Brexit and the UK inflation market: Delivery and response amid challenges

Sponsored forum: BGC Partners

Brexit and the UK inflation market: Delivery and response amid challenges

As inflation continues to rise amid uncertainty following the Brexit vote, banks are being called upon to think outside the box in response. At a forum convened by Risk and sponsored by BGC Partners, our panel discusses the direction of the UK inflation market post-Brexit and the impact the referendum result has had so far, as well as the upcoming regulatory changes banks should fear the most.

The Panel

  • Guy Winkworth, Managing Director, Head of GBP Rates & Inflation Trading, Morgan Stanley
  • Richard Head, Partner, BGC Partners
  • Angus Abbot, Inflation Trader, Barclays
  • Boris Lefebvre, Partner, Head of  UK and European Inflation, BGC Partners
  • Kari Hallgrimsson, Managing Director, Head of GBP Rates Trading, JP Morgan
  • Dariush Mirfendereski, Managing Director, Global Head of Inflation Trading, HSBC
  • James Bucknall, Head of UK Inflation Trading, Deutsche Bank
BGC Partners sponsored forum
From left: Guy Winkworth, Richard Head, Angus Abbot, Boris Lefebvre, Kari Hallgrimsson, Dariush Mirfendereski, James Bucknall

Risk: To kick off with a market update, let’s discuss the growth in volumes in the UK inflation market post-Brexit.

Boris Lefebvre, BGC Partners: Volumes between 2014 and now have been relatively stable. We noticed a drop-off in early 2016 due to Brexit referendum uncertainty, quickly followed by a pick-up in volumes. What is most striking is the change of percentages of trade types in the total volume. Indeed, there has been a sharp decrease in outright swaps trading to the benefit of swaps versus bond breakeven, the so-called IOTA spreads. In 2015, IOTAs were approximately 10% of total volume, rising to 20% in 2016, and we expect them to be 25%+ of total volume in 2017.

We have also seen a decrease in very long-end swaps as IOTA trading is mainly concentrated in the 10-year, 20-year and 30-year tenors. The largest part of our volumes consists of curve and fly spreads. In the past year we have also seen the continued growth of fixing trades – so the very short end of the curve, where volumes have tripled over the past three years, which has been aided by BGC’s introduction of new electronic trading technology.

 More trades are being carried out electronically and represent about 40% of the total market volume. BGC has been utilising such auction technology since 2010, and there are now about 20 electronic swap trading sessions a day across the broker market – a trend I expect to continue. Since September 2016, almost all trades have been cleared through LCH, which has led to the establishment of a spread between cleared and non-cleared swaps.

 

Risk: Post-Brexit, do you recognise some of these trends? 

Kari Hallgrimsson, JP Morgan: After the Brexit vote there was an interesting dynamic in the inflation market. Correlation between interest rates and inflation, historically positive, turned negative. Interest rates moved sharply lower as a result of monetary policy reaction from the Bank of England. In the meantime, inflation expectations rose quickly because of the weakness of the currency. 

This dynamic, along with the uncertain outlook for the UK economy, led to increased focus on the short end of the curve. Volatility rose significantly, which created trading opportunities for market participants to get desired exposure at decent levels. The increased volatility also incentivised market participants to hedge unwanted fixing risk. The increased activity in the short end of the curve, along with the volatility of inflation prints, created more trading in inflation fixings. This is a welcome development for the inflation market as, traditionally, the short end of the retail price index (RPI) curve has been relatively illiquid compared with the long end.

Guy Winkworth, Morgan Stanley: Brexit was one of the big macro stories of last year, and the change in volumes probably reflects a slight change in end-users involved in the inflation market, particularly at the front end. But the increased volumes going through in curves and flies are also reflective of more relative-value players, more fast money activity in the market. So that’s probably a sign of a maturing market.

Dariush Mirfendereski, HSBC: Foreign exchange has probably been the overriding driver of the UK inflation market’s outperformance post-Brexit versus the other major markets – US and euro – which were themselves doing quite well in breakeven terms, driven up mostly by commodities. So you had two drivers for the UK where breakevens globally were going up on the back of forex weakness – but, globally, breakevens were all going up anyway. Detaching these two drivers was challenging if you wanted to see whether the forex move was being correctly priced.

