The Synthetic Lender of Last Resort

One dumb way to think about “the basis trade” is that asset managers want to borrow money to buy Treasury bonds, and asset managers want to lend money against Treasury bond collateral, and for some reason big hedge funds sit in the middle. The trade is:

You could imagine another way of doing the trade.2 You could imagine a bond manager saying “I would like to own Treasuries but not put up a lot of cash, so I am going to go across the hall to the money market fund manager at my firm and ask him to lend me the money to buy the Treasuries.” This is not the norm, in part because a lot of bond managers aren’t supposed to borrow money but are free to use futures. (This is called “synthetic leverage”: It’s economically equivalent to borrowing the money to buy Treasuries, but it doesn’t technically count as borrowing.) A lot of asset managers will buy Treasury futures but won’t go to the repo market to borrow money to buy Treasuries. Instead, hedge funds will do it for them; they will package the leverage into the right synthetic format for the asset managers.