New derivatives rules could reduce buy-side hedging

Buy-side firms may end up not hedging their risk using derivatives products, representing an alarming unintended consequence of regulatory changes, according to industry experts.

Buy-side firms may end up not hedging their risk using derivatives products, representing an alarming unintended consequence of regulatory changes, according to industry experts.

Increasing costs of trading OTC derivatives through increased margin charges and collateral requirements could force participants to stop trading swaps, while exchange-traded alternatives may not always provide an appropriate hedge.

The result of the changes in OTC rules aimed at reducing systemic risk could mean buy-side firms would rather leave their positions unhedged than face the increasing cost of execution.

“The cost of hedging is becoming more expensive than the potential risk,” said Hirander Misra, CEO of the Global Markets Exchange Group (GMEX).

“Some of the pension funds have worked out the probability of things going wrong and they would rather take a hit on that than taking it on the hedge. This is another example of unintended consequences and it can’t go on forever.”


Risk rising

GMEX is one of a handful of venues planning to launch swap futures, a cheaper alternative to trading OTC interest rate swaps once new European derivatives regulations come into force.

The Group of 20 leaders have demanded mandatory clearing of standardised swaps, and rules in Europe are set to come into force throughout 2015-2016 for clearing members and buy-side firms.

“All of this regulation has renewed the focus on the true cost of collateral and how to generate margin efficiency as firms are having to lodge margin where they weren’t before,” said Steve Grob, director of group strategy, Fidessa.

“One of the potentially counter-intuitive impacts of this is that firms may decide not to hedge certain risks at all.

“So the true purpose of derivatives – in their traditional sense to manage risk – may, under the new rules, actually be increasing systemic risk to the whole system.”


Hitting liquidity

A recent study from the International Swaps and Derivatives Association (ISDA) found that 65% of OTC interest rate derivatives turnover are being used to hedge risk and volatility on balance sheets.

The research – based on figures from the Bank for International Settlements – was undertaken to dispel myths of derivatives trading not benefiting the ‘real economy’.

The largest category of users currently includes pension funds, insurance companies, asset managers and building societies, but this could change significantly if such firms stop hedging their risk due to regulatory costs.

“Given the amount of assets they own, life insurers need to hedge that asset portfolio to protect it against interest rate risk, their largest risk,” said Audrey Costabile, director of research, ISDA.

“If that becomes expensive, the concern is that they begin using partial hedges – for example, a 40% hedge instead of an 80% hedge, no hedge at all, or a cleared but less suitable substitute.”


Cash flow impacts

Another concern is that the reduction in hedging would end up impacting derivatives liquidity with buy-side firms accounting for a major portion of OTC derivatives trading.

Particularly vulnerable would be long-dated instruments such as long-term interest rate swaps (IRS), which life insurers and pensions funds are particularly active in trading.

“If for some reasons these market participants don’t engage in a 30-year IRS, then you may get a drop in liquidity as participation declines on that part of the curve,” added Costabile.

Another ISDA report from March – which examined the consequences of replacing OTC derivatives with exchange-traded products – highlighted the scope for greater cash flow volatility in a case study analysing different hedging scenarios.

“You can see the impact on cash flows is negative when you use these imperfect hedges, because there are some situations where an exchange-traded product to suit the situation just doesn’t exist,” said Costabile.