James Bucknall, Deutsche Bank: In the aftermath of the Brexit vote, the two big themes for us were the repricing of short-end inflation expectations and the huge wave of liability-driven investment (LDI) activity. Schemes that were overweight overseas equities and larger FTSE companies – whose revenues are forex-sensitive – saw a significant windfall gain from those assets. The Office for National Statistics’ (ONS) MQ5 data showed a £15 billion disinvestment by pension funds and insurance companies in the third quarter of 2016. Many schemes felt comfortable with a world of lower yields and lower real yields, and so we saw a notable increase in LDI demand for long-dated linkers in order to de-risk from the asset sales. Inflation expectations were going up globally, and another big driver of that later in the year, of course, was the US presidential election and the US reflation theme.

Angus Abbot, Barclays: On the point about IOTA perhaps becoming a more important medium of risk transformation on the Street – that’s driven partly by client flows. A major theme has been clients unwinding existing risk hedges in inflation swaps and interest rate swaps (IRS) to move into cash. For the Street, this means trading IOTA and nominal asset swaps as a hedge.

Presence in the cash market has also become a much bigger focus – most outright inflation risk trades in cash – and if you hedge your outright in the cash market then trade the IOTA rather than the outright swaps, you obviously end up doing a lot more turnover than if you just traded the swaps, and may be able to hedge more efficiently.

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Risk: Clearing has had quite an impact on the market since September 2016. What impact has the sell side seen on liquidity, client flows and the like?

Guy Winkworth: The inflation market did a good job of getting inflation into clearing. Many were sceptical of inflation working when we first discussed setting up clearing, given the size of some of the end-user flows, but it has been relatively smooth. On the client side, a portion of the market has been very keen to utilise clearing to, for example, make their trades more commoditised and easier to unwind and move around. It has arguably made bilateral swaps more complicated, but I think the clearing side has been a success.

Kari Hallgrimsson: The emergence of a CME/LCH clearing basis in the IRS market prior to the active clearing of the inflation swaps certainly focused the market on potential risks of clearing basis in the inflation market. As a result, a basis quickly developed between cleared inflation trades and trades under bilateral credit support annexes (CSAs). Many LDI clients have moved to clearing. Given they are largely buyers of RPI due to their hedging requirements, while much supply of RPI remains either bilateral or uncollateralised, we will see the cleared swaps trading above bilateral swaps until we see this dynamic change.

For some end-users, clearing inflation swaps is beneficial despite the costs of initial margin (IM). It is easier to enter into a trade with one bank and unwind it with another. Collateral is more centralised. Now that the vast majority of inflation swaps traded in the interbank market clear, most screens assume LCH clearing. As a result, there is a lot more transparency for cleared swaps. For other end-users, the benefits of clearing may not outweigh the costs. These costs include the funding of IM. Additionally, many end-users have CSAs with banks that allow them to post securities, which give them flexibility to use their current assets as collateral. However, the lack of transparency of the clearing basis can be an issue. I am confident that as the cleared/bilateral basis markets develops these clients will get more transparency.

Dariush Mirfendereski: In terms of the development of LCH inflation clearing, I see three distinct phases: (i) when LCH clearing started and the initial month or so of market activity when reasonable volumes cleared in the broker market; (ii) the in-between phase, where pretty much nothing was clearing; and (iii) from September 2016, where bilateral IM rules kicked in for some banks, from which point pretty much all broker market zero-coupon (ZC) inflation swaps cleared.

A key question for the market is the direction of inflation flow: why one direction in LCH might dominate the other and what this would mean.

In theory, asset swap trades can be cleared if they’re bifurcated into the component pieces (ZC inflation and ZC IRS). However, that takes effort, and some asset swap counterparties may be unable – or unwilling – to bifurcate. For example, running the asset swap on an accrual accounting basis may make it impossible to bifurcate, so a proportion of the asset swap trades will be unlikely to ever clear.

Then there’s a legacy of pre-financial crisis elements: swap supply from corporates, private finance initiatives and securitisations. These swaps aren’t even collateralised and also won’t clear. That market is opening up again, in terms of some infrastructure deals, so we will have additional directional flow that also won’t clear. So, the side(s) of the market that won’t clear are those where banks are receiving inflation cashflows (either from corporates/Infrastructure or in asset swap trades). The side we’re selling inflation to is more likely to clear. Given this directionality, a preference has developed as to the direction of inflation flow to face LCH.

