At the start of 2020, there was widespread confidence the recent growth seen in products linked to consumer price inflation (CPI) would continue. Yet the onset of the Covid pandemic and uncertainty around the timing of the UK’s planned transition of its dominant retail prices index (RPI) to CPI-H – a housing-inclusive variant of CPI – made handling those trades trickier than anticipated.
NatWest Markets rose to the challenge, using its warehousing capabilities and sizeable back book to ensure clients needing to trade CPI could continue to do so.
The bank’s success didn’t go unnoticed by rivals. In late 2020, two members of the inflation trading team were poached by a competitor after the interviews for this article were conducted.
CPI is still a budding market. While some users are comfortable and committed to trading the product, others are dipping their toes into the water. A double whammy of pandemic dislocations and reform uncertainty meant supply and demand in the notoriously illiquid market all but dried up at times.
“Because Covid became such a focus for many institutional and corporate clients, the steady stream of supply and demand we’d seen previously, and clients’ ability to be reactive, diminished,” says Carina Lindberg, a director on the inflation trading team at NatWest Markets, who was one of the traders poached.
There was still trading that needed to be done, however. This meant greater onus on dealers to warehouse CPI positions, as laying off risk was especially difficult in a market where this is already a big challenge.
Banks such as NatWest, with big back books of CPI positions, had an advantage. First, the bank’s internal risk team was already comfortable warehousing risk on an index that wasn’t regularly traded in the interbank market. Second, the bank could provide supply of CPI to clients when they needed it.
A large back book also creates opportunities for strategic unwinds, which can benefit both parties. For example, a short-end CPI trade put on by UK-based renewable power generator Drax in 2019 had by the following year moved significantly in-the-money to the client.
From a client point of view, they just want to buy inflation hedges. And they’re ambivalent between derivative or bond hedgesIan Cooper, NatWest Markets
“We wanted to free up valuable headroom on credit lines, manage our own derivatives portfolio credit exposure and lock in the value on the CPI swap by entering a partially offsetting trade. However, with Covid making the short end of the curve volatile, liquidity was hard to find,” said Chris King, group treasurer of Drax.
This was especially difficult given the direction; corporates usually look to pay inflation, while Drax was looking to receive it. It means supply tends to come from corporates at the longer end of the curve.
NatWest found a neat fix in an existing CPI trade with a UK liability driven investment (LDI) manager dating back to 2014. This client had taken a tactical widening view on the wedge between the two inflation measures. The position, which saw the LDI fund receive CPI and pay RPI, had moved significantly in-the-money to the client, and had rolled down the curve. NatWest approached the firm with an opportunity to unwind the position.
The LDI fund traded an offsetting swap, which saw it pay CPI to NatWest. The bank was then able to pass that CPI supply on to Drax for its own unwind.
The Drax trade came with added complications. As the trade was uncollateralised, the bank was receiving variation margin from its in-the-money hedges, but not enough to cover the full close-out payment to Drax. The cost of funding this extra amount, known as funding valuation adjustment (FVA), would typically be taken off the final payment.
There was no funding cost for us, and if anything there was a slight CVA benefit, because we’re crystallising the position in-the-money to Drax, which we’re able to show to the customer as a resultLuke Hasham-Smith, NatWest Markets
To avoid this haircut, NatWest offered to schedule the payout over time, in line with how the mark-to-market would have evolved if the trade had stayed on. This meant the bank wasn’t paying out cash margin any faster than it was implied to be on the existing trade, removing the FVA chargeable to Drax.
Locking in the risk of the trade also meant the uncollateralised mark-to-market couldn’t evolve. This enabled NatWest to release resources attributed to counterparty credit risk, known as credit valuation adjustment (CVA), and hand them back to Drax. In all, this structure saw Drax go from facing an 8% haircut on its payout to actually receiving a small premium.
“So there was no funding cost for us, and if anything there was a slight CVA benefit, because we’re crystallising the position in-the-money to Drax, which we’re able to show to the customer as a result,” says Luke Hasham-Smith, a member of NatWest Markets’ corporate financing and risk solutions team.
NatWest’s CPI warehousing capabilities came to the fore again in May, when the bank executed a £50 million, 10-year-bond-style CPI swap with a UK water utility. The utility wanted to synthetically convert some of its outstanding RPI-linked bonds to CPI – a transition driven by regulatory requirements for the water sector.
NatWest was not a relationship bank to the company, and its Baa2/BBB credit rating was below the threshold the utility sets for bank counterparties. Yet a combination of pricing for the wedge, credit charge, and the colour and advice provided around execution, saw the utility change its internal credit rating policy to facilitate the trade.
The bank warehoused the position for around two months, speaking to clients about the likely direction of the wedge until it found an insurer seeking a similar CPI exposure to the one NatWest had on its books.
