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Bankers have been muttering darkly about the unintended consequences of new regulation for some time. A requirement to clear over-the-counter derivatives trades, combined with new rules on bank capital and liquidity, will have far-reaching consequences that some regulators may not have initially considered, they claim – from a squeeze on high-quality collateral to a reduction in corporate hedging activity. To illustrate their argument, some participants point to a recent, seemingly innocuous rule change for insurance companies and pension funds by Danish and Dutch regulators – an adjustment that has had a massive impact on the long end of the euro swaps curve.
The rule change is rational enough. Nordic regulators, in particular, have been concerned for some time about persistently low interest rates and the lack of liquidity at the long end of the curve, as insurers and pension funds in the region typically discount their liabilities using market rates. Dutch pension funds, for instance, are required to use a discount curve based on the euro swap market – and the low rate setting has meant soaring liabilities and deteriorating funding ratios.
These firms have been keen users of derivatives to help extend the duration of their assets and match their liabilities – and the weight of pension fund hedging has actually contributed to the problem. Many funds opt to hedge with receiver positions in long-dated swaps, receiver swaptions and constant maturity swap (CMS) floors, but that activity has helped force rates in the less liquid long end of the curve lower, in turn requiring them to put on more asset-liability management (ALM) hedges.
Since July however, there has been a strong push against the UFR methodology. For one thing, critics have argued that firms are exposed to the risk that regulators could change the UFR in future, triggering an immediate change in the present value of liabilities – a risk that can’t be hedged. “Assuming you do hedge yourself against the UFR and regulators changed the 4.2 per cent level, you just can’t hedge that political risk. Things get more complex, more expensive – it’s just a disaster”, says Cardano’s Kocken. In addition, participants point out the 20-year euro swap is not, in reality, the last liquid point, and that swap volumes in 20-year to 30-year maturities are actually only slightly lower than volumes in the 10-year to 20-year sector. The real cut-off point, they claim, should be the 30-year point.
As a result, some alternatives have been bandied about. One solution was outlined in a paper written by three executives from Cardano and subsequently published in Risk’s sister publication, Insurance Risk (Insurance Risk September 2012, pages 24–27, www.risk.net/2197265). Essentially, the authors propose using market data beyond the LLP on a weighted basis, rather than ignoring all market data beyond the 20-year point. As the curve approaches the UFR, less weighting is given to actual market data. By making that change, it removes the concentrated exposure at the 20-year point and also removes the reverse exposure at the 15-year segment, the authors say.
The revised methodology means pension liabilities will be less sensitive to the 15-year to 20-year parts of the curve, and funds will still need to maintain some ALM hedges beyond the 20-year LLP. However, the weighting given to market rates decreases over time as the curve converges to the UFR, meaning there will be less interest in ultra-long ALM hedges, participants believe.
That could have a lasting impact on the dynamics of the long end of the curve, he adds. “Each time during a market flight to quality, we used to have bull flattening at the very long end, which was quite often driven essentially by fears of this kind of flow materialising”, he says. “The fact that these potentially destabilising factors should be less strong means we may get a more stable long end and, ultimately, maybe better liquidity because there is less fear.”
That may come as a relief to many market participants, but the episode has clearly illustrated that tinkering with regulations in one area can have ripple effects across the market, participants say. “I’m sure those who invented this didn’t have a single clue about what they were doing, what the impact would be on financial markets and hedging for pension funds and insurance companies, otherwise you don’t come up with this idea. And that’s the risk of politicians and semi-political institutions inventing new regulations”, says Cardano’s Kocken.
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