Guy Winkworth: The asset swap, traded in traditional par-par or proceeds format, creates more of an issue regarding clearing. This is a greater challenge for the euro market, where more trades are structured this way. That may be one of the next topics that LCH looks at in terms of clearing asset swaps, in that format. They are clearable in component parts, but not as one. That may change over time.

Angus Abbot: LCH clearing has been very successful, and has helped to attract more tactical volumes alongside the conditions Brexit has created. However, I think there will always be interest in trading bilaterally from some end-users. There’s not really a tradable market for the LCH basis, because you have to post a bilateral independent amount against bilateral trades, so nobody wants to trade the LCH basis in the Street, but dealers want to define where it is. That introduces an additional layer of idiosyncratic price opaqueness that end-users must face.

James Bucknall: For us, the direction of the basis is really a function of the potential bilateral demand for RPI swaps in relation to the bilateral supply, which could be project finance-related and shorter-dated as opposed to the pace of backloading of historic bilateral positions into LCH. It’s not necessarily clear there’s a structural reason for it to be one way or the other, and a large bilateral programme of RPI buying could easily take the Street the other way around.

There’s certainly a bifurcation of views among clients on the clearing conundrum, with the benefits of clearing – increased transparency and ease of execution and restructuring – against the concerns over the additional IM and what may or may not be able to be posted as collateral. Additionally, there are genuine concerns about the clearing model in terms of exposure to a clearing house and to clearing brokers.

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Risk: Consumer price inflation (CPI) markets have been growing slowly for some time. Do you expect this to continue? Are there any particular challenges that are restricting growth?

Angus Abbot: One of the first challenges is that the government will potentially switch to using CPI including owner-occupiers’ housing costs (CPIH), rather than CPI as its statutory measure of inflation. CPIH has been redesignated as a national statistic and is the ONS’s preferred measure of inflation. Regulated utilities will probably move to benchmarking against CPIH rather than CPI, which potentially means ending up with three different indexes, one of which – CPI – essentially becomes defunct. Before the market can really take off, we need to get that decision out of the way.

The market has picked up. There have been a few deals in CPI over the past nine months or so and there is certainly interest on the demand side – mainly from insurance buyout firms that have to hold capital against their CPI liabilities, whereas pension funds don’t, and can run the RPI/CPI basis much more comfortably. For this market to develop you need government assets, you need the Debt Management Office (DMO) to start issuing CPI or CPIH bonds. That’s the only thing that is going to drive the market to become anything like as liquid as RPI.

Dariush Mirfendereski: For the CPI market, there are some publicly visible deals on the bond side, including utilities, housing associations and others, although they have all been CPI-linked, not CPIH. I agree that the UK DMO issuing CPI linkers is going to make this market really take off, but we were not in a position to even think about that possibility until the ONS’s announcement on July 31 that CPIH was being redesignated as a UK National Statistic. The process of assessing whether or not to issue CPIH index-linked gilts can now slowly begin. Between now and then, I don’t think we can assume that very little will happen. We are seeing steady growth in the flows, typically in terms of demand from the pension/insurance side versus supply from the infrastructure side.

I see a healthy future for this market, but the biggest growth phase will come after the DMO enters the market – that phase could be quite interesting. You don’t have to just issue clips of CPI, you could even do switch auctions, which make sense in the context of insurers and others who are proxy-hedging CPI liabilities with RPI. So you could see a decent-sized CPI (CPIH) market building up on the DMO side relatively quickly.

Kari Hallgrimsson: Some market participants have suggested that, if the DMO were to issue CPI linked bonds, then that would have a negative impact on the liquidity in the RPI market. I disagree; I think it will increase the liquidity in the RPI market. In the European inflation market, where you have French linkers linked to French inflation and French linkers linked to European inflation, there is quite a bit of trading between the two. This actually increases the overall flow and the two products complement each other.

Guy Winkworth: The DMO released a consultation around demand at the time for CPI or CPIH bonds. The feedback was that there was uncertainty around which of CPI or CPIH would be the more widely used index. We should see over the next year or so most of those metrics referencing CPI slowly switch over to CPIH

One of the things that is important to the DMO is proving it can issue CPI/CPIH bonds at an attractive valuation for the taxpayer. Depending what investors view the RPI/CPI wedge as, that’s an easier decision to make when breakevens are lower because – given that the Bank of England targets 2% CPI – it’s perhaps harder for investors to want to pay more significant premia to that than RPI. There’s always some uncertainty about where the RPI/CPI wedge may sit.

