02 Jul 2012, Boris Lefebvre , Jeffrey Hogan , Stephane Salas , Kari Hallgrimsson , Georges Sitbon , Christian Alibert , Franck Triolaire , Risk magazine
Risk: How have volumes been this year?
Boris Lefebvre, BGC Partners: Our inflation products have not been immune from the unfolding drama in the eurozone. The waves of high and low liquidity in 2012 have matched the risk-on/risk-off spikes we have witnessed, and the credit component of bond elements combined with capital charges on balance sheets has weighed on liquidity. For example, European asset swaps have virtually disappeared from the interdealer market. However, in the UK, asset swaps have remained strong due to the relative safety of sterling. An essential overall factor in liquidity has been innovation, where BGC as the first broker to introduce a volume match auction platform has been hugely important in both cash and derivatives flows by creating price reference points at which the whole market can participate.
Risk: Have you seen a trend in a split between cash and derivatives? Are asset swappers still actively providing supply?
Franck Triolaire, Morgan Stanley: Basically, you have too much credit component inside the linker, and it is actually specific to the format. When you have what we call the inflation balloon at the maturity, the principal is almost double on the 30-year bucket, so the linker is much riskier than the nominal paper. As such, splitting derivatives and bonds is a good point because they don’t behave in the same way. We talk about central clearing for derivatives, which is key, and we hope to have inflation swaps within LCH.Clearnet in one or two years. It will be huge progress. The behaviour on linkers is so random, you don’t attract investors any more on a relative-value basis, and that is the main problem for investors that use bonds to replicate the inflation indexes. To me, splitting assets inside the inflation space was not key – I like integrating everything on the same desk. But the behaviour is so different, you have to think of them differently now.
Kari Hallgrimsson, JP Morgan: You cannot underestimate the need for pension funds to be able to invest cash in other products such as equities or credit products while hedging inflation and picking the exact point of the curve they need to hedge given their liability structure. I would expect inflation hedging for pension funds to be more natural using swaps, particularly in the long end. However, in the short end, they are more comfortable owning some of the shorter-dated bonds because they are comfortable holding them to maturity. With regard to the asset swaps, in our view it seems the market goes from one extreme to another, either liking inflation-linked asset swaps or not liking them. Asset swap flows are very much dominated by domestics now – so we have Italian banks buying Italian linkers and French banks buying French linkers. I expect that to continue.
Risk: What is happening with options in the broker market?
Boris Lefebvre: The options market has massively developed. Some days we were trading more options than underlying swaps. The European market is three to four times busier, maybe because there are fewer players in the UK options market than in the European market. There has been a little bit of a drop in liquidity lately, probably due to the macro-economic environment, but I’m confident the matrix is developing, not only the 0% but the -1% and the +1% strikes. Traders are also looking at solutions to avoid credit support annex (CSA) risks such as the quotation in running and forward premium.
Stephane Salas, Deutsche Bank: There is no question that liquidity in the options market has improved dramatically. It is even more evident in the US, where we see some hedge funds that are volatility specialists and are extremely active in inflation options, both year-on-year and zero-coupon, and they sometimes touch on European inflation. The sizes that go through in that market amaze me. I am concerned about how much of that liquidity in the market is genuine. We have seen artificial liquidity bubbles in the past.
Risk: Greece has already been ejected from the key inflation indexes. Italy is just above the rating trigger that would force it out. Is the market prepared for this?
Franck Triolaire: When we got the first private sector involvement (PSI) in Greece last year, it was not positive. In July, following the second PSI, it was much better. We have mentioned the term sheets for Greek linkers – it was explicitly stated that, in a default, the payment would be notional times index ratio times the recovery rate. In August, when we saw Italy under massive pressure, the question about a downgrade and an index exit was key. It was not clear what would happen in a default – none of the term sheets for inflation-linked Italian government bonds (BTPeis) were explicit in terms of early payments. At one stage, BTPeis traded in default, and investors took the worst-case scenario – they forgot the index ratio. Afterwards, primary dealers and other market participants made a statement and pushed the issuer to be more explicit on early payment, including default. In the end, it was determined that, if there is early payment or default, whatever the law – international or domestic – it will be with the index ratio. France committed on that statement as well, and the asset class recovered after that. In terms of the indexes, most of the issuers are working with the index providers about new rules for linkers, and there are other index providers with more flexible constraints than the main one. Customers were reactive and switched from the main index to other indexes with a broader flexibility in terms of rating downgrades constraints.
