In early 2018, a string of events formed an exploit in America’s sovereign debt market. Following a surge in Treasury issuance and regulatory reforms, asset managers (pension funds, mutual funds, and insurance companies) began to shift out of cash bonds and into long positions of their associated Treasury futures contracts.
A Treasury futures contract is a standardized agreement to buy Treasury securities at a predetermined price on a specified future date. Unlike option derivatives, which provide a right but do not obligate, futures contracts involve a binding obligation to transact on or before the contract matures.
The reason the basis (the difference between the cash Treasury price and the Treasury futures price) exists is because said asset managers began piling into Treasury futures, thus raising the futures' price relative to cash Treasuries. They prefer the futures over cash Treasuries because futures are operationally simpler and have less impact on their expense ratios. Most asset managers are not set up for repo, for example.
The cash-futures basis trade, or simply "the basis trade", is a three-legged arbitrage trade that seeks to exploit the basis, spanning three crucial financial markets: the cash Treasury market, where investors purchase Treasuries today; the Treasury futures market, where investors agree on a fixed price to pay for Treasuries they will receive in the future; and the Treasury repo market, where investors leverage their cash Treasury purchases.
Basis trades buy cash Treasuries and short Treasury futures to construct a payoff that depends on the two prices converging as the delivery date approaches (see Figure 2 in the third image).
This is similar to a long/short equity strategy, and convergence is virtually guaranteed: at the delivery date, cash and futures prices must be equal because otherwise on that date a trader could just buy a Treasury in the cash market and immediately deliver it into the futures market for an instant profit.
Shorting a Treasury futures contract means entering into an agreement to sell the underlying Treasury at a future date and at a predetermined price. It is an obligation.
To "deliver on a futures contract" means to fulfill that obligation by transferring the underlying Treasury to the buyer on the expiration date.
The key is that, so long as futures prices keep rising markedly above the price of their underlying Treasury securities, traders would buy bonds at a discount to what they’d receive when delivering these securities into futures contracts. If the basis were to narrow (or, potentially, invert), the trade would no longer be profitable, and this marginal buyer for Treasuries would vanish.
Only certain futures contracts and Treasury securities are used in basis trading. On any given date, there is just one Treasury security that basis traders want to own for each contract to make a particular deal as profitable as possible, called the “cheapest-to-deliver” Treasury.
The CTD ("cheapest-to-deliver") is simply the Treasury security with the cheapest value that is eligible to be delivered onto a futures contract.
Otherwise-similar Treasuries will differ in whether they are deliverable into a futures contract. A conversion factor attached to the futures price is meant to account for the desirability of individual Treasuries (the CME provides updates on conversion factors).
Due to these conversion factors, only one Treasury will be cheapest-to-deliver into each futures contract. But which that is can change over the life of a contract.
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