 

Risk: Do you foresee an increase in the supply side of the UK inflation swaps market, particularly on the corporate and infrastructure side? Are there any hidden supply-side sellers of inflation lurking out there?

James Bucknall: The DMO will continue to be the major source of inflation for the next few years, although there is some discussion on whether the pace of linker issuance will be maintained against that we’ve seen over the last five to 10 years. That said, I think the adoption of International Financial Reporting Standard 9 (IFRS 9) could bring a huge change to the market as early as next year, and we could see significant new sources of inflation from, for example, corporates and utility companies. I don’t think it’s limited just to the supply side. It could spur some new demand as well, but I think that’s probably one of the biggest changes we’ll see.

 

Risk: What element of IFRS 9 allows this?

James Bucknall: It’s the change in the hedge accounting rules so assets and liabilities can be hedged with inflation assets and inflation derivatives more easily. If companies can show sufficient correlations, then the accounting treatment of the market-to-market of the hedge could be easier to manage.

Dariush Mirfendereski: I’ve spent 20 years having discussions with corporates with regard to hedging their inflation-linked revenues and it’s a tough task. Unless there’s explicit linkage of the net revenues to an inflation index, and they can achieve a breakeven that’s above consensus or survey views on inflation, it’s very difficult for them to be able to, or agree to, hedge. This is why the UK is usually a good market for corporate flows – the breakevens are much higher than the consensus because of the pension demand, while utilities and some infrastructure deals or leases have explicit linkage to either RPI (or, more recently, CPI).

The signs are positive for renewed growth – a few years ago there was virtually nothing. Now there are pockets of supply coming into the market. With LCH, that just creates an additional reason why the basis might be where it is because all these supplies will be one way. They’re typically uncollateralised – therefore, they won’t be clearing. Then your hedge is going to be in the market or with clients who may or may not eventually clear. It’s basically going to create an additional source of friction.

Guy Winkworth: There is a large amount of natural inflation linkage in the market from all avenues we’ve spoken about. So while there may not be a ton of new entrants into the market, some of that natural hedging has perhaps not happened as much over the last several years compared to before that because of changes in the way banks think about long-dated and/or uncollateralised derivatives.

Changes to the market since then have probably helped reinvigorate some of that supply. Should CPIH become more traded, there will be some more natural macro supply from that side were it to trade at a premium. Global investors and players are arguably happier to be trading an index that they have more understanding of, and is more comparable to other global indexes.

Kari Hallgrimsson: I do think we are going to get more UK inflation supply from corporates in the medium term, as supply has been relatively light recently, and this supply could be in either CPI or RPI. Previously uncollateralised trades have been a concern for banks. However, as the market finds ways of recycling some of that risk, it should lead to transaction costs for these corporates to decrease. 

Angus Abbot: I think there will continue to be a deal flow. Large capital projects on the horizon could provide supply to the market, probably CPI or maybe CPIH, but we’re not going back to the heyday. Although banks have found ways to recycle these positions, many of the natural suppliers already have a lot of this stuff on their books and are very ‘underwater’ on it. Persuading their boards that they want to do more of this has some barriers.

On the demand side, a lot of supply that was coming pre-crisis was going to investors who either don’t exist anymore or are no longer a force in the market. It seems investors now want a premium for inflation-linked corporate debt, which issuers aren’t prepared to pay. That’s one reason there is a lot less corporate supply, and I’m not sure that is going to change very quickly.

Dariush Mirfendereski: On the buyer and investor side, if there was a wide corporate bond market for linkers across all sectors, not just utilities, there would be a lot more interest in them. However, the issuance is pretty much limited to utilities or a few infrastructure projects, which leads to concentration risk for the investors – one of the reasons it can become challenging to sell those bonds. And that’s why, if you could split the inflation from the credit, you could bring more of this supply to market.

 

Risk: Are there any developments on the wholesale horizon? 

Richard Head, BGC Partners: As already mentioned, we have seen the birth and year-on-year growth of the one-year fixing market. Volumes continue to increase with on-the-run roll trades, and the August/September pairing are noteworthy trade points. However, with the linker 17s maturing in November, the potential for two-year fixings comes into play. The linker 19s and 20s will become the nearest bond maturities, fixing versus August/September 2019 and, with an uplifted notional of around 30 billion, these could potentially provide a liquidity anchor for the short end. So we could see the development of a two-year fixing market, like we see in the euro markets.