Christian Alibert, Royal Bank of Scotland: For the most part, the adjustment has been made. The majority of very active index trackers have either switched to the more generous indexes that allow more scope for the BTPeis to continue to be included, or have shifted to being underweight in Italy. The fact there has been a shift towards domestic trading of product means that the majority of BTPeis are held by Italian domestic entities, which should be less inclined to liquidate following such a move. The market has made the adjustment to the risk.
Risk: The European Central Bank (ECB) has come up with solutions to the problems, with the introduction of the Securities Markets Programme (SMP) and longer-term refinancing operation (LTRO). However, inflation-linked bonds weren’t included in the SMP. How did market participants respond?
Georges Sitbon, Société Générale: On inflation indexes, we were close to a crash at the end of the year and we have adjusted in three steps. The first step was all the players who tracked the Barclays index got out of Italian linkers at whatever the price. Then came the first and second LTROs, and the breakevens on Italian linkers recovered. As they were still tracking the same index, they came back on the bid. The question in this second step was about index tracking – should I still track a not-diversified inflation index or not? The third step was to design a new index that would be much more flexible in terms of credit rating. The nominal bond indexes are much more flexible than the linkers, so it would just be a convergence of the linker index with the conventional one. Now, most of the real-money players that are tracking the index have switched, either to new indexes or the same index player, but to a new index that will be much more flexible. So there is no disruption risk in the market anymore. The market isn’t entirely in domestic hands – some international players hold the bonds, because they couldn’t miss out on the performance of this market. But there is no more need for them to sell because they have already prepared to change the mandate of the funds to track the new index. There could be a small shock if Italy is downgraded again, but it may be a good opportunity to buy some bonds.
To come back to the SMP – the other structural reason the ECB did not buy inflation is political – the ECB’s mandate is to control inflation, so buying linkers would result in playing against ECB. We have collectively approached the ECB to tell it about the risk of disruption we had in this market, but the ECB has not changed its line so far.
Christian Alibert: One reason linkers weren’t included in the SMP was that it was perceived as an Italian problem. For the ECB, including linkers in the programme could be viewed as tantamount to favouring Italy. Of course, we all saw the impact of them not doing so – breakevens ceasing to represent inflation expectations – and the market became horrendously dislocated.
Kari Hallgrimsson: If the ECB resumes the SMP and it creates a big dislocation again, the sovereigns, and particularly Italy, will probably be quicker to react with buy-backs and switch auctions. Last autumn, they proved they were willing to step in and, as a result, the market was more willing to hold on to certain positions. The flexibility of the sovereigns is key when it comes to the bond indexes as well. My expectation is that the Italian Tesoro could consider stepping in and doing a bond buy-back or a switch auction if Italy drops out of the Barclays index and if BTPei breakevens drop by a significant amount.
Risk: What is the market doing about redenomination risk?
Georges Sitbon: We used to trade the peseta before the euro, and we converted it to euro. It would just be a technical and legal issue to move the inflation swap to peseta or to keep it denominated in euro – the contract would still exist. I think it is pure fiction because it won’t happen but, in case it does, we would be able to plan it and arrange it. It would have been a bigger problem if the index had not been the domestic index, if it had been the Harmonised Index of Consumer Prices, for instance. Then there would not have been any reason for this index to exist anymore.
Kari Hallgrimsson: As [JP Morgan Chase chief executive officer]Jamie Dimon said earlier this month, we have devoted resources globally to scenario analysis such as euro break-up, and this is just part of that. Most banks here have quanto contracts anyway, where you have, for example, payments linked to US interest rates on a euro notional and, in one way, euro-denominated contracts linked to inflation indexes outside the eurozone is just a different angle on that, although the trade wasn’t set forth under those assumptions. The issue is more likely to arise when you’re facing a domestic entity on one side and an international entity on the other. If you’re facing an international entity, it is more likely to continue to be denominated in euros, such as quanto contracts are in general. But, if a country drops out, it will depend on what format the transition takes, whether they say all contracts for domestic entities that previously had euros now have domestic currencies instead. The big question is how switching between having the euro and a domestic currency will work, and how the government will conduct that switch with regard to contracts for domestic entities.
Risk: Basel III will require banks to hold more capital against long-dated uncollateralised trades, which suggests the inflation market will be affected. How will dealers respond?
