How big is cash-futures basis trading in Canada’s government bond market?

Introduction

Cash-futures basis trades, or basis trades, exploit profit opportunities that arise from differences in the prices of government bonds and their corresponding futures contracts. A bond futures contract is an agreement to exchange a bond at a fixed price at a future date—the contract’s expiry date. On the expiry date, the difference—the “basis”—between the bond price and the futures price should vanish.1 This convergence forces bond and futures prices to closely track one another.

In practice, an investor who trades the basis in government bonds and futures buys the relatively cheap security and sells the expensive one. This helps align bond and futures prices, ensuring that both markets accurately reflect information about the future path of interest rates, inflation expectations and investors’ willingness to bear interest rate risk. Ultimately, accurate prices mean that risks can be shared efficiently across these two markets. For example, when futures prices closely track bond prices, dealers can use the futures market to better manage the risks of their bond inventories. This reduces the cost of intermediation and supports market liquidity.

While basis trades help to maintain an efficient government bond market, they can also amplify market stress. Since the basis is small, market participants typically use leverage to scale their potential profits. For instance, an investor who sells the futures contract and buys the bond would generally finance the bond position in the market for repurchase agreements (repos). The risk with this leverage, however, is that it exposes market participants to sudden increases in borrowing costs or margin calls, which can force them to exit prematurely from their positions. Such sudden exits from basis trades can cause significant selling pressures in government bond markets, as witnessed during March 2020 in the US Treasury market.2

Given the potential implications of the cash-futures basis trade for financial stability, this note sets out to measure its size in the Government of Canada (GoC) bond market and to give an idea of the main market participants involved in the trade. Our evidence suggests that basis trades are responsible for a growing share of secondary market trading volumes in GoC bond and repo markets. From 2016 to 2024, the estimated share of total trading volume involved in basis trades increased from 1% to 8% for the GoC bond market and from 1% to 2% for the repo market. Approved participants (APs), which are financial institutions with direct access to the futures market, make up 60% of the trading volume in basis trades on average, while trades of their clients make up the remaining 40%. We provide evidence that on the client side, hedge funds have the largest footprint in the trade.

How does the basis trade work?

An investor who seeks to profit from a basis trade begins the process by comparing the current price of, for example, a 10-year GoC bond with the price of its corresponding futures contract, the 10-year GoC bond futures.3 The basis is the difference between these two prices, adjusted for the short-term financing cost of holding the GoC bond position. If the basis indicates that the GoC bond is relatively cheaper than the futures contract, the investor enters a long basis trade, which entails buying the GoC bond from the bond market and simultaneously opening a short position in the futures contract (Figure 1). This obligates the investor to deliver the GoC bond at a future date for a fixed price set today.

The investor must also set aside margin with the Canadian Derivatives Clearing Corporation, owned by the Montréal Exchange. This margin protects the Exchange against default risk. The amount of margin required generally corresponds to the volatility in futures prices. When volatility spikes, the investor is exposed to margin calls.

To finance the bond position, the investor typically borrows cash from the repo market. In a repo, the investor borrows cash from a counterparty, buys the GoC bond and pledges this bond as collateral to the repo counterparty (Figure 1). If the term of the repo is shorter than that of the overall basis trade, the repo financing will have to be renewed before the trade ends. This exposes the investor to refinancing risk.

Figure 1: Stylized example of a long basis trade

Figure 1: Stylized example of a long basis trade

The investor can close the basis trade before the futures contract expires by entering a long position in the futures contract, selling the GoC bond and paying back the repo counterparty with the cash from the sale. If the investor waits until the futures contract expires, the same set of transactions occurs with one difference: instead of selling the GoC bond in the bond market, the investor fulfills their obligation for the futures contract by delivering the GoC bond to an investor with a long position in the futures contract in return for cash.

What is the share of basis trading in the futures market?

