New rules add to basis-risk fears

By Michelle Price

Regulatory rules will force buyside firms to make a trade-off between the cost of continuing to buy hedges in the over-the-counter markets and the additional risk incurred by using imperfect hedges in the listed futures market, analysts and buyside firms have warned.

Speaking at an industry conference hosted by Worldwide Business Research, Will Rhode, principal, director of fixed income research at Tabb Group, said: "Regulation is making its presence felt. The industry response will be product innovation, but this raises the issue of basis risk."

Basis risk measures the possibility that hedges do not always move in an equal and opposite direction to the underlying asset. When a variance occurs in how the prices move, the underlying risk may no longer be offset and a bank or buyside firm's books can be exposed to potential losses.

Buyside firms and pension funds require highly customised OTC contracts to hedge their investments and liabilities. Although proxy-hedges can be found in the cheaper, listed derivatives markets, the standardised nature of these instruments means that they are unlikely to fully cover the underlying exposure, potentially increasing basis risk.

New rules outlined under Dodd-Frank in the US, the European Market Infrastructure Regulation, and additional capital rules, however, are set to dramatically increase the cost of trading OTC derivatives by requiring buyside firms to post liquid collateral against all OTC transactions.

Terence Nahar, investment director, investment solutions team, Scottish Widows Investment Partnership, said that firms will be forced to make a trade-off between the cost of continuing to buy hedges in the OTC markets, and the additional basis risk incurred by using imperfect hedges in the listed futures market.

He said: "Clearly, the futures market at the moment doesn't offer the product range that these types of [pension fund] institutions need to hedge out their liabilities. A lot of the exposures that these funds have go way beyond the 10-year point, they can go out to 50 or 60 years. There is a need for instruments that go that far out on the curve and those products aren't available on exchange, so a lot of basis risk is introduced if institutions were to go down the exchange-traded route to hedge those liabilities. Whether they do will depend on the trade-off of the costs savings versus the basis risk."

Juan Landazabal, head of trading, fixed income, Fidelity Worldwide Investment, said: "There will be some innovation and some swap instruments may end up looking more like futures than swaps, but it will boil down to what you are trying to achieve and the costs of that. As a fund manager we don't have too much in the way of pension-type liabilities, but if you are trying to match that specific type of liability there might not be the depth in the futures market and hence it may still be preferable to use the swap market, despite the additional costs."

Susan Hudson, chief administrative officer, UBS Global Asset Management, said: "The instruments used to offset risk could potentially be too costly [in future]. There are a lot of costs in the overall workflow that aren't well understood yet, and until we get into live situation we're not going to fully understand all the implications for the front office."

Rhode said: "Ultimately, the buyside will go to its service provider who will offer a menu of choices, and some of those choices will require margin costs but match the risk completely, and others will be cheaper but incur a degree of basis risk that the service provider will calculate. It will come down to product selection."