Christian Alibert: The inflation market is going to be significantly impacted by Basel III and we have taken steps to address this. If you look at long-dated UK utility transactions, what stands out about those is the extent to which the mark-to-market can grow over time due to the zero-coupon nature of these inflation trades. Steps were taken to introduce mitigants, not least of which was the introduction of the pay-as-you-go transaction, which serves to fix the cumulative indexation at intermittent steps and therefore dampen the extent to which the index growth expands the mark-to-market.
The take-up has been interesting. The comments from Moody’s Investors Service on the Southern Water transaction and the fact that it was downgraded as a result didn’t help the product but, if you look in a bit more detail, the overriding point they made was that it introduced a degree of uncertainty in their funding and their cashflow schedules, and that is because they had embarked on a series of transactions that had a variety of fixtures. Some reset after a period of time, some reset after a period of index growth, and there was a randomness to their future cashflow path they had introduced that was formerly not there. Notwithstanding the benefits of the reduction in the mark-to-market volatility, the net result was more variation in their funding programmes, which was more difficult to plan for. If you step away from that and consider the pay-as-you-go transactions that are simply periodic, then they are measurable and the extent of the uncertainty is no greater than the fact that there will be one very uncertain cashflow in, say, 50 years’ time. On that basis, numerous other utilities have continued along this line. It’s not perfect but it has more benefits than detriments.
There are other solutions – we can introduce break clauses, and collars can limit the extent of the inflation index driving the mark-to-market. You can look in the long run at swaptions ahead of fixings, so if you have five-yearly resets, or any other kind of periodic fixings, you could then use swaptions at those dates to mitigate the fixing risk.
More steps can be taken, and there is a willingness to address this. There are a lot of unknowns. Some have lobbied for exclusions, and others will probably follow suit, but no one can get away from the fact that the regulators want more capital to be held against derivatives and the cost of business is going to go up. That is something we are seeing already factored into transactions. There has already been disparity between banks since the introduction of overnight indexed swaps (OIS) discounting, so it can be very difficult to value transactions on a like-for-like basis.
Kari Hallgrimsson: Among the top-tier players, there has been a convergence in pricing Basel III to a greater extent. There are a couple of banks – outliers, if you will – that are a little late to be able to integrate that into their pricing, just as they do with regard to OIS discounting. Hence, the bulk of the major houses in the interbank market are pricing it in to some extent. And how you price in Basel III versus how you price in something like the OIS discounting versus how you price in the credit exposure – those three things all interact when you’re quoting a long-dated uncollateralised structure. The market is assessing this and it is just a question of what the final outcome is, then banks will be able to switch towards that solution.
Risk: Has the Moody’s rating action slowed down the pay-as-you-go structure?
Franck Triolaire: Yes. The pay-as-you-go format is probably the more accurate format for inflation products. In the linker format, you have a zero-coupon-type format, so you create too much of a credit component inside a pure linker. For pay-as-you-go, you can decide where you reset your principal. The fact you pay your uplift gradually – let’s say every five years – means you diminish your credit exposure relative to the linker format. Actually, Italy created its first pay-as-you-go linker with the second BTPei this week. In a clever way, the uplift is paid at each coupon payment. So the problem with pay-as-you-go is it is seen more as a credit product compared to an inflation product when utility companies want to go to the market. But the format is less a credit component. So I really don’t understand why Moody’s made such a comment because the pay-as-you-go managed to create a virtuous circle in the UK market with natural supply. The beauty of this market is that it is much more symmetrical than in other markets. Unfortunately, we should have a drop in activity in this sort of format after such a report.
Risk: How important is it for clearing houses to consider inflation sooner rather than later, and would the industry consider going outside LCH.Clearnet?