The GoC bond futures market has grown rapidly in recent years. In April 2024, the notional amount of open interest in the 10-year bond futures contract stood at approximately $56 billion, followed by $23 billion in the 2-year contract and $12 billion in the 5-year contract. These amounts correspond to about 18%, 6% and 7% of the outstanding amounts in the respective maturity segments of the GoC bond market. Monthly dollar trading volumes in the 10-year GoC bond futures match those of the corresponding GoC bond market segment, while volumes in the 5-year and 2-year GoC bond futures are currently about one-half of the corresponding GoC bond market volumes (Chart 1). Since the Montréal Exchange relaunched the 5-year and 2-year GoC bond futures with a designated market maker program in late 2018 and 2020, respectively, trading volumes in these contracts have increased steadily.4

Chart 1: Trading volumes of 2-year and 5-year Government of Canada bond futures have grown in relation to Government of Canada bond trading volumes

Futures trading volumes related to the cash-futures basis trade have grown in tandem with the GoC bond futures market (Chart 2, panel a). In April 2024, monthly trading volumes in the basis trade totalled $51 billion.5 Dollar trading volumes in the basis trade for the 5-year and 10-year GoC bond futures have followed the growth of overall volumes, leading to steady shares of overall volumes (Chart 2, panel b). Since the relaunch of the 2-year GoC bond futures in December 2020, the share of basis trading in it has stabilized at a level similar to that in the 5-year GoC bond futures. Notably, when measured as a share of total volume of GoC bond futures trading, the basis trade appears to be more prevalent in the 2-year and 5-year GoC bond futures than in the 10-year GoC bond futures.

Chart 2: Trading volumes in the basis trade have increased in line with the growth of the Government of Canada bond futures market

Chart 2: Trading volumes in the basis trade have increased in line with the growth of the Government of Canada bond futures market

Note: Futures trading volumes exclude transactions related to replacing expiring contract with new contracts and inter-group strategies.
Sources: Montréal Exchange (TSX © Copyright 2024 TSX Inc. All rights reserved.) and Bank of Canada calculations
Last observation: April 2024

What is the share of basis trading in the bond and repo markets?

The growth of the GoC bond futures market likely means that a higher share of Canadian bond and repo market activity is now linked to basis trading. To compare the trading volumes of futures and bond markets, we make a simplifying assumption that the futures leg and bond leg of the basis trade are the same size. In other words, the $1 billion of basis trading volumes translates to $1 billion of bond trading volumes.6

With this simplifying assumption, we find that trading volumes in the basis trade have more than doubled since January 2016 (Chart 3, panels a and b). According to the rules of the Montréal Exchange, bonds that are ineligible for delivery into a GoC bond futures contract can be part of a basis trade if their prices have a strong correlation with the price of the futures. Assuming that all basis trades are executed with GoC bonds, we find that the share of GoC bond trading volumes related to basis trades grew from 2% in January 2016 to slightly below 8% by April 2024 (Chart 3, panel a).7 Focusing on different maturity segments among all GoC bonds, we find that the estimated monthly shares of trading volume involved in basis trades are currently 9%, 10% and 8% for the 2-year, 5-year and 10-year maturity segments, respectively (Chart 3, panel b).   

Chart 3: Basis trades are a growing share of Government of Canada bond market trading volumes

Chart 3: Basis trades are a growing share of Government of Canada bond market trading volumes

Sources: Montréal Exchange (TSX © Copyright 2024 TSX Inc. All rights reserved.), Market Trade Reporting System 2.0 and Bank of Canada calculations
Last observation: April 2024

Because investors may borrow cash to gain leverage when trading the cash-futures basis, an increase in basis trading volumes is likely to translate into higher trading volumes in the Canadian repo market. If we assume that all basis trades involve a GoC bond and are financed in the repo market, then monthly GoC repo trading volumes related to the basis trade have grown from 1% to 2% (Chart 4, panel a). Clearly, this growth coincides with the relaunch of the 5-year and 2-year GoC bond futures. Since the relaunches, the share of repo trading volumes that is related to basis trades in these maturity segments has increased to about 3.5% (Chart 4, panel b).

Chart 4: Basis trades make up a stable share of repo market trading volumes

Chart 4: Basis trades make up a stable share of repo market trading volumes

Note: Repo transactions include only Government of Canada bond collateral.
Sources: Montréal Exchange (TSX © Copyright 2024 TSX Inc. All rights reserved.), Market Trade Reporting System 2.0 and Bank of Canada calculations
Last observation: April 2024

Overall, basis trades in the shorter 2-year and 5-year tenors have grown, while basis trades in the longer 10-year tenor have been stable. Compared with basis trades of short-term tenors, basis trades of long-term tenors may be subject to higher margin calls when yield volatility spikes. This is because the prices of long-term bonds are more sensitive to interest rate changes than the prices of short-term bonds. This also implies that sales of long-term GoC bonds would lead to sharper price declines than sales of short-term GoC bonds because investors would demand greater discounts to compensate for the higher interest rate risk of long-term bonds.

