Hedge funds are piling in once again to a trade that was popular before the COVID crisis — until it blew up, Matt writes.

Why it matters: In March 2020, this bet went bad and amplified the chaos in the most important market on earth, the market for U.S. Treasuries.

• The Federal Reserve was forced to pump massive amounts — about $2.5 trillion — of newly printed money into the markets to put out the fire.

The latest: Over the last couple of months, there's been a range of renewed warnings about the growth in the size of this trade, known as the "Treasury cash-futures basis trade," or just "the basis trade."

• In August, Fed researchers rounded up the evidence that the trade was back, noting that "sustained large exposures by hedge funds present a financial stability vulnerability."
• In September, the Bank for International Settlements — often called the central bank for central banks — noted in its quarterly report that the buildup in the trade "is a financial vulnerability worth monitoring."

The bottom line: Despite wars, congressional chaos, persistent inflation, and volatile markets, the U.S. economy is actually in pretty good shape.

• But adding a messy unwind of a big Wall Street trade to the mix probably isn't a great idea — so it's worth exploring exactly what this trade is about. Keep reading...

It's either a masterpiece of the art of arbitrage — or a prime example of "picking up pennies in front of a steamroller." Or both.

The big picture: The basis trade consists of two separate Treasury market bets, that, when combined, can generate what looks like free money.

An overly simplified explanation goes something like this:

1. Buy a Treasury security, say a two-year note, in the regular old Treasury market, which is known as the "cash" market.
2. Go to the futures market, and sell a contract to someone — usually to a large asset manager — who will pay you to deliver the same Treasury security in a few months at a price higher than the one you paid.

For example: You pay $100 for a Treasury note, then deliver it to the futures market three months later for $100.50. Congrats, you made half a percentage point on the trade.

• The trade works when futures prices for Treasuries are a teensy bit higher than the price paid for the actual cash bond, as they have been lately.

Yes, but: A 0.5% return isn't enough for any self-respecting hedgie.

• So hedge funds amplify those returns by using a lot of borrowed money — also known as leverage.

How that works: Let's say you only put up $10 of your own money and borrow the other $90 to own the $100 bond.

• When you deliver the Treasury bill to the futures market, you still collect $100.50 and you still earn 50 cents on the trade.
• But if you only used $10 of your own money, that's a 5% return, rather than half a percentage point. Not bad.

Too easy? Maybe ... After all, that leverage is a source of risk. And in March 2020, we saw what can happen when using leverage backfires.

To get leverage, hedge funds head to the "repo" market.

• There, they take out mortgage-like loans, make a down payment, and then borrow the rest of the money they need to buy securities like Treasury bonds.
• Just as a house is the collateral for a mortgage loan, the Treasury bond is the collateral for the repo loan.

Yes, but: Unlike a mortgage, which can last 30 years in the U.S., the term for repo loans can be a single day.

• That means the hedge fund has to find a new lender each day to provide it with the one-day mortgage on its Treasury — and the interest costs associated with that loan can change.

The big picture: Most days this is no problem. Repo is a giant wholesale financial market where between $2 trillion and $4 trillion worth of these loans are made each day as a matter of course.

• Part of the reason the market functions is that everybody knows that Treasury bonds, which are the vast majority of assets financed in the market, are basically the safest investment on earth, and therefore the perfect collateral.
• But once in a while, a giant shock appears that makes people question such assumptions — like a once-in-a-century global pandemic.

What happened: When the realities of COVID hit the U.S. in early 2020, it sparked a worldwide rush to convert investments into cold hard cash.

• Usually, Treasuries are viewed as pretty much the same thing as cash. But the uncertainty surrounding COVID was so vast, investors were reluctant to even hold Treasury bonds.
• Amid the rush to sell, Treasury prices grew increasingly volatile.
• That volatility spooked repo lenders, who raised repo lending costs to protect themselves against growing risks.
• The rising cost to finance the cash bond leg of the trade effectively turned the basis trade into a money-loser.
• So these hedge funds exited the trade en masse, essentially selling all their Treasuries, which put further downward pressure on Treasury prices and magnified the death spiral of selling.

Worth noting: Nobody knows precisely how much the blowup of the basis trade in 2020 contributed to the disorder in the Treasury market. But the mass selling certainly didn't help.

There's no central repository of hedge fund trades, but there are several indications that the basis trade is popular once again.

• One is the surge in short positions in the Treasury futures market by hedge funds — that's the line on the chart above that went sharply negative starting last year. (Hedge funds fall under the category of "leveraged funds" in the data collected by the government.)
• Translation: This is the leg of the trade in which the hedge fund promises to deliver the Treasury at some point in the future.

Seeing as so many of the sophisticated financial risk watchdogs — the Fed, the BIS, the OFR, the Bank of England — have reported concerns about the growth of the basis trade, surely something will be done, right?

• Ha! Of course not! No way! That was a good one.

The big picture: Regulators are more than willing to issue white papers, and publicly stroke their beards about areas of concern.

• But it's much harder to muster the political will and legal firepower needed to make a decision and push through a plan that would basically disrupt the lucrative activities of major economic actors.
• Not to put too fine a point on it, but hedge fund titans and the banks that provide repo financing are often big donors and pretty darn influential among top politicians of both parties.

The other side: Hedge funds actually have a pretty good argument on their side, in that there's nothing inherently bad about putting on a big basis trade.

• In fact, with a straight face, they could say that the basis trade actually plays a helpful role in the Treasury market, as it means that hedge funds own a lot of cash bonds, and effectively help finance the national debt. (Up to and until some shock forces them to dump those bonds.)

The bottom line: For all these reasons, regulators tend to wait to address areas of major concern, even if they're already in plain view, until after financial blowups actually occur.

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