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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.

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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.

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  • $\begingroup$ Thanks this is very helpful. When you say leverage exposure, are you referring to the bank's LENDING me cash to fund my net basis trades as the exposure. Since the bank is taking on $100 million in collateral, it shows up on the denominator of that ratio and as a result, banks have to raise or hold more capital against it. $\endgroup$ – VanillaCall Apr 6 at 11:08
  • $\begingroup$ I am referring to the leverage exposure calculation as defined by Basel and relevant to the bank in question (review page 7 (SFTs) of the link). It applies whether you buy or sell basis (repo or reverse-repo). $\endgroup$ – Attack68 Apr 6 at 12:33
  • $\begingroup$ Thanks for the article. It's very insightful. $\endgroup$ – VanillaCall Apr 6 at 19:04

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