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Risk: One of the things that has been talked about over the past five years was the idea of inflation special-purpose vehicle (SPV) repacks, and whether that technique can help restructure some of these long-dated inflation swaps that move risk to hedging funds and pension funds. Is it a scalable solution, is this only for one-offs or are there better ways to do it?

Guy Winkworth: Pre-crisis, banks intermediated between corporate risk and the structures investors wanted – which at that point were largely standardised inflation derivatives for liability matching purposes. Obviously, with the regulatory, capital and accounting changes since, that’s not such an efficient way for the market to go. Anything that leaves banks with more nuanced risks and more of the directional risks in the hand of the end-investors is good for the efficiency of the market.

Angus Abbot: It’s somewhat scalable once you’ve created the SPV and you have all the documents in place – you can then relaunch from the same platform, but getting there is quite an involved process. A lot of approvals are required, particularly on the corporate side, for them to get comfortable with the format of the note, and so on.

Another option we’re investigating is for investors to face corporates directly – to actually step into the trades. Again, it requires quite a lot of approvals – the corporate must get comfortable with the investor’s credit, and vice versa. I don’t think this is going to become everyday business, but it will, over time, allow banks to free up a bit more capital.

Kari Hallgrimsson: Yes, I do think it’s scalable but it’ll be a relatively slow process. More corporates have to get familiar with the structure, and the buyer will also have to get more comfortable with the product. Many LDI accounts manage their inflation risk and credit risk separately. This product combines them so they have to find a home for it within their mandate. 

Dariush Mirfendereski: For long-term or new business you ultimately need to be able to split the inflation from the credit exposure.

Aside from the SPV or the repack route, there are ways to sell the exposure synthetically, for example, via some sort of contract. That might mean the exposure is to the bank selling the contract but, again, there are alternatives to SPVs and repacks that can make it easier and faster to achieve because you’re bypassing approvals from the issuer/borrower.

 

Risk: What is your view on how the inflation rate swap can involve flows? What kind of flows do you see dominating UK pension fund clients over the next year, and how do you see them holding up?

Guy Winkworth: The general themes are very much the same as in the past few years – ongoing flows into de-risking strategies – which is obviously more of the same hedging. There has been some talk of people taking cash out of defined-benefit schemes, which has had some impact on the schemes. It’s unlikely to immediately change any hedging activity, but I would say it’s very much ‘as you were’: hedge, move to buyout and move on from there.

Kari Hallgrimsson: Two things are happening simultaneously. Some pension funds are choosing to use linkers as a benchmark rather than inflation swaps and adjusting their hedges accordingly. Other pension funds that have flexibility to use either product are choosing linkers rather than swaps. Their decision is not only driven by outright levels of linker asset swaps, but also their ability and cost to get duration in each product. The decreased pressure on banks’ balance sheets and the relatively stable underlying repo market have cheapened the funding costs for linkers, which in turn make linkers more attractive to hedge. The flows above have led to more interest in trading IOTA.

Guy Winkworth: We’ve just seen the decision to adopt Sonia as the risk-free rate, and to move away from Libor, and that adds questions. But it’s also another driver in terms of people, perhaps on the margin, moving into cash instruments and away from derivatives. Inflation swaps, however, reference an index that is not changing through this process and are discounted at Sonia already – so the inflation side is in particularly good shape there.

Dariush Mirfendereski: On the topic of defined benefits being transferred into defined contribution pots, a study by Mercer estimated that 50 billion of this transfer has happened since 2015. That’s a big number. DMO issues roughly GBP 30 billion index-linked gilts a year. In that context, 50 billion would look very significant, in the sense that there are then 50 billion fewer liabilities to hedge. But, if you put the 50 billion it in the context of roughly 1.5 trillion total liabilities that are inflation-indexed – with the index-linked asset class being 500 billion and the unhedged liabilities about one trillion, give or take a few hundred billion – that 50 billion is still a small fraction (5%) of the unhedged liabilities. Nevertheless, transfers out of defined benefit could gain additional traction and this needs to be monitored should it continue at a similar pace.

James Bucknall: Those numbers about the liabilities are, of course, very large, which, put in the context of gilt issuance – which is perhaps going to be falling over the next five years – paint a positive picture for the inflation market in terms of hedging activity. That said, a significant amount of hedging has been done already over the past few years – pension funds have been net buyers of index-linked gilts for the last 22 quarters. The pension fund outflows are a story that will probably start to gain traction. In addition, as trustees start to allay their concerns over potential mis-selling of transfers, it’s likely they will start pushing it.

