"The Bailout Of All Bailouts" Is Coming
Explaining the dangerous hedge fund basis trade.
More fucking bailouts.
OK, now that I’ve got that out of my system, I wanted to bring you a great piece by my friend James Lavish. For those that don’t know James, he’s a seasoned professional in institutional investing and risk management with over two decades of experience.
He is currently the Managing Partner of the Bitcoin Opportunity Fund, which focuses on public and private investments in the Bitcoin ecosystem.
Lavish is recognized for his work in educating others about financial fundamentals through his newsletter, The Informationist, which simplifies complex financial concepts for a broad audience.
For those of you that haven’t noticed over the years, I’m extremely selective about who I allow to sponsor my podcast and/or who I give a platform to on my site.
James is one of those people who has earned my trust not only due to his excellent ability to explain complex financial concepts, simply, but also because he is trusted by others whom I know and trust personally.
So strap in, because once you understand how the Fed has all but made leveraged treasury trades totally risk free for hedge funds while you blow up your E-Trade account for the 3rd time this month with zero bailouts, you’ll likely be pissed.
I sure am.
The Dangerous Hedge Fund Basis Trade
Hedge funds have reportedly plowed capital back into the so-called Basis Trade, using massive leverage this time and setting themselves up, and the rest of the markets for that matter, for a cataclysmic implosion.
Hold on, you say, what is this Basis Trade, and how are they leveraged?
And are you saying, the hedgies didn’t learn their lesson from the last (two) time(s)???
Say it isn’t so!
Well, if all this has you scratching your head in wonder and worry, have no fear. Because we are going to unpack this Basis Trade business and the risks that come with it for both you and me, right here today.
And we are going to do it nice and easy, as always.
What’s the Basis Trade?
As you likely know, hedge funds are always looking for ways to generate profits. And the best of these can be through arbitrage.
You know, capturing true inefficiencies in the markets, where one security is worth the same as another but trading at a different price.
You can imagine how, when they find such an opportunity, they employ leverage to enhance the returns.
Since, you know, they’re really just crumbs of inefficiency, not chunks.
The leverage multiplies these crumbs and makes them more bite-size, more enticing.
I mean, instead of a penny on a hedged trade, if they leverage the trade 20X, that penny becomes 20 cents.
And if they lever it up 50X, well…you get the point…
So, what is this Basis Trade opportunity, and how are they levering it up?
Pretty simple. The hedge fund will buy a US Treasury and then hedge against it (sell short) a similar futures security.
Huh?
Here’s how it works: funds buy long-term Treasury bonds (say, 10-year notes yielding 4%) while shorting Treasury futures contracts tied to the same maturity.
The futures price typically trades at a slight discount to the cash bond price due to financing costs and market mechanics, creating a spread—often just 10-20 basis points (0.1%-0.2%).
This trade is dollar-neutral: profits don’t hinge on bond prices rising or falling, just the spread getting smaller.
But the real juice comes from leverage.
Funds borrow heavily in the repo market—where they pledge the Treasuries as collateral for short-term loans at ever-so slightly lower rates—and then amplify their positions.
With $1 billion in capital, a fund might control $10 billion to $20 billion in Treasuries at 10:1 or 20:1 leverage.
And a 15-basis-point spread on $10 billion nets $15 million annually—a 1.5% return unlevered.
But levered 10X, that becomes $150 million, or a 15% profit.
Here are 5 Keys to the Basis Trade:
Borrowing at Low Rates: Hedge funds typically borrow in the short-term funding markets, often through repurchase agreements (repos). In a repo, they sell securities (like Treasuries) to a lender with an agreement to buy them back later at a slightly higher price, effectively paying an interest rate on the loan. Repo rates are usually low because they’re secured by collateral and tied to short-term benchmarks like the Secured Overnight Financing Rate (SOFR).
Investing in Higher-Yielding Treasuries: The borrowed funds are used to buy longer-term US Treasuries, like 10-year or 30-year bonds, paying higher yields due to the term premium (longer maturities carry more risk, so they pay more). I.e., if the repo rate is 3.5% and the 10-year Treasury yields 4%, the fund pockets a 50 basis point (.5%) spread on the notional amount.
Leverage: To amplify returns, hedge funds borrow significantly more than their own capital. For instance, with $1 million of their own money, they might borrow $9 million via repos, controlling $10 million in Treasuries. If the spread is 1%, they earn $100,000 annually on that $10 million, a 10% return on their $1 million, minus borrowing costs and fees. Leverage ratios can vary widely, from 5:1 to 20:1 or more, depending on risk appetite and market conditions.
Financing Mechanics: The repo market is key. It’s liquid and allows funds to roll over short-term loans daily or weekly, while holding long-term bonds. They post the Treasuries as collateral, so lenders feel secure. Hedge funds may also use prime brokers, who provide financing and facilitate trades, usually at competitive rates due to their scale.
Profit and Risks: The profit comes from the yield spread, magnified by leverage. But it’s not risk-free. If short-term rates spike (raising borrowing costs) or long-term yields drop (raising bond prices), the trade can turn unprofitable. Leverage amplifies losses too. Using the example above, a 1% price drop on $10 million of bonds wipes out $100,000, a 10% loss on the fund’s $1 million equity. Other risks include margin calls (if collateral values fall) or liquidity crunches in the repo market.
The Basis Trade: A Super Simple Example
What’s the Goal?
Make money by exploiting a tiny price difference between a Treasury bond and its futures contract—without betting on interest rates going up or down.
The Setup
You buy a 10-year Treasury bond for $100. It pays a 4% annual yield (like a coupon).
You don’t have $100, so you borrow the money in the repo market at 3% annual cost. Here’s how:
You lend the $100 bond to a repo counterparty (like a money market fund).
They give you $100 in cash to fund the purchase, and you agree to buy the bond back later.
You pay 3% interest for borrowing the cash.
You sell a Treasury futures contract (same bond, delivers in 3 months) for $100.50.
Step 1: The Bond Side
You earn 4% on the bond = $1 over 3 months ($100 × 4% × 0.25).
You pay 3% to borrow in the repo market = $0.75 over 3 months ($100 × 3% × 0.25).
Net: $1 - $0.75 = $0.25 profit from holding the bond.
Step 2: The Futures Trick
The futures price ($100.50) is a bit “rich” (overpriced) compared to the bond’s value. By the time the futures contract ends in 3 months, its price has to match the bond’s price—let’s say the bond is still worth $100.
You sold the futures at $100.50.
At delivery, the futures price is $100 (same as the bond).
You “buy back” the futures at $100, making a profit: $100.50 - $100 = $0.50.
Total Profit
From holding the bond: +$0.25 (after borrowing costs).
From the futures: +$0.50 (price convergence).
Total: $0.25 + $0.50 = $0.75 on a $100 bond.
That’s a 0.75% return in 3 months, or 3% annualized ($0.75 ÷ $100 × 4).
Add Leverage
Hedge funds use leverage to boost returns. If you put up $5 of your own money and borrow $95 (20:1 leverage), that $0.75 profit becomes:
15% return on your $5 in 3 months ($0.75 ÷ $5).
Annualized: 15% × 4 = 60%!
And that’s what hedge funds loooooooove this trade
Tiny price differentials + lots o’ leverage = bigly profits
Bigly profits = Huge-O Bonuses
But what if prices move the wrong way?
What happens then?
Good question. Let’s talk about that.