Hedge funds shift to derivatives strategies requiring fewer Treasury bonds

Hedge funds have accumulated $2 trillion in Treasury holdings by year-end 2025, nearly seven percent of all marketable US debt, but are increasingly using derivatives-based strategies that require fewer bonds to generate the same returns. This shift threatens to reduce demand for government securities at a time when the Treasury must fund record deficits, potentially forcing other buyers to step in at higher yields.

• Hedge funds held an estimated $2 trillion in cash US Treasuries at the end of 2025, or about 7% of the marketable debt outstanding.
• The cash-futures basis trade, where funds buy bonds and short futures to profit from small price differences, grew from $213 billion in January 2023 to $832 billion in September 2025.
• Swap-spread trades can produce equivalent returns with fewer bonds required, potentially redirecting hundreds of millions in demand away from the Treasury market.

• $2 trillion Hedge fund cash Treasury holdings as percentage of marketable debt outstanding
• 7% Hedge funds’ record share of the cash Treasury market at year-end 2025
• $832 billion Estimated basis trade position by September 2025, up from $213 billion in January 2023
• $305 billion Estimated swap-spread arbitrage position by September 2025, up from $42 billion in January 2023

According to the Office of Financial Research, hedge funds emerged as dominant participants in US Treasury markets as their combined cash holdings reached $2 trillion at the end of 2025, representing approximately 7% of all marketable Treasury debt outstanding. CryptoSlate reported that research published by the Federal Reserve Bank of Dallas on October 16 found hedge funds can achieve similar risk-adjusted returns using alternative strategies that require substantially fewer Treasury securities, potentially reducing government bond demand at critical moments.

How the basis trade scaled hedge fund Treasury demand

The primary engine behind hedge fund Treasury accumulation has been the cash-futures basis trade, a relative-value strategy in which funds simultaneously buy Treasury securities and sell Treasury futures contracts to capture small price discrepancies between the two instruments. The strategy generates profits measured in basis points rather than percentage moves, forcing funds to scale positions through heavy use of leverage via repo financing and futures margin. This leverage structure allows hedge funds to absorb Treasury issuance when traditional primary dealers face capital constraints imposed by post-2008 financial crisis regulations.

Position data reveals the strategy’s explosive growth. The estimated cash-futures basis position rose from $213 billion in January 2023 to $832 billion in September 2025, while swap-spread positions grew from $42 billion to $305 billion over the same period. Those two strategies combined accounted for roughly $1.14 trillion, or 47% of the $2.4 trillion in total long Treasury exposure reported for large hedge funds that September. The basis trade profits from embedded optionality in Treasury futures contracts, specifically the right of the short seller to choose which eligible bond to deliver at settlement, known as the cheapest-to-deliver option. Funds finance the long bond position using repo, an arrangement resembling a collateralized loan, and deploy their own capital to cover the portion lenders will not advance plus futures margin and other carrying costs.

Swap spreads offer equivalent returns with smaller bond requirements

The Dallas Federal Reserve research identified a competing strategy that threatens to fundamentally reshape hedge fund Treasury demand without requiring any fund to exit the market or suffer losses.

The alternative strategy pairs a Treasury purchase with an interest-rate swap in which the fund pays a fixed rate and receives a floating rate. When swap rates rise relative to Treasury yields, the swap-spread widener trade generates profits comparable to the classic basis trade on a risk-adjusted basis. The critical difference lies in how much leverage is required. Because swap-spread trades can expose a fund to more dollar risk per unit of notional position, a manager allocating an identical amount of risk capital to the new strategy needs fewer bonds to support it. The Dallas Fed illustrated this mechanism with a hypothetical example: if a manager tolerates a $10 million loss under a chosen stress scenario and a basis position would lose 1% of its notional value in that scenario, the fund could support $1 billion in Treasuries. If the replacement swap-spread position would lose 2% under identical stress, the same $10 million risk allowance supports only $500 million in bonds. Portfolio decisions of that kind can remove hundreds of millions in bond demand without any fund closing its doors or experiencing financial distress.

The basis trade has also become less attractive to some Treasury futures buyers themselves. The value of the cheapest-to-deliver option for certain long-maturity futures contracts has declined as higher yields make eligible bonds more similar in relative value, reducing the flexibility that option value provides. Researchers also noted that some investors seeking long-duration fixed-rate exposure may obtain it through interest-rate swaps tied to artificial intelligence data center financing rather than purchasing Treasury futures, though they characterized that avenue as plausible but not yet quantifiable from available evidence.

The April 2025 tariff episode and future stress scenarios

The substitution of one trade for another does not eliminate dependence on leverage, dealer intermediation, and counterparty availability when market financing conditions tighten.

Monthly position data from April 2025 illustrated how different strategies can unwind at different speeds during market stress. As tariff announcements disrupted bond markets that month, the Federal Reserve’s estimated swap-spread exposure contracted 20% from $295 billion to $237 billion, while estimated basis exposure moved in the opposite direction, increasing from $725 billion to $829 billion before easing to $798 billion in May. Those movements suggest the strategies do not necessarily liquidate in parallel, complicating any model of hedge fund behavior that assumes all Treasury positions unwind together during stress. The April experience contrasts with pandemic-era conditions in 2020, when the basis estimate fell 27% from $429 billion in February to $312 billion by the end of March during an acute Treasury market seizure. By September 2025 the basis estimate had recovered to $832 billion despite reaching a June peak of $894 billion, illustrating how month-end snapshots can obscure violent intra-month moves and portfolio rotations.

Whether hedge funds gradually reduce holdings or face forced selling determines who must absorb the Treasury supply. If managers choose to reallocate capital smoothly to higher-return strategies, pension funds, overseas buyers, banks, households, and stablecoin issuers including Tether and Circle can purchase the securities at somewhat higher yields without market disruption. Stablecoin demand, concentrated in short-term Treasury bills backing tokens like Circle’s USDC, cannot automatically replace demand for longer maturities. Stress emerges when funds need cash simultaneously due to lenders demanding additional collateral, futures positions generating margin calls, or repo contracts failing to renew. Those scenarios force rapid asset sales into markets where dealers are reluctant to expand inventories, potentially amplifying price moves across leveraged positions and other asset classes.

The BlockWest read. We see a market adjustment that poses no immediate crisis but signals structural supply pressure ahead. The shift from basis trades to swap-spread strategies is not leverage reduction; it is leverage reallocation. Funds maintain balance sheet growth while demanding fewer Treasuries, leaving the government dependent on less patient buyers or higher yields. The real test arrives not during gradual rotation but during the next funding disruption, when we learn whether dealers still have capacity to intermediate and whether stablecoin issuers can expand Treasury holdings fast enough to replace departing hedge fund demand.

The Federal Reserve’s monetary policy decision scheduled for October 27-28 could alter short-term rate expectations that feed into repo financing costs, though private lenders can tighten terms independently of Fed action. More revealing than any single policy move will be successive monthly reports of hedge funds’ cash Treasury holdings, futures positioning, and swap exposure, particularly whether Treasury demand falls while funding markets continue operating normally or whether tighter dealer financing begins signaling a transition to the stress scenario Dallas Fed researchers outlined.

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