capital rules vary across institutions, and the document does not offer a comprehensive treatment of all constraints or funding markets.
Key ideas
- A long Treasury basis trade combines a repo funded bond purchase with a short futures position.
- Bank leverage rules can make balance sheet usage a cost separate from repo funding.
- The capital charge and desired return on capital imply a minimum net basis for a trade.
- Exposure netting can change the capital requirement, subject to the relevant rules.
- Banks may reduce leverage near reporting dates, affecting liquidity and market prices.
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Full text
# Funding Treasury net basis trades and balance sheet
# Funding Treasury net basis trades and balance sheet
I am trying to extend my understanding of Treasury futures net basis trading by understanding the funding markets.
If net basis is cheap, an investor can buy the basis. This means that the investor buys the underlying bond and sell the conversion factor weighted futures contract. This assumes that the bond can be funded and locked at the repo rate. However, what I don't quite understand is the availability of balance sheet. Does this mean the investor cannot obtain repo financing at the supposed repo rate? If it cannot, then wasn't the view that the net basis was cheap predicated on an actual repo rate?
Lastly, if you're short the basis. Does this "create" synthetic balance sheet? Since you're buying futures, you would post a small variation margin. And since you're selling the underlying bond, you're generating cash and lending in repo.
Are there reading materials or discussions that explain this more? It seems like I've gotten a good feel of futures basis trading but now balance sheet limitations and regulatory constraints adds another wrinkle to this.
## Answer by Attack68 (score 3, accepted)
https://quant.stackexchange.com/a/44954
The constraint of balance sheet when operating a bond trading business is different for different entities.
Suppose you are a bank. Your main concern is the Basel III Leverage Ratio (https://www.bis.org/publ/bcbs270.pdf). In this context a bank is required to maintain Tier 1 capital equivalent to 3% of its Total Leverage Exposure. (6% for US-Global Systemically Important Banks GSIB).
In the most simple form the total exposure will be the size of the position, e.g. if you purchase 100mm bonds at par and repo them for 3months locking in the net basis vs selling futures, then your total exposure is 100mm. Therefore the bank is required to have 3mm (or 6mm) Tier 1 capital against this position. If your Return on Capital Employed target is say 10% (p/a) then this is equivalent to making $\frac{300}{4}=$75k (or 150k) through the trade, i.e. you should be making at least 7.5cents (or 15cents) of net basis over 3 mths for this trade to be efficient within your capital structure.
The rules about netting exposures can give you freedom with respect to some of these exposure constraints but you have to review the documentation provided to userstand fully how the effect of netting can reduce your exposure (and therefore capital requirement).
This constraint has greatest trading impact when a bank is coming up on a reporting period, i.e. between reporting windows they typically expand leverage, especially US-GSIBS, and for reporting windows they shrink their leverage exposures. This can have significant effect on markets because the liquidity offered by these banks (for rolling positions) is removed leading either to exaggerated prices or liquidations. Often reporting windows align, e.g. end of Dec, strengthening the effect.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.