We had an immediate post-Brexit era of lower real yields and higher inflation expectations. The Brexit outlook is now more uncertain, which raises questions over higher medium-term inflation expectations. We’ve had a faster pass-through than many thought from forex weakness into the spot inflation prints. But medium-term expectations are high already and, should we have a soft Brexit or marked slowdown in the economy, it’s likely they would come down.

Angus Abbot: One other flow that is related to the point about easing of balance-sheet conditions is that ultra-long linkers have been in seemingly terminal decline on the curve for the past year or so. There was a point when they were very much in vogue, and everyone was piling into them with the view that pension funds were structurally underfunded and repo was becoming very tight, so LDIs needed to get as much bang for their buck as possible – which meant buying the longest-duration instruments on the curve. The repo market has eased back a bit, and seems to be less of a concern for the industry, so LDI can access leverage to buy at shorter maturities.

Something else that has been in the background is that, post-Brexit, we had a big spike in the linker market. There was talk of the government potentially easing regulations on the pension fund industry, so they weren’t forced to hedge at very low real yields. However, when the green paper on defined benefits was published in February, if anything it set the opposite tone and all the noises we’ve heard since then from the pensions regulator and the government have been quite hawkish, meaning hedging demand should remain firmly intact.

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Risk: LDI strategies have been a popular theme for quite some time, and dealers are under a lot more regulatory pressure about being able to facilitate some of those strategies. Is there an LDI execution bottleneck, these guys wanting to do all these trades to get this scheme under way and, if there is a case, how it could be resolved?

Kari Hallgrimsson: Frankly, I don’t think there is a bottleneck. There are developments in the market that may form a decision of whether to hedge or not, as there always are in a dynamic market. Currently we have Brexit, low real yields, lack of transparency on clearing basis, etc. However, it is my view that, once the decision is made to hedge, implementation will be straightforward.

Guy Winkworth: If anything, there’s less of a bottleneck than there used to be. If we go back post-crisis, the syndication approach programme for gilts and linkers came around, essentially, to remove some of the pressure on market-makers from dealing with these very large LDI flows. The trend over the past three or four years has been for these execution programmes to happen gradually over time. The market is now better at dealing with that from both a risk management and a distribution perspective, so that has been quite a positive development for the market.

James Bucknall: If you were to talk about a bottleneck, it could be put in the context of too big a liability chasing too few assets, and therefore UK real yields being perhaps too low versus a macroeconomic framework, but that is not a dealer bottleneck.

In terms of interaction with dealers, I think the Street has been through a cathartic process over the last few years. We’ve seen several dealers pulling back, but there’s a core that remains with an appetite to facilitate large client flows. There is clearly a lot of hedging to be done – it may not be at the same pace as before, but those dealers that remain are in a strong position to provide liquidity to clients.

Dariush Mirfendereski: Overall, given the ongoing recycling of legacy real rate swaps, i.e. older hedges being unwound and replaced by index-linked gilts, or the total return swap alternative, the market is capable of delivering LDI’s hedging needs. I therefore agree about there not being a bottleneck. However, if we get a sharp back-up in yields, and therefore pension scheme solvency ratios become much healthier, you might get a much bigger wave of demand. So we can’t guarantee this situation will stay the same and everything can be delivered, at least on the RPI-only front. If the RPI demand volumes grow two- or threefold, it may become more challenging.

Kari Hallgrimsson: The RPI market has evolved. Banks and LDI clients are now more careful in executing large hedging programmes so as not to leave a big footprint in the market. For example, inflation hedging activity now tends to be clustered around syndications, which is met by the supply from the DMO.

James Bucknall: To come back to the point about the provision of leverage, perhaps as a metric for this bottleneck, I think cash efficiency has been a huge driver of the inflation market over the past few years – whether it be the shape of the real yield curve or the relationship between the inflation bonds and inflation swaps. We’ve recently seen a significant improvement to the Street’s offering of leverage to LDI clients. While the sourcing and management of leverage is still a huge focus for LDI portfolio managers – perhaps as big as more traditional risk decisions – the concern that leverage is a big problem for them has subsided to a great extent.