Stephane Salas: I’m supportive of clearing. Clearing will bring transparency, and transparency increases volumes. Unfortunately, in discussions we’ve had with LCH.Clearnet, it appears swaptions are coming first. I don’t see inflation derivatives or zero-coupon swaps clearing before 2014. It’s not just the dealer community – it is investors to which LCH.Clearnet is talking. There is a group of investors they have talked to that is looking at potentially clearing inflation derivatives but with the view of gaining possible benefits in terms of margin and the initial margin they would have by being able to net their interest rate derivatives exposure and their inflation exposure. It wouldn’t be wise to go towards different clearing houses. If LCH.Clearnet is already clearing interest rate swaps, one of the benefits will be having a complicated historical value-at-risk measure of margining, where you will be able to get a netting benefit in terms of your margin from the different products you have with it. LCH.Clearnet is definitely the most likely route and that is the counterparty we’re talking to. It should start off with the simplest, which are zero-coupon swaps, but we have already told LCH.Clearnet that we eventually need to clear asset swaps. If we’re in a market where only zero-coupon swaps get cleared and asset swaps don’t, we’ll be missing a big chunk of the market. That will require clearing the embedded zero-coupon floors, but what we suggested to LCH.Clearnet was that, rather than remodelling the floors, all the banks could just commit to providing daily prices on all the embedded floors in the eurozone linkers and Treasury inflation-protected securities (Tips). There are no floors on the UK gilts. Every bank would provide end-of-day prices on the floors for clearing purposes. So zero-coupon swaps, yes – but, very quickly, they will need to clear asset swaps to resolve some of the issues that have led to the dry-up of liquidity on long-dated asset swaps. These issues will be resolved with the standard CSA. If you clear asset swaps, you will also resolve the issue of the discounting methodology.
Risk: What are brokers – and BGC in particular – doing to satisfy regulatory requirements?
Jeffrey Hogan, BGC Partners: We are building compliant environments globally across the asset classes. While inflation derivatives will not be in the first wave of centrally cleared products (this will be interest rate swaps and credit products), and inflation bond products will benefit from being exempt from central clearing and the associated margins, inflation products will benefit as regulation reduces counterparty risk generally and the velocity of trades overall picks up with the efficiency of exposures continually netting down at the central counterparties (CCPs). Once the clearing mandate is phased in to include a variety of inflation products, these positives will accelerate, and BGC is preparing for this by having a single globally compliant front end and single application programming interface for all derivatives classes, which will carry all the ‘made available to trade’ swaps in one location where clients can stream, respond to requests for quotes, and use voice brokers in a single liquidity pool. Overall, in the new environment, execution venues such as BGC will be the central gateways for trading, so we are ensuring that links to multiple CCPs are in place globally and that all reporting requirements for our clients can be met.
Of course some elements of the proposed reforms could discourage liquidity provision and, for example, BGC – along with all of the members on today’s panel – is contributing to the debate by meeting with regulators to highlight that Group of 20 systemic risk management is about post-trade analysis rather than pre-trade transparency and disclosure. It could be crippling for dealers to post, publish and hold prices if so required, and will result in less competitive pricing. In Europe the calibrations in the Markets in Financial Instruments Directive text offer some intelligent relief, but the tone in the US is more complicated, with so many key rules still outstanding and with the US authorities expressing their displeasure with the delayed reform timetable in Europe by extending the reach of the proposed US rules.
Risk: What are the benefits and disadvantages of pre- and post-trade transparency?
Georges Sitbon: First, transparency begins with the internal market – the reading of the fair price and liquidity. In the past, some players did not show transparency in the interbank market (no posts, closed markets, etc.) in order to protect their own interests at the expense of the general one. All of this hurts the market a lot because of the lack of transparency, as well as to develop new products like swaptions. We have been insisting for a long time to have a kind of International Swaps and Derivatives Association fix on inflation that we would commit on. Even this is very difficult to obtain. Our responsibility is to give up the protection of our current positions in the market, providing more liquidity and more transparency to our competitors – that is the way to show more transparency, more liquidity to our clients as well as to LCH.Clearnet. So, it has always been our responsibility to bring more transparency. What will probably make this happen is the clearing issue.
Stephane Salas: Our products will gain the additional layer of control from clearing in terms of the trades being booked properly. Because our product is a zero-coupon product, there is only one cashflow on the maturity date. It has happened in the past when you hear that, on an interest rate swap, after three months or six months, the back office is calling saying it is paying the floating leg as well. You realise that a deal has been input the wrong way. Even if deals are done through MarkitWire, sometimes you have a chain of unlikely events that happen and you end up with one trade not being input in a portfolio the right way. The operational risk component of inflation swaps is all the greater because of that single payment at the end. One of the benefits we will gain from central clearing is the decrease in the operational risk coming from that issue. That will allow us to be much more comfortable, having much bigger portfolios and trading much bigger volumes in and out.
BGC wishes to thank all participants for their valuable contributions to this forum and we invite any feedback and anyone interested to discuss these issues now and in the future.
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