“This was meant to be a big breakout year for CPI liquidity because you had that additional impetus from the reform story, and in the early months of the year, there were some really, really promising signs. And it just suddenly got very, very jammed up by the Covid situation, which is where bilateral conversations rather than wider marketing opportunities came to the fore,” says Richard Turner, who was head of inflation trading at NatWest Markets until December when he was also poached by a rival.
Like all asset classes, liquidity provision for RPI instruments was extremely difficult during the Covid-driven volatility in March. Nevertheless, NatWest maintained its commitment, ranking number one on Tradeweb for RPI swaps by duration weighted volume, and number two on Bloomberg. The proportion of requests-for-quote where the bank couldn’t give a price – known as a no-quote – was just 3% in March on Tradeweb, compared with an industry average that month of 14.5%.
An ability to transact in size during that period was widely praised. “We did a lot of trading in March and they were there for us,” says a senior trader at one UK LDI fund. “We did some inflation trades during the March volatility. Because of their size and relationships, they had the ability to do large size,”
One example saw that UK LDI manager with a 50-year RPI swap look to unwind into a cash hedge on March 6. At the time, there was a significant dislocation in the levels of future inflation implied by the cash market – measured as the difference between gilt nominal and gilt linker yields – and the RPI swap levels. As such, the client wanted to move out of the swap and into the more attractive cash position.
“From a client point of view, they just want to buy inflation hedges. And they’re ambivalent between derivative hedges or bond hedges; they often play the difference between the two to get maximum value for their liability hedging,” says Ian Cooper, head of rates sales for Europe, the Middle East and Africa at NatWest Markets.
The client entered a so-called Iota trade, shorting the existing RPI swap and taking a long position in the cash breakeven. The long-dated nature of the trade and a lack of interbank liquidity at the time, made this very challenging for NatWest to risk manage.
In March, they were the counterparty for us. When lots of banks couldn’t quote, they were thereNick Constantine, Nationwide
Dislocations between cash and derivatives continued through March, as holders of cash bonds looked to raise cash as the crisis took hold. This selling pressure caused cash bonds to cheapen and asset swap spreads to skyrocket.
UK bank Nationwide had cash on hand to take advantage. NatWest sold Nationwide a £50 million 2024 gilt linker on asset swap at an attractive spread. A volatile asset swap spread meant NatWest’s inflation desk worked with the rates team to find a client looking to unwind a nominal gilt asset swap trade to raise cash.
By trading a nominal asset swap to close out a rates client, NatWest effectively locked in the asset swap spread from the Nationwide trade, and was only running the basis risk between the spreads on the linker and the nominal.
“In March, they were the counterparty for us. When lots of banks couldn’t quote, they were there,” says Nick Constantine, a senior manager in the treasury team at Nationwide.
Amid the volatility, NatWest also managed to squeeze in some structuring innovation. The bank worked again with Drax, which wanted to sell RPI swaptions as a way to monetise its entry points for hedging inflation exposures. The company has rolling long-dated exposures, a base of which are hedged in advance. It retains flexibility over how and when to hedge the remaining exposures.
Drax could simply leave conditional orders with dealers to hit when RPI hits certain levels. However, it saw greater value in monetising the entry points by selling RPI swaptions and earning the premium.
The corporate asked a number of banks for ideas but only NatWest initially came back with a structure that worked. The bespoke product sees payment of swaptions premiums deferred to the point when the trade was to be exercised. If Drax didn’t want the swaption to be exercised, it could use that premium to close out the sold swaption and then sell another, in-line with its underlying exposure profile.
The first swaption was done in September 2019 and activity picked up from January 2020. Since launch, the two parties have struck more than 30 trades, and typically less than half would be expected to end up being exercised.
As the corporate trades are uncollateralised, the swaption premium paid to Drax would usually be discounted to take into account charges that would be included if it was exercised, such as CVA and FVA.
But if the swaption is only exercised half the time, the company didn’t want to pay those charges in full. So, the exercised swaps include a break clause that kicks in just after the swaption is exercised – if the corporate wants to take delivery of the swap, it pays up the XVAs and the trade continues.
NatWest also helped clients looking to restructure their books to take into account imbalances between initial margin paid on RPI swaps at the clearing houses versus trading bilaterally.
Corporates typically pay inflation bilaterally and many LDI funds receive inflation at the clearing house. The two risks don’t net out, so dealers are left with large initial margin exposures at LCH. It means an LDI client looking to do a new cleared trade could get a worse rate than trading bilaterally if the trade increases the initial margin requirement at the clearing house. This difference between cleared and bilateral trades is known as the LCH-bilateral basis.
One LDI fund with big positions at LCH spotted that the LCH-bilateral basis had risen to a point where it was attractive to ‘de-clear’ some trades and turn them into bilateral positions. Facilitated by NatWest, this allowed the client to effectively earn the basis. It also permitted the firm to post bonds as variation margin under bilateral collateral documentation, whereas the CCP only allows cash.
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