 

Risk: To what degree could discounting apply in the UK market? In Europe or the eurozone, the dislocation between the repo rate and the Eonia rate has always tended to be quite similar, but now it has opened up, people are thinking they should be discounting at repo, not Eonia. Some think it should apply to cash in bonds as well. Given that the client base of the inflation derivatives market is very bond-focused in terms of the margin they post, is this discounting at repo worth thinking more about?

Kari Hallgrimsson: The underlying collateral in a CSA will affect the discounting. Banks are now comfortable with differential discounting, and differentiating between cash and securities collateral is part of that. As mentioned before, there can be benefits for LDI clients to be able to post bonds as collateral. However, trading under bilateral CSA with securities further reduces the transparency. Not only is there basis between bilateral CSA and cleared trades, even when both have cash only as collateral, but there is also discounting differential between trades under bilateral CSAs with cash versus securities collateral.

Guy Winkworth: First, the gilt repo market has been much more tightly bounded than perhaps some of the euro equivalents, partly because there is only one issuer and partly because of the standing repo facility. So, despite the holdings within the asset purchase facility, the repo market has performed very efficiently through all the perturbations of the last several years. And some of the discounting effects are perhaps less relevant in the UK.

I agree that you have this sort of bifurcation between cleared cash CSA trades and more bespoke equivalents. For new trades, end-users need to weigh up the cost benefit among themselves. There are some developments in terms of things such as repo clearing that may, to some extent, change the balance between where people want to post into CSAs or use other methods to essentially transform those bonds into cash to post. That was a fairly large part of the thought processes that many had between whether to adopt Sonet or Sonia as the risk-free rate.

Dariush Mirfendereski: If you believe the glide path is for pension funds to ultimately move to clearing, then go from a dirty CSA or a multicurrency CSA to sterling cash/gilts and then from cash/gilts to cash only, this process paves the way to ultimately clearing. That’s one strategy: to recognise the ultimate end-point and get ahead of the game by starting to move along that path. There is another rationale for pension funds to clear: that is for accounts that are much more active. For those active mandates it is much better for them to get the transparency from clearing now rather than having to deal with the additional friction of transacting in and out bilaterally.

James Bucknall: This has certainly been a hot topic over the past couple of years – but I think the fears over unduly harsh capital costs for giving someone the ability to post you bonds, for example, have subsided to some extent. That means bilateral business is a lot more competitive than it was perhaps a year or so ago, when there were real concerns. That’s also painting an increasingly positive picture for bilateral business going forward.

 

Risk: With a lot of regulatory change coming up, do you have any particular concerns over the next year? 

Angus Abbot: There has been a lot of regulatory change over the past few years, and there’s still quite a lot coming up. It feels like we might be getting towards peak regulation, but I’d be very cautious about saying that. Changes to the way capital was treated have probably been the major driver of change in the RPI market over the past few years – but the banks that have been able to stay relevant in the market have adapted, have become more returns-focused, done a lot of work on reducing legacy portfolios and perhaps disintermediated some of their more capital-intensive positions.

The obvious next big regulatory hurdle is the Markets in Financial Instruments Directive (Mifid) II. At the moment, it looks like RPI swaps aren’t going to be considered liquid under Mifid II, so I don’t think it will have a huge impact on the market. Clearing paves the way for electronic trading in RPI, which I would expect to kick off reasonably soon. If that starts to attract a broader asset base, and down the line we move to CPIH and that becomes a more interesting market for international investors, then maybe we will see Mifid II start to have more of an impact.

James Bucknall: We’ve focused on the regulatory impact on the sell side, but I think we’re entering into a period where the buy side is starting to see significant regulatory changes. So, while that will require a period of adjustment, it will certainly present many opportunities for banks that provide liquidity and new solutions going forward. I see it as an opportunity rather than anything else.

Boris Lefebvre: At BGC we see any regulation changes as a potential opportunity to react to a fast-moving market. As an example, we were the first to offer a swap execution facility (SEF) trading platform when SEF regulation was introduced, and we were fast to respond to the market need to clear RPI swaps.

Obviously, we are now preparing for Mifid II. Each change in regulation challenges an interdealer broker to rethink the way they offer, quote and report trades to their customers and the regulator itself. BGC has a history of fast response to change and will continue to do so.

 

The panellists were speaking in a personal capacity. The views expressed by the panel do not necessarily reflect or represent the views of their respective institutions.

 

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