Who trades the basis?

Only APs of the Montréal Exchange have direct access to the futures market. An investor who wants to enter a basis trade must do so as the client of an AP. APs can also trade the basis using their own balance sheets. APs fall into two broad groups: government securities dealers (GSDs) that are also important dealers in the Canadian bond market, and principal trading firms (PTFs) that specialize in market-making in the futures market. The remaining APs are specialized futures brokers and large international banks.8

Client trades constitute, on average, 40% of the trading volume in basis trades (Chart 5, panel a). Clients in GoC bond futures are typically large institutional investors, such as pension funds, hedge funds, foreign investors and banks. The remaining 60% of trading volumes in the basis trade are APs’ own trades (Chart 5, panel a).9 APs may use basis trades to hedge risks associated with bond positions that result from their market-making activities in the bond market. APs’ own trades can also reflect intermediation activity in the basis trade, where they provide liquidity on either side of the trade to accommodate temporary imbalances in supply and demand. PTFs have a small footprint in the basis trade because they typically do not operate in the bond market.

Chart 5: Both clients and approved participants are active in basis trades

Chart 5: Both clients and approved participants are active in basis trades

Note: Averages calculated over January 2019 to May 2023
Sources: Montréal Exchange (TSX © Copyright 2024 TSX Inc. All rights reserved.) and Bank of Canada calculations
Last observation: May 2023

For GoC bond futures, specific information on client identities is not available. However, we can get an idea about the types of clients that contribute to basis trades by estimating the correlation between the daily volumes of GoC bond trading of different types of investors and the total volumes of basis trading by clients. A strong correlation suggests that the basis trade is an important component of a given investor group’s trading activity in the GoC bond market.

We find that hedge funds’ bond trading has the strongest and most positive correlation with clients’ basis trading in terms of volumes, followed by pension funds and wealth managers. This link between hedge fund activity and basis trading is intuitive given that hedge funds are known to specialize in relative value strategies, such as the cash-futures basis trade. On an average day, a 10% increase in GoC bond trading volumes by hedge funds in the 10-year bond segment coincides with a 4% increase in basis trading volumes by clients in the 10-year futures contract (Chart 6).

A positive correlation between an investor group’s bond trading volumes and client basis trading activity does not necessarily mean that the investor group is directly involved in conventional repo-financed basis trades. Trading both bonds and futures may arise as a cost-efficient way to adjust the share of bonds in a portfolio while maintaining a constant exposure to interest rate risk. The correlation can also arise indirectly. For instance, GoC bonds sold by one investor group may be bought by another investor group that, in turn, sells GoC bond futures to manage the interest rate risk from the ensuing bond position. Hedge funds, for example, tend to trade GoC bonds in the opposite direction of other investor groups.10

Chart 6: Hedge funds’ Government of Canada bond trading volumes correlate significantly with trading volumes in the basis trade

Conclusion

This note documents facts and recent trends in the cash-futures basis trade in Canada, including the evolution of trading volumes and the types of participants typically active in the trade. It shows that the increase of the basis trade is concentrated in the shorter tenors, driven by the relaunches of the 2-year and 5-year GoC bond futures contracts. Even though basis trades with shorter tenors are less susceptible than those with longer tenors to abrupt increases in funding costs, dealers’ capacity to intermediate in the GoC bond market may still be strained by the unwinding of these basis trades, as witnessed in the US Treasury market in March 2020.11 Given the potential implications for financial stability, Bank of Canada staff will continue to monitor the size of the trade and the types of investors that participate in it.

Endnotes

Acknowledgements

We thank Jean-Philippe Dion, Alexandra Lai, Stéphane Lavoie, Toni Gravelle, Nick Leswick, Boran Plong and Harri Vikstedt for helpful comments and suggestions. We also thank Corey Garriott for multiple discussions on Government of Canada bond and futures market structure and the Montréal Exchange for providing the data on Government of Canada bond futures used for our analysis and helpful discussions. Finally, we are grateful to Carole Hubbard and Colette Stoeber for editorial assistance, Patricia Marando and Annie Robin for translation assistance, Mike Dalziel and Himawan Sudarso for publishing this note on the web and Caroline Hewetson for